Tuesday, October 28, 2008

Europe's sub-prime problem

It was Europe’s dirty little secret. While American banks were lending irresponsibly to homeowners who couldn’t pay, European banks were lending emerging countries who couldn’t pay. Europe’s sub-prime crisis has now come home as heavily-indebted nations of the Eastern bloc - Hungary, Ukraine, Bulgaria, the Baltic states - are collapsing one by one into the arms of the IMF. “Icelandisation” is the new spectre stalking Europe.

And, as with sub-prime in urban America, this latest crisis was shockingly predictable. I visited Latvia at the height of the credit bubble eighteen months ago, and it was clearly an accident waiting to happen. Riga, the capital, ws bristling with upmarket shopping malls and classy bars that were all quite empty. Stalin-era flats were going for $200,000 in a country where the average wage was less than $400 a month. Latvia has hardly any industry, no energy and few natural resources - except trees. But such was the irrational exuberance of foreign banks like Swedbank, it was awash with credit.

According to the Bank for International Settlement, Western European banks have lent over $1.5 trillion to Eastern Europe. Austria has loans equivalent to 80% of GDP and stands to make huge losses as Hungary and Ukraine collapse. This week, the Austrian government had to cancel an auction of government bonds (like our gilts) because it couldn’t be be sure that investors would buy them. It is not inconceivable that Austria itself could end up needing rescued.

Other European countries implicated in global sub-prime include Spain, which has loaned immense sums ($316bn) to Latin American countries like Argentina. Britain hasa $329bn tied up in Asia - or did until values collapsed in the Asian stock market rout. Japan’s Nikkei index fell to a twenty six year low this week wiping out tens of billions. The losses are now winging their way home to British pension funds and banks like RBS and HSBC.

So, banks behaving badly, what’s new? Well, the Bank of England told us this week that global losses from the financial crisis so far amounts to $2.8 trillion, but that only includes a fraction of the likely losses from global sub prime, which have yet to land on balance sheets. Until last week’s rout in the Asian bourses, there were still economists who believed that emerging markets wouldn’t be greatly affected by the credit crunch. Now, the theory that developing countries, led by China and India, have “decoupled” from the West, has been thoroughly discredited. It’s clear that they have been dependent on consumer spending in America and Europe all along - and now that these Western consumers are shopped out, no one is buying their cheap goods. The Baltic Dry Shipping Index, which tracks the cost of hiring ships for international trade, has collapsed by 79% this year signalling a severe global recession.

So, when Gordon Brown hints that Britain might spend his way out of this recession he needs to consider how his remarks might be viewed abroad. There’s no guarantee, in this climate, that the British government will be able to borrow the money to pay for further bank rescues (they’re coming), plus the cost of three million unemployed, plus a programme of Keynsian infrastructure spending, however desirable that may be. Investors are already shunning the pound because of anticipated losses from the UK property crash. Sterling has fallen 28% this year, further than in the ERM crisis of 1992 when interest rates rose to 15%. We could be heading for a classic 1960s run on the pound.

The government hoped that a devalued pound would stimulate exports and pull Britain out of recession, as happened after the Black Wednesday sixteen years ago - but times change. We don’t actually make things anymore and the world isn’t buying anyway, and it has also had quite enough of our ‘innovative’ financial services. This means that Britain’s current account deficit of 6% - what used to be called loosely the balance of payments - suddenly becomes a major economic issue again Borrowing may be a good thing in a recession, but international financiers, sovereign wealth funds, hedge funds and banks may not agree.

The UK of course has the honour of having been the last G7 country to call in the IMF - during the 1976 sterling crisis - and while the government isn’t dusting down the application forms quite yet, Britain’s finances would not impress the fund’s economists. The standard IMF lending conditions are: privatisation, cuts in government spending and increased interest rates. You may notice that we are going in exactly the opposite direction, slashing interest rates, borrowing to spend, and nationalising the banks.

Of course, seen another way, this is only an indication of the extent to which the IMF is no longer fit for purpose in the Great Deleveraging. In recent years, the IMF has been an engine of Wall Street neoliberalism, of financial deregulation, which makes it ill equipped to deal with the new international environment of deflation and banking crashes. There is anyway a fiscal crisis facing the IMF. It only has about $250bn in reserves to throw at a rolling financial crisis that has now engulfed half the planet, from Iceland to Pakistan. Gordon Brown has called on energy exporting nations to stump up more cash for the fund, but there is a strong case for reviewing how the IMF operates also.

Set up as part of the Bretton Woods financial system in 1944, the IMF was designed to cope with episodic currency crises. It is now having to deal with potential insolvencies in countries the size of Argentina as well as bailing out entire regions like Eastern Europe. It will have to be very much better capitalised if it is going to perform this role, and it will have to abandon much of its free market ideology. We need a new set of interventionist institutions capable of managing financial rescues on an international scale.

Ultimately, what is needed is an international central bank with resources to provide liquidity guarantees, recapitalise banks and regulate international financial flows. This is an immense task, and the world may not appear to be ready for it. But it is not a new idea: John Maynard Keynes argued for precisely this during the Bretton Woods negotiations in 1944. He even suggested a world reserve currency “bancor”. This is the kind of thinking we need today.

The alternative, if nothing is done, is international tension and war - all history tells us this. Consider countries today like crippled Ukraine with its large Russian population and its dependency on Russia for energy supplies, right at the moment when Russian dreams of becoming an energy superpower have been dashed by the collapse of the oil price bubble. Look at nuclear Pakistan, where the entire country is disintegrating in financial chaos. And will all those unemployed workers in China - where half the toy manufacturers have gone bust - go peacefully back to the paddy fields?

When leaders of the “G20” group of leading and emergnt nations meet in Washington next month for what is being called “Bretton Woods 11” they’d better believe that they are not just dealing with a banking crisis. They could be deciding the future of civilisation itself.

