How to play dominoes

I keep getting an error (good old Beeb) when I try to post on Robert Peston’s blog. What I wanted to say was:

“Rob, Why does the link to this blog entry [Postscript: broken, i.e. story changed – unprofessional by the Beeb, as usual, where’s the audit trail?] refer to a ‘secret bank meeting’? Be careful. Btw, I don’t agree with Robin Bruce that the NR accusations against you are ‘unfair’.”

Here, in my space, rather than Rob’s, I’ll go further. I fail to understand why Peston is receiving awards for the scoop of the year (the NR “emergency” loan). I suggest that we make appropriate laws so that the next reporter that provokes a bank run instead finds themselves “helping with police enquiries”. Laws that will also ensure that the next media organisation that allows this to happen is instead the organisation that has to lay off 1/3 of its staff and whose shareholders are “punished” and executives disgraced.

And now it’s happening all over again with Bear. People who’ve invested their entire working lives into the organisation have been wiped out overnight: “‘My life has been flushed down the drain,’ one senior figure [said]”. Imagine how this must feel, all you so quick to apportion blame. Imagine, Mr King, as you still apparently smugly believe: “…there should be some ‘moral hazard’ in the system and… banks should not expect the central bank to step in to ease their funding crisis.”

I went to a discussion yesterday evening about “money” – the topic being “where does it come from?”, I think. It was quite clear that the average (educated) person has little clue how the financial system works, so perhaps it might be best if I don’t bandy about terms like “liquidity” and “risk” on the assumption that people will be clear what I am trying to say. Let me first try to explain a few points, and maybe convince a few people that “moral hazard” is a bankrupt concept, morally and intellectually.

First point – I know nobody understands money – but let’s nevertheless talk about risk. Who takes the risk when a loan is made, say to buy a house? Well, the answer is it all depends. In some US States, the bank takes all the risk, as I noted before. Yeap, can’t pay the mortgage, just walk away, yippedee doodaa! And this, of course, is the root of the entire global credit crisis.

That may seem a bit odd to those out there who, like me, lay awake night after night in the early ’90s worrying about the negative equity over their heads. No, indeed, ‘cos over here in the UK, we’re tough. Walk away and the banks will hunt you down. In fact, there’s still the occasional story in the papers of court cases from the ’90s crash, only now finally being resolved.

Let’s put it in starker terms. You’ve all been to the movies. I watched “Mean Streets” on DVD the other day. Borrow off the local hoodlum, and it’s you that’s taking the risk, not him.

See what I mean, there are risks to all parties involved in a lending transaction – and, as Scorsese demonstrates in “Mean Streets”, to third parties as well.

For the record, IMHO, the UK system is superior. It is in the general public interest for losses to the banking system, in which we all have a stake, to be minimised. It won’t stop people making mistakes, but it is in the general interest for people who take on debts to pay them back (and IMHO, bankrupts and IVA beneficiaries should have to pay back their debts forever, if necessary, as long as they are earning enough money, in a similar way to student loans, or by having a higher rate of tax).

So, second point, what is a systemic problem? Answer: it’s a problem that affects an entire system. While house prices are rising, all those involved in the mortgage-lending transaction are hunky dory. When prices start to fall, then problems arise for those carrying the risk, which, as I’ve demonstrated, is arbitrary – it depends to a large degree on local circumstances.

One way to contain the problem is for individual home loans to be as isolated from each other as possible. That is, they have to be paid back (i.e. via mortgage indemnity insurance and/or being hunted down by Jack Bauer). The impact on the bank – and the banking system which we all rely on – can only be minimised in that way. This is why I believe the UK system as it operated in the ’90s to be superior. Somehow the Building Societies survived, perhaps against the odds. Who knows what this daft Government will try to do this time, though.

A systemic problem, then, is one affecting a whole system, in the case in point the US housing market and banking system – at first parts of them, and now pretty much the whole caboodle, not to mention much of the rest of the global economy. Whoops.

What we have is a uncontained systemic risk problem. One that we have so far failed to solve.

Third point, let’s introduce another concept: scapegoating. Scapegoating – making one or more people the scapegoat – is a great way to deal with systemic problems. Instead of fixing the system, those involved agree that only some people are wholly to blame for the problems – whether they are in fact solely guilty or not. These people can be stoned, sacrificed or shot depending on societal preferences, or, in the case of financial systems in our civilised modern world, bankrupted and/or disgraced.

Fourth point, scapegoating works best when people can be convinced that it is not in fact scapegoating, but true apportionment of blame. In the modern world, some kind of intellectual justification tends to work best. And this is where the concept of moral hazard comes from. It is at best a bit of fashionable pseudo-science. The idea is that if you bail people out when they run into problems “of their own making” – especially due to risks they’ve taken – then they will repeat the same behaviour.