Wednesday, October 15, 2008

Bankers should resign now

Well, the first thing that has to happen is that those in positions of responsibility take responsibility and resign. Today will see the biggest banking rescue in history as the government effectively nationalises HBOS and Royal Bank of Scotland by taking majority shareholdings in both banks. If confidence is to be restored, then it is surely essential that those who were in charge to step aside. Otherwise, how can investors - now effectively us - be sure that they will be run any differently in future?

There are now indications that Sir Fred “the shred” Goodwin of RBS may be prepared to be dragged from his post if the shareholders demand it. But in what other walk of life would leaders who have presided over such a comprehensive disaster have remained in their jobs for so long? He should have gone six months ago after he promised that the Royal Bank didn’t need to raise money and then launched the biggest rights issue in corporate history. Sir Fred and his doppleganger, Andy Hornby of HBOS have made immense personal fortunes - Goodwin paid himself four million last year alone - from wrecking these two great Scottish institutions. If you accept huge rewards you must accept that when you mess up hugely you accept the consequences.

Their behaviour tells you all you need to know about the culture of modern banking. Andy Hornby is a supermarket salesman out of his depth who moved into dodgy mortgage lending in the belief that house prices would rise forever. Sir Fred went on a buying spree he couldn’t afford at the height of the credit bubble and bulldozed through the sale of the banking group ABN Amro on sheer ego alone , even as the credit crunch deepened. He also led RBS into buying sub-prime mortgages in America and bet heavily on the derivatives market. Yet like the rest of the banking fraternity they continue to behave like masters of the universe even though there universe has imploded and their companies are on life support from the state.

A little contrition would not go amiss - like those Japanese bankers last week who bowed humbly before the people on TV. Not a single British banker has uttered any kind of apology for what has happened over the last year. Yet these are the same people who lectured governments about irresponsible public spending, who attacked trades unionists for trying to save their jobs, who called for manufacturing industries to be closed if they required public subsidies. Now they are demanding the biggest public subsidies in history.

In America they take a more robust approach. When the mortgage giants Fannie Mae and Freddy Mac were nationalised, the top managers walked the plank immediately. Same with the investment banksters who ran Bear Stearns when it collapsed and had to be rescued. Dick “the ape” Fuld of bankrupt Lehman Brothers has been hauled before congressional inquiries to explain how he justified his hundreds of millions in remuneration. No, it hasn’t stopped the stock market from collapsing, but it has at least given some hope to taxpayers that those who have destroyed the financial system may some day be held accountable for their greed and irresponsibility.

Personally, I would call in the Serious Fraud Office, just as the FBI has been called in to investigate Wall St..banking scams. The practices that have been routine in the City of London - like setting up special purpose vehicles to allow risky trades and dodgy assets to be kept of bank balance sheets - must surely have been unlawful. Enron executives are in jail today for doing much the same . These special purpose vehicles - many set up, unbelievably, as charitable trusts - were purpose designed to get avoid tax and evade regulations on banking capitalisation. The collapse of this shadow banking system is one important reason why the banks are now coming cap in hand to the state to save them from insolvency.

Confidence needs to be restored as a matter of urgency. If the stock markets fall again by 20% this week - as the IMF believes is likely - then the entire banking system in Britain will effectively have to be nationalised. The complete failure of banks to lend to each other - or anyone else for that matter - is now becoming a threat to the entire economy. This cannot be allowed to continue. The credit famine will result in a wave of corporate collapses across the world, starting with companies like Ford and General Motors in America which are already effectively bankrupt. There will be thousands of business failures in the UK and millions will lose their jobs.

Iceland, which was big on ‘financial engineering” is bankrupt, and it is not impossible that a large country could default, especially if it happens to be a world centre of the dodgy credit industry. Our banks are insolvent yet with liabilities running into trillions. The government last week threw £500bn at the City in the hope that it would sort the problem, but the verdict of the markets was clear on Friday when panic consumed investors. People keep asking why, if the “plumbing” of the financial system are clogged, can’t someone just unblock it But simplistic metaphors don’t really help in this situation because it fails to understand the psychology of the actors. Plumbing doesn’t panic, it doesn’t indulge in derivative trading, and it doesn’t try to hide from its own responsibilities.

The banks are not lending to each other because they are stuffed with assets which are not worth the paper they are printed on. They don’t want to expose their shaky assets to any market because they will then have to confront the scale of their losses on the property markets and on obscure derivative trades. The countless billions in cash the government - the bank of you and me - is giving to the banks in the form of treasury bond swaps is not working because the banks are hoarding this cash to rebuild their balance sheets. The only way out of this is for all the banks to ‘fess up and for all the dodgy mortgage backed securities to be thrown into a market to find out what they are really worth. The assets are worth something - after all, most are based on mortgages which will be repaid. It is only the fear and, yes, the greed of the banks that is preventing this triage taking place.

This is why it is so imperative that a new generation of banking executives are installed who are not tainted by the debt and bonus culture of the bubble years. We need people who have a degree of social responsibility and a willingness to accept political direction, not plutocratic monsters drunk on their own vanity. There is a very real possibility now that the entire banking systems of the developed world - the G7 - may now have to be nationalised. This is the end of an era - but the last people to realise it are the people who have brought the age of risk capitalism to its end. History will not look kindly on them - so why should we?

Sunday, October 12, 2008

What banks do. And how we got in this mess

Last week, something happened which I never expected to see in my lifetime. There was a general run on the entire British banking system, something that hasn’t happened before, even in wartime. Ordinary people started moving their money around from bank to bank in fear that they might lose their cash. Millions of pound were flowing across the Irish sea for the safe haven of the Irish government’s 100% depositor guarantee. The banks were on the verge of losing public trust, and public trust is the one thing banks need to survive.

We are witnessing what the commentator Martin Wolf of the Financial Times, calls “the disintegration of the financial system”. But how did we get here? How did a few dodgy sub-prime mortgages in American inner cities lead to what is beginning to look like the collapse of capitalism? This is the great unanswered question in the midst of this extraordinary crisis, as banks explode one after the other across the world. We hear endless talk about “deleveraging” “derivatives” “collateralised debt obligation” “credit default swaps” most of which is completely incomprehensible - and very often designed to be. A lot of what has been going on is essentially fraudulent. But underlying it all the jargon is a fundamental truth about banking; that it is based on a kind of confidence trick

It's called "fractional reserve banking". Alone of commercial institutions, banks are allowed to create value out of nothing - they are allowed to lend out money they don’t have. To explain: at any one time a bank may have, say, a billion in assets, but it will have lent out at least ten billion. That ten billion will yield interest - interest on money the bank doesn’t actually own, that is not based on deposits in its accounts. Magic. Money for nothing. But this magic only works if the debtors the bank has lent to don’t default on their loans and that the savers who have placed deposits in a bank do not all try to take them out all at once. If they did, then the bank would rapidly become insolvent, because of the nine billion it has lent out that it never had in the first place. That’s what started to happen last week. The confidence trick began to fail.

Banking practice dates from medieval times when kings and aristocrats deposited their gold with goldsmiths for safe keeping. The goldsmiths noted that they owners didn’t all ask for all the precious metals back at the same time, so they started to lend it out. This is why, until very recently, bank notes “promised to pay the bearer” a sum of sterling silver. It was all based on precious metals. Not any more. Currency ceased to be linked to precious metals in 1971 when America abandoned the gold standard and ordained that, instead, the world should regard dollars as “good as gold” and use it as the universal medium of exchange. This is called “fiat” money, and some economists believe that it is the root of all evil because, with no intrinsic value, governments cannot resist printing more and more of it thus devaluing their currency.

Now, the prevailing view nowadays among economists is that central banks can maintain the value of their currencies by manipulating interest rates up or down to control inflation. But this depends on the willingness of the central banks to do so. It also depends on the wisdom and prudence of the banks who manufacture this magic stuff called credit. For the past twenty years, central banks have seen economic growth as more important than combating inflation, and banks have thrown prudence to the winds.

After the 1987 crash, central banks cut interest rates, and economic life resumed. Again in the late 1990s, after the Asian financial crisis and the near collapse of the hedge fund Long Term Capital Management, banks cut interest rates again. After the dot com crash in 2001, the US Federal Reserve followed by the Bank of England cut rates dramatically yet again, and kept them low for the next three years, stimulating house price bubbles in both countries. The central bankers made saving money a loser’s game. Interest rates were held below the rate of inflation, so anyone who saved actually lost money. The bankers knew perfectly what they were doing - the former Bank of England governor, Eddie George, told a Commons Select Committee two years ago that the housing boom was “unsustainable” but that he and Gordon Brown deliberately inflated it prevent a recession. Unfortunately, it got a bit out of hand.

The other problem with central banks always cutting interest rates was that this encourages the banks to stop behaving themselves. Huge institutions like Lehman Brothers and HBOS started to think they were invincible, masters of the universe, ‘too big to fail’. Banks like Halifax Bank of Scotland piled into property, believing that house prices would never fall, and if they did, the Bank of England would slash interest rates and house prices would rise again. Banks like Northern Rock stopped bothering about the boring business of attracting deposits from savers and started borrowing money on the international money markets to fund ever more ludicrous mortgage lending - such as their 125% “suicide” loans. Northern Rock was still selling these “Together” loans six months after it was nationalised.

This confidence that central banks would ride to the rescue led banks to take bigger and bigger risks. Instead of lending ten times the value of its underlying assets, investment banks like Lehmans started lending out thirty times asset value. This is called leverage, and allowed the hedge funds and private equity groups financed by Lehmans to go on buying sprees across corporate world. They were getting colossal quantities of almost free money. “Leveraged buy outs (LBOs)” became the name of the corporate game. Groups of investors would get together, target a company like AA, borrow to buy it, load it up with more debt, sell it, and move on. Hedge funds flipped multi-billion companies the way amateur property speculators in California flipped houses.

But it was all based on credit, and the dark side of credit is debt. All of this works only so long as the underlying assets retain their value. Using leverage seemed like free money. But when assets decline in value, the ugly side of debt appears in the form of “deleveraging”. If a bank has loaned out thirty times its assets, it has loaned out three trillion on the basis of only a hundred billion in reserves. If those assets lose half their value, the bank finds itself in the hole to the tune of one and a half trillion. Greatly oversimplified, this is what has happened in the last year. A class of complex paper assets called “securities”, based on the value of residential mortgages, started to lose value as US house prices started to slide. The banks suddenly stopped trading these mortgage backed securities because they were afraid of the potential losses that might show up if they did. These assets included the infamous sub-prime loans - fraudulently lent to Americans who couldn’t possibly pay - which were packaged up into “collateralised debt obligations” and sold on to other banks and governments who didn’t really know what they were buying.

That’s about where we stood at the time of the collapse of Northern Rock in August 2007. A general panic among banks froze interbank lending. Governments then stepped in, first to nationalise Northern Rock, then to pump billions of so called “liquidity” loans into the system. In essence, the Bank of England agreed to exchange valuable treasury bonds for dodgy mortgage assets. The banks could use these treasury bonds as a kind of currency, because everyone accepted their value was underwritten by the government - ie you and me.

But then something else happened. Huge Wall St investment banks like Bear Sterns started to discover their assets were declining even more rapidly than expected, and investors started withdrawing their funds from them, causing a kind of bank run. To prevent widespread defaults, the US government stepped in an forced a another bank JP Morgan to buy Bear at a fraction of its value. But this didn’t stop the contagion.

Within the space of six months all the big investment banks on Wall St had collapsed or been merged with other institutions in one of the greatest banking crashes of all time. Then the big mortgage banks started to go under, like IndyMac, Washington Mutual, Wachovia, HBOS, Bradford and Bingley. The two huge state supported US mortgage banks, responsible for $5 trillion in mortgages, Freddie Mac and Fannie Mae had to be nationalised, along with the world’s largest insurance company AIG. Banks which had handled hundreds of trillions of investments were finding that they were becoming insolvent almost overnight. Because fo the global reach of these companies, this became a crash even more severe than the series of banking failures that led to the Great Depression in the 1930s.

We are now reaching what might be called the terminal stage in this crisis. The contagion has spread through the entire banking structure of the West. It has moved from a crisis of liquidity, to a crisis of insolvency and finally to a crisis of confidence in the entire banking system. Suddenly, everyone wants their money out because no one trusts their banks. That essential trust that allowed the goldsmiths to lend on the basis of their borrowed gold, has begun to evaporate. To prevent Ireland’s banks going bust, the Taoiseach last week decided to guarantee all of the deposts in Irish banks, even though it would be impossible for the Irish government to pay up if everyone withdrew. Money is now flooding out of British banks to the Irish “safe haven” which is why Britain and the EU are furious at this unilateral action by the Irish. Meanwhile, European banks are now starting to explode, one by one.

So, what made the collapse quite so catastrophic that even hundreds of billions of liquidity loans were not enough to staunch the flow? Well, the answer appears to lie in what is called the “shadow banking system”. This refers to the unregulated dealing by banks in what are called “derivatives” - these are financial instruments which don’t have a value in themselves, but relate to a future value. Originally, derivatives were things like pork belly futures - essentially bets on the value of that year’s cull of hogs. But a hugely complex market evolved in the trading of derivatives called credit default swaps, which are like insurance policies taken out on corporate debt. In the space of five years the value of credit default swap contracts rose to $62 trillion, larger than the value of all the world’s stock markets. The bank of international settlement in Basel calculated that the total value of all derivatives in the world last year amounted to some $500 trillion dollars.

The market in these ‘over the counter’ derivatives is completely unregulated, and traders are allowed to make bets and enter into contracts without necessarily having assets to back them up. The derivatives banks thought they had removed the risk by using complex mathematical formulae which seemed to indicate that they could so finely calculate the likelihood of making a loss that they could insure against it. These derivatives and the mathematics underlying them were immensely complicated and very few people understand them. Indeed, it has emerged that the people who devised them didn’t understand them either because the whole derivatives pyramid is now collapsing.

But through all the confusion the simple essential fact is that banks have hugely over-lent, their assets are declining, debtors are defaulting and their losses, multiplied by complex derivatives and deleveraging, the losses have become almost incalculable. The banks have had to cut back their lending drastically to build up their capital reserves, and they are now appealing to governments for direct injections of capital. This is what the $700bn Troubled Asset Relief Programme was all about - using taxpayers money to try to shore up banking capital by buying their worthless assets. But the trouble with this scheme. devised by the former Goldman Sachs boss, Henry Paulson who is now US Treasury Secretary, is that no one really knows how big the losses of the banks are, because of this huge amorphous cloud of impenetrable derivatives contracts.

But the story isn’t over there. Not only did the banks lend too much, and binge on dodgy derivatives, they based most of their devilish formulae on a presumption that house prices always go up. Now, statistically speaking, this is arguably the case - over time, house prices have always risen in the long run. However, in the short run, the graph can be a very lumpy one, with rises and big falls. For some reason, the banks forgot this, and thought that the bubble in house prices that was ignited by the 2001 interest rate cuts, would continue forever.

This was utter madness. House prices are now falling to trend - which means to their historic values. This means a reduction of something like 30-50%, because the graph of prices always overshoots on the upside and downside. Look at any historical table of house prices and this is blindingly obvious - but for some reason the banks believed that the laws of economics had been suspended by their brilliant mathematics.

So now what happens? Well, as house prices continue to fall, as fall they must, the value of the assets in companies like HBOS will continue to be marked down. This is why LLoyds TSB shareholders are very reluctant to take on HBOS at any price, because it is stuffed with dodgy mortgages which are falling in value. The banks all hoped that by now the central banks would have cut interest rates and people would all have started buying houses again - and that is what the US and British governments are still hoping will happen. But it won’t and it can’t. House prices are simply too high and have to fall, even with cuts in interest rates. The banks know this, which is why they are refusing to lend unless people can put up large deposits.

This creates a vicious circle which can only be resolved by the assets being revalued. House prices must come down; the banks’ assets must be repriced; insolvent banks must be closed; interest rates must be recalibrated to encourage saving; consumers will have to stop borrowing to spend and everyone will have to start paying their debts. It’s a tall order, and governments across the world are in denial. But the only way out of this mess is some very hard medicine. The longer governments and banks put off swallowing it, the longer the slump will last.

Saturday, October 11, 2008

Darling's having a good war

You wonder why they bother, finance ministers I mean. The stock market fell when Alistair Darling dithered over a rescue package for the banks. So he handed the banks the biggest bail out in history - £500bn of our money - and what happened? The market crashed in the worst panic since 1987. There’s just no pleasing some people

The same thing happened in America. When Congress rejected Treasury Secretary Paulson’s $700bn TARP plan last month the Dow collapsed; when Congress passed it, the markets collapsed again. The lesson seems to be that if you dither things get worse, but when you act they still get worse.
This revolution of falling expectations was a phenomenon noted by the economist JK Galbraith in his study of the Great Depression. It’s all part of the process called “deleveraging” - the modern term for drowning in your own debt. Government interventions, however well intentioned, become stages in the continuing crisis of insolvency.

Shocks like the Icelandic default, itself a knock on effect of the collapse of the investment bank Lehman Brothers last month, leave British savers bereft and British councils with hundreds of millions of losses. This breeds more fear and more government interventions which make markets even more nervous. The latest epic falls in the stock market are partly a consequence of the Icelandic insolvency reinforced by obscure traumas in the credit default swap market. And don’t be fooled that these are just paper losses. Last week’s share-price collapse will hit the asset base of companies and banks causing a further wave of write downs, fire-sales and bankruptcies. We are now in a kind of death spiral.

Last week we nearly saw a run on the entire UK banking system - an event which was only forestalled by the Chancellor, Alistair Darling’s, rescue package on Wednesday. Darling is having a good war, so far. His unflappable calm - which I witnessed at close hand at a reception at Downing St last week at the height of the crisis- has turned into a real asset for the government. He must have known about the bank run as he nibbled at canap├ęs with various hyperventilating hacks. But he looked as if he’d just dropped in on his way to the opera. Not that the Chancellor appeared complacent or detached. No one can accuse Darling of failing to appreciate the gravity of the situation because of that Guardian interview two months warning us that this could be the worst financial crisis in 60 years. He was not wrong.

It’s a sobering thought, but our own Alistair Darling will now forever be associated with one of the greatest economic catastrophes of modern times. His face will adorn every website devoted to the Great Crash of 2008. That curry he bought in to feed his team on the night of the rescue has already become part of history as the “Balti bailout”. Economists and historians will now assess his every move, his slightest utterance. Remember hapless Tory Chancellor, Norman Lamont, outside the Treasury on Black Wednesday 1992 standing next to a dumpster and trying to sound calm while his hair was blowing away in what seemed like a financial hurricane. Further back, Philip Snowden had the misfortune to be Labour’s Chancellor during the 1929 crash and the Great Depression, and is hardly a congenial role model for Darling. The hard-bitten Snowden imposed a fiscal crackdown and split the government, and the Labour Party. with his call for cuts in unemployment benefit. Snowden never recovered. Let’s just not go there.

No, it’s really not a good idea to be a Chancellor in a recession - which may explain why Gordon got out when he did. Finance ministers are largely there to carry the can for everything that goes wrong - and as we know, in a financial crisis, everything goes wrong, even the things that go right. Darling’s economic package last week was in many ways a triumph. It was hailed by economists, commentators and financial analysts as an imaginative and comprehensive solution to the problem of credit drought and insolvency in the banking system. The recapitalisation of the leading banks, backed by colossal sums in liquidity and debt-relief, almost certainly halted the run on the banks. You could almost see people breathe easier. Coupled with the co-ordinated cuts in interest rates, it looked like the government had stepped up to the plate and hit a home run. How much better it seemed than the US Treasury Secretary Henry Paulson’s botched and divisive TARP bailout last month.

The only problem with Alistair Darling’s cunning plan was that it didn’t actually work - at least not in the markets. The FTSE share index shrugged, thought a bit, and then indulged in a senseless act of panic selling on Black Friday.. The FTSE dropped 9% in one day and is now down 40% on last year. The markets are simply not in the mood to be reassured right now, and the fact that the balti bailout was the biggest in history only made them more fearful that things must be really, really bad.

This is what Roosevelt meant in the 1930s when he said that there was “nothing to fear but fear itself”. It is the nature of markets to indulge in self-reinforcing panics which prolong and intensify economic crises. Unfortunately, it is not that easy to halt the fear spiral, as we saw last week. It takes more than a financial package, however well crafted.

So what would work? Well first of all heads should roll - and yes, I know that sounds a bit petty and vindictive, but it’s true. The fact that the bosses of those banks, like Sir Fred “the shred” Goodwin of RBS and Andy “spiv’s spiv” Hornby of HBOS are still in post with their multimillion pound salaries and bonuses is not just a scandal, it is an obstacle to recovery. Until the people responsible are cleared out of insolvent and irresponsibly-managed financial institutions, how can the public, and the markets, be sure that things have actually changed? In any other walk of life, when there is a major failure of leadership, the leaders take the walk to restore confidence.

The other failing is more profound. Everyone accepts that the problem has been one of an irresponsible credit and housing bubble which has now burst with spectacular consequences. House prices are falling faster than in 1991. The debt-model for the British economy is dead, the markets understand that viscerally. Just cutting interest rates and stuffing the banks with public money will not work - and, if it did, might just lay the ground for the next bubble.

We cannot live on house prices alone. Recovery will require a broad economic strategy - like the New Deal in the 30s - involving investment in infrastructure, like fast rail, sunrise industries like renewable energy, and a manufacturing and technology strategy. This is a lot harder than giving money to banks. But as someone said in another context: there is no alternative.

Friday, October 10, 2008

Baugur it! We'll not let Johnny Icelander seize our assets!

Well, it makes a change from fighting over fish. I can dimly recall scenes of from last cod war with Iceland in the 70s - gallant British trawlers biffing Johnny Icelander where it hurt, right in the fish stocks. We lost that one.

But this time it’s personal. The Icelandic fiends have frozen British bank accounts - and they know a thing or two about cold storage up there. Britain retaliated by seizing £4bn of Icelandic bank assets under our anti-terrorist laws. Clearly, these assets were dangerous Icelandic militants armed with suicide belts set to explode in branches of the Bradford and Bingley.

But as ceasefire talks begin in Rejkyavik the horror continues. British savers are being slaughtered in their savings accounts. Other casualties include local authorities with millions lost in Icelandic accounts, housing associations, charities. Even police authorities lost their shirts and now want Mr Landsbanki to help them with their inquiries.

It’s at times like this that the nation has to pull together, so thank goodness for our Great Leader. It's Gordon’s finest hour. “We shall fight them in the branches, we shall fight them in the savings accounts, we shall fight them in the bankruptcy courts and shopping tills- we shall never surrender”.

It may seem an unequal struggle. Iceland has 330,000 against our 60,000,000 - but they do have a lot of puffins on their side. And Iceland is a very cold country where British soldiers would not be allowed actually to fight because of the health and safety. So we will have to use British ingenuity to win this great fight. Undercover bankers with golden parachutes will be dropped on Reykjavik to wreak havoc on their banking system with crazy derivative schemes.

There is one problem though. The Icelanders have already conquered most of our high streets. Over he last decade House of Fraser, Debenhams, Whistles,, Iceland (honestly) and West Ham United, have all fallen into Viking hands as a result of brutal raids led by flame-haired billionaire Jon Asgeir Johannesson backed by Icelandic bank-terrorists. Plans are afoot to seize these stores for Britain and hand them over to the councils as part of recreation and leisure.

Only it isn’t quite as easy as that. Turns out that the Icelandic retail group, Baugur, didn’t actually buy shares in the high street companies, but bought derivatives called “contracts for difference”. This is a wonderful piece of bubble-era financial “engineering” which allows investors to hold a stake in companies without actually owning shares. Or owning the money to buy the non-shares. It means that no one knows who owns what. It’s a mess.

There’s only one solution. Alistair Darling will have to organise a new multi-billion pound bail out of the Icelandic banks, so that Gordon can demand our money back. That’ll Baugur them!

Thursday, October 09, 2008

Fifty billion here, fifty billion there, and pretty soon you’re talking serious money. Except that you aren’t anymore. Fifty billion has become a trivial sum in the new post-bubble world. If it doesn’t have at least eleven noughts at the end of it, people’s eyes glaze over in boredom.

John Paulson the US Treasury Secretary started it with his epic $700 billion Troubled Asset Relief Programme. Chancellor Alistair Darling couldn’t let that pass, so he launched last week’s one trillion dollar bank bail out - that’s 500 billion of your English pounds. The biggest gamble in history. Proportionately, UK’s help for troubled assets is four times as high as the American one. So there.

But this is only the start. This latest phase of the credit crisis has involved the implosion of the $62 trillion dollar - that’s $62,000,000,000,000 - market in credit default swaps. These are insurance policies on bond default, and have been described as being like betting on your neighbour’s house burning down. Only multiplied so that hundreds of thousands of investors are waiting for your neighbours house to burn down.

Trouble with CDS’s is that no one actually knows what happens if the house actually does burn down, because no one knows who is to pay the losses on all those contracts if there is what is called a “credit event”. This is basically what happened after the huge Wall St bank Lehman’s Brothers - a big player in this market burned down leaving a $400bn or so charred hole. No one wants to know who takes the losses for this and banks won’t lend to each other in case they find out.

You might wonder how a 62 trillion dollar derivative market could grow to this size in only seven years when no one knows whether the contracts can be honoured. It’s like betting with a bookmaker who doesn’t have any money to pay you when you win. But no doubt the good old taxpayer will stump up to finance all these derivative losses. It’s what we do. As we speak Mr Paulson is putting the finishing touches to his 62 trillion dollar Derivative Assets Finance Trust (DAFT) which he says will finally get the system going again.

Only that wouldn’t be nearly enough. The bank of international settlement in Basel estimated last year that the global derivatives market has grown to $500 trillion. Now, at half a quadrillion, that really is serious money: $500,000,000,000,000 A nice round sum equivalent to ten times the value of all the shares on all the world’s stock markets.

Soon the trillion will be a pathetic joke uttered only by villains Austin Powers films. If you’re not in the quadrillion game now you ain’t even at the races. Next time Alistair Darling has a curry he’ll have to add three noughts if he wants to catch our attention. .

Now someone might ask where all this money comes from, and it is a good question There isn’t enough real money in the world to settle all those swaps, futures, puts, options and other bizarre contracts - if they all had to be monetized. So what actually are they? The answer is that no one really knows. Somehow bankers have managed to create a kind of virtual world of synthetic finance, a derivative Second Life, where they have been trading all sorts of exotic financial instruments without actually having to put money up front.

But you can be sure they have been making real money out of this virtual machine otherwise they wouldn’t have done it. But that has all gone into property and retirement yachts. So it’s down to the bank of you and me to pay for the next collapse through our taxes and inflated prices. They’ve got a name for this state we’re in - it’s called Zimbabwe.

Sunday, October 05, 2008

The arc of prosperity become the arc of insolvency

Typical. After three hundred years Scotland elects an aspirational and popular nationalist government and looks to make its own way in the world, and what happens? A global financial catastrophe threatens to clobber the Scottish economy senseless. Just Scotland?s luck. It?s back to the drawing board.

Well, not quite. But the SNP government can be in no doubt about the seriousness of what has happened in the last few months. The landscape has changed utterly. The Nationalists rode to power on high employment, high house prices and a sense of optimism that was restoring the nation?s battered self-confidence. Now we will see how they cope with national disillusion as Scots discover that houses are not after all a source of free money, that you actually have to make things to have a viable economy, and that while the state can help it can?t make up for what isn?t there.

The idea of turning Scotland into a Celtic Tiger like Ireland looks decidedly sick now that the Tiger is dead and its cubs are looking to emigrate because they seen no future. Ireland made the terrible mistake of believing that a property bubble equated to real wealth. It wasn?t alone, the UK made the same mistake on an ever greater scale ? but Ireland is now faced with the mother of all crashes in a small island. Property prices are plummeting, and the Irish banks are effectively bankrupt as their extravagant loans face default.

But it is as nothing compared to what is happening in Iceland ? the Nordic Leopard that tried to buy up Britain?s high streets. Iceland became a kind of private equity island in which buccaneering bankers, who would give spivs a bad name, used cheap money to go on a leveraged buy out binge of big retail names like Matalan, Debenhams House of Fraser. They bank-rolled entrepreneurs like Sir Tom Hunter and seized trophy assets like West Ham football club. The Icelanders made Russian oligarchs look prudent. But now that their cheap money has been taken away, the Icelandic banks are collapsing one by one, interest rates and inflation have rocketed above fifteen percent, businesses can?t get loans, supermarkets are running short of currency to buy food and people have reportedly resorted to barter to sell houses because of the lack of credit. The Icelandic krona has collapsed and the betting is that it will not survive as Iceland faces national bankruptcy.

National insolvency may await Ireland too. In a state of panic last week the Irish Taoiseach took the astonishing step last week of guaranteeing all bank deposits without limit. This four hundred billion euro gamble is even more of a moral hazard than the US Treasury Secretary, Hank Paulson?s, seven hundred billion dollar bung to Wall St.. The Irish government has placed the profits of its banks above the welfare of its people by mobilising the entire nation?s financial resources in a desperate bid to bolster the share prices of delinquent financial institutions. Moral hazard is too small a word for it.

This is a tragedy for the countries involved, both of which believed they had transformed themselves from sluggish ruminants into entrepreneurial predators within a generation. The effects will be devastating and long lasting as the ?arc of prosperity? has become an arc of insolvency. It is a crisis for what might be called Celtic neoliberalism ? the idea that small countries like Ireland could slash taxes, borrow like there?s no tomorrow and go on raiding parties to the big old economies of Europe. It?s been a salutary lesson too in not placing all your eggs in one basket case: the banks. Iceland and Ireland thought that they could rely on financial expertise alone to build what used to be called ?a modern service economy? and now looks more like a pyramid selling scheme. Only fools believe that you can build an economy on inflated property prices

It?s a lesson that Scotland needs to learn too because we are too dependent on the banks for our own good. Banks like HBOS delude themselves that they create wealth by manufacturing exotic ?financial products? and generating humungous profits from irresponsible property lending. But all they do is create more and more debt, which ultimately trashes real economy. The Royal Bank of Scotland, under Sir Fred ?the shred? Goodwin went on a buying binge, lapping up sub-prime loans in America and dodgy European banks like ABN Amro. It is astonishing that, after the largest rights issue in corporate history, and an unprecedented collapse in RBS shares, Sir Fred is still in post. As is the spiv?s spiv himself, Andy Hornby of HBOS. I?m sorry: these are not the people you want anywhere near running the country.

So the SNP needs to learn how to distance itself from the banks and shun the financial pirates who brought Ireland and Iceland to its knees. The Nationalists have already damaged themselves by association, holding up these egregious examples of collective greed as national role models. This is all the more surprising because there are other rather better models which the SNP could have be looking as as small countires which have tamed their banking tigers.

Both Sweden and Norway had banking crises in the early Nineties. The Scandinavian banks collapsed after ? yes you?ve guessed it, a credit and property bubble in the 1980s that burst just like ours. The Norwegian government moved quickly, driving down the shares of the banks to zero, nationalising many and taking an equity stake in the rest. It restructured and recapitalised the banks and then sold them off, so that the Norwegian taxpayers didn?t lose and the bankers didn?t get bailed out. It was the reverse of what the Irish have done, which is to hand unlimited taxpayers money as collateral to the very bankers whose irresponsibility brought the country to ruin.

Why has there not been more discussion of the Norwegian bust? I don?t know, but perhaps it is because it carries a hard lesson: that you have to destroy the bad banks before you can rebuild good ones. Bailing out the existing banks is folly, as is basing a national economic policy on insititutions that have little financial wisdom and even less moral integrity. It is understandable that the First Minister, Alex Salmond, has like his Labour predecessors been bigging up Scotland?s banks as national champions ? they employ a lot of people. But it is a devil?s embrace which could destroy his party and destroy the country. If independence were to happen, it cannot be on the terms set by the banks. As Thomas Jefferson observed, if you let them anywhere near the seat of power: ?the banks will,first by inflation then by deflation, deprive the people of all property until their children wake up homeless?.

Saturday, October 04, 2008

Peter Mandelson is to politics what the naked short seller is to corporate finance. Bringing back the @prince of darkness@ was one of those ideas that probably sounded great late at night after a few beers, but should have been abandoned in the cold light of day. What is worrying is that there is clearly no one around the Prime Minister capable of telling him so.

Yes ,I know all the arguments for having the former Labour spin-doctor back in cabinet - about ?keeping your friends close and your enemies closer?. Having Peter Mandelson in the tent stops the Blairites setting fire to it; grabs the attention of the business community; shows Brown is capable of commanding the news agenda; marginalises rivals like David Miliband; creates a kind of ?war cabinet? of all the talents to deal with the economic crisis. But really, this is not an act of decisive leadership; it is a gesture of Prime Ministerial attention-seeking . Brown couldn?t think of anything sensible to do, so he did something daft.

Why is it daft? Well first of all, because Peter Mandelson is, as the Labour MP John McDonnell poijnted out, the most divisive figure in Labour politics. He is an accident waiting to happen. He has resigned from cabinet twice ? the first time as Trade and Industry Secretary in 1998 after he failed to disclose a large loan he had accepted from a wealthy ministerial colleague, Geoffrey Robinson, who was under investigation by his own department. His second resignation, in 2001, followed his apparent canvassing for a passport on behalf of a billionaire businessman, Scrichand Hinduja. With form like this, every action of the new Business Secretary, will be under scrutiny by a sceptical press. Every disaffected official and political contact will be on the lookout for dirt.

.And is twice-disgraced Peter Mandelson really the man to clean up the City.? There is a lot of prima facia evidence emerging from the mortgage bust of fraud, malfeasance, misselling, accountancy irregularities and plain theft. Look at what we are learning about the corporate culture of banks like HBOS. Of Bradford and Bingley. How can Mandelson,with his record, be expected to crack down on bad behaviour by the banks? Yes, he has done the crime and served his time in political obscurity. But his resignations have fatally undermined his probity, and that will make it very difficult for Peter Mandelson to carry credibility when it counts, when dealing with the spivs and speculators. They will sense his moral vulnerability and will exploit it.

Moreover, Peter Mandelson is an evangelist for globalisation and deregulation right at the moment when free market idolatry has become discredited. He is the minister who famously said he was ?seriously relaxed about people becoming filthy rich?. Well, he should not be relaxed. It was the pursuit of extravagant personal gain that led to the breakdown in the financial system, as bonus-driven executives took greater and greater risks in their determination to become filthy rich before the system collapsed. At this crucial time we do not need someone in charge of the store who adores wealth the way Peter Mandelson evidently does.

As European trade commissioner, Peter Mandelson antagonised developing countries because of his commitment to free market globalisation and his willingness to expose vulnerable economies to the predations of supercapitalism. And it isn?t just development organisations like the World Development Movement who think he is a neoliberal bully. Mandelson managed to fall out spectacularly with the Chinese over clothing exports ? the infamous @bra wars~- and with the French President Nicholas Sarkozy over agriculture tariffs. The Doha round of international trade liberalisation collapsed under Peter Mandelson?s watch, and while he cannot be held entirely to blame for that, his unthinking commitment to globalisation certainly played a part in its downfall. The Prime Minister has hailed his experience in international economic affairs ? but what exactly does this experience bring to the UK cabinet as Secretary for Business, Enterprise and Regulatory Reform? Further deregulation, no doubt, of the kind that has turned Britain into an unstable hedge fund.

So, Peter Mandelson is unreliable, tainted with sleaze, handicapped in office, confrontational in negotiations and passionately committed to precisely the kind of unregulated financial globalisation that has brought the world economy to the bring of total collapse. But there is something much worse that Peter Mandelson brings to the cabinet table. He is the author of Labour?s original sin: spin.

I well remember, on the day of John Smith?s death in 1994, watching Peter Mandelson oiling around the Lobby in Westminster - where I was a political hack - working the press, easing Brown out and easing Blair in. Mandelson functions by cultivating a handful of press insiders who are fed stories provided they remain on message. Sometimes the stories are even true. He is an incorrigible manipulator of the media, a politician who simply cannot stop plotting and briefing. He tried on many occasions to give up his addiction to the black arts of spin after he entered government in 1997, and invariably failed.

A cabinet with Mandelson sitting in it will be a cabinet which is always looking over its shoulder, permanently waiting for the knife in the back. Brown hopes that they will all think Mandelson?s knife is now being wielded in the interest of the Prime Minister, and that this will keep them all in line. Like Stalin who used the psychopathic secret policeman Beria to frighten his politburo. But fear is not a climate that encourages stable and effective government.

Gordon Brown clearly feels rejuvenated, intoxicated even by his conference success and his recovery in the opinion polls. He feels he is in charge again, driving events, making headlines, just like the old days. But this isn?t the old days. Labour is a tired and discredited administration led by a Prime Minister who has lost his way and is profoundly unpopular ? more unpopular than any Labour Prime Minister in history. His attempts to surround himself with cronies and manipulators will not help him recover his political standing and will only diminish him in the eyes of history.

Gordon Brown faces his nemesis in Glenrothes in about four week?s time. Does he seriously think that Peter Mandelson is going to help him win that important by-election? Of course not. He expects Mandy to do what Mandy does, and find ways of creating diversions, identifying scapegoats, burying bad news. It is another profound shock to those who have always respected Gordon Brown as one of the great Labour politicians of his generation. That Gordon should have descended to this desperate rehabilitation of a discredited political fixer is not just bad, it is sad.

Friday, October 03, 2008

Tories offer free buckfast

We all know that Alex Salmond is a miracle worker, but last week he surpassed even himself. He managed to get students up early enough to go to nine o’clock lectures. Admittedly they were up at the crack to lobby parliament against banning alcohol sales to under 21 year olds, but at least it was a start. Perhaps the Scottish government should propose banning sales of pot noodles or mobile phone ring tones. It would be a revolution in student behaviour, a new dawn of higher education.

The Scottish Government’s plan to come between the Scottish teenager and his bottle has won few supporters. Libdem, Tories, Labour, Greens - even Margo MacDonald - agree that banning off licence drink sales to under 21s is a violation of human rights. A unique and historic political consensus has been forged in Holyrood. They may not have been able to unite in defence of the Union, but when it comes to alcohol, the opposition parties are shoulder to shoulder at the bar of public opinion.

“It would be a ludicrous situation”, thundered the Tory spokesman, Murdo Fraser, during last week’s debate, “when a 20 year old soldier back from Iraq or Afghanistan cannot buy a bottle of champagne from an off-license to celebrate his safe return with his wife”. This conjured an image of battle-hardened squaddies roaring around Buchanan St waving bottles of Heidsieck and Mumm. Clearly Murdo knows some pretty well-heeled sodjers.

The point is taken, though. What does the SNP Justice Secretary Kenny MacAskill think he's doing trying to stop young adults who can vote, fight and marry being able to buy a six pack in Tescos? Especially when they can legally blow the housekeeping getting rat-arsed in the pub next door. Perhaps a lot of SNP supporters are publicans and this is a fund-raising project. The Nats say that pilots in Larbert, Stenhousemuir, Armadale and Cupar showed a reduction in crime, but they would wouldn’t they. They’ve probably got nothing better to do there than go to the pub and drown their sorrows.

Clearly the SNP think it will show them to be tough on neds and tough on the causes of neds. Kenny MacAskill tore into the Tories for having “moved from Cameron hugging a hoodie to Murdo Fraser’s free bottle of Buckie”. Tories giving away free tonic wine! Now, that’s the way to win the youth vote. Another MSP helpfully pointed out that in Inverness offys they’re knocking £2 off a bottle of Buckfast if you buy two. Now they were talking.

MSPs rejected the alcohol sales limit in the Tory-sponsored debate by a wide margin - and then knocked off to the pub for a post-match analysis.