And that’s why, when Northern Rock ran into difficulty, the people who had bought mortgages from it were forced to sell their houses to pay the bank’s depositors who wanted to withdraw their money. And with everybody selling at once, most people had to sell their homes for less than they bought them for and were hunted down by Jack Bauer… Oh, sorry, that’s not what happened.

No, moral hazard is why Northern Rock’s depositors lost their savings… Oh, sorry…

No, in this case Merv and Gordo decided (while Darling fetched their coffee) to blame Northern Rock’s management and shareholders. That’s right, the intermediary between the lenders (the depositors) and the borrowers (the mortgagees) was deemed solely to blame for the “excesses”. Get rid of them and we don’t have to fix the system. We are not all to blame – we, the depositors, the homebuyers, and most of all those (Merv and Gordo) supposedly overseeing the whole system and responsible for its health, no, we‘re not to blame – so we can blame Adam Applegarth and the Northern Rock shareholders. And we’ll try to regulate the banks even more… and history will repeat itself (with a few twists) in another 10 or 20 years.

Let’s sum up:

  • scapegoating doesn’t solve the problem because it doesn’t fix the system (and in fact makes it more difficult to fix the system, because it implies the cause is understood – it was those wicked people, um, doing their job);
  • moral hazard is a pseudo-intellectual justification for scapegoating.

What might improve matters?

Fifth point, let’s introduce another concept – expectations. It is scientifically proven that people make decisions according to their expectations of the future. Momentum investing (buying assets that are already rising – or falling – in value) is illogical (since the market should already have determined the value of particular assets), but works [I’ll supply a link if I find it].

The moral hazard concept is insidious, because it is partly true – it is based on not setting false expectations. The trouble is, it does nothing to address movements in the value of assets such as houses. It is in fact entirely rational to buy when house prices are rising. And to loan money to people buying such houses. Everyone expects prices to continue to rise, because they know that’s what everyone else expects. No-one has any way of knowing when house prices are about to peak. And, as I say, it has been scientifically proven that whatever the absolute value of an asset, such as houses, if it is rising, it is more likely to continue to rise than not.

Hmm, so how do the authorities stop bubbles and subsequent busts? Well, they can either adopt policies aimed at keeping price growth at a certain level or they can try to slow the crash. And they’ve done neither.

House prices are not included in the otherwise successful targeting of inflation.

And back to our game of dominoes, the authorities have made the problems worse by failing to assist the intermediaries – banks and building societies – enough. Or rather, they’ve failed to make it easier for them to help themselves.

Let’s introduce some more concepts.

Point six is the idea of the balance sheet. Banks have assets – in particular, loans, such as mortgages, which provide an income, and which they could sell – and liabilities – in particular, deposits, which could be withdrawn at any moment. Assets minus liabilities gives some idea of the value of the bank.

Now, what’s happened is that some of the assets for some banks have suddenly become worthless. Now, assets, such as mortgages for x pounds, are risky – they may be worth £x + interest or somewhat less than £x. Nobody knows yet. Banks have to avoid the value of their assets falling below their liabilities at all costs. When some assets turn out to be worthless, they can do two things:

  • stop lending to ensure that the x pounds they have remains worth x, instead of an indeterminate amount;
  • raise more capital (or retain more profits).

That is, they can sell more shares in the bank, so that the difference between their assets (those mortgages) and their liabilities (those accounts) is higher. This gives them more headroom for taking on those risks, that is, for writing mortgages. Allowing people to buy houses again and stop prices falling

So, point seven, and this is what I’m leading up to, what you really want to do, is to get more private capital into the bank – and, if you’re Merv, or Ben/Hank – and I should say, Hank has stated this explicitly (link when I find it) – into the banking system in general.

So what’s happened? NR: shareholders willing to put up £700m. Amount of extra capital put into the UK banking system by nationalisation instead? £0.

Bear: Citic (China) offering to invest $1000m. Amount of extra capital put into the US banking system via Bear Stearns? $0 (JPM took out Bear with shares rather than cash, Citic cancelled investment).

Now, point 8, we have certain beneficiaries of these exercises to wipe out those shareholders as the evil Professor Roubini puts it. Let’s try to work out who these are:

  • the UK taxpayer – but only in the long-term if they succeed in privatising NR and don’t lose court cases to the expropriated shareholders (and I think they’ll lose hands down);
  • JPM;
  • competitors of NR and Bear (who may have had a hand in cutting off their lines of credit);
  • short-sellers in NR and Bear, rumour-mongers among them.

Remember, you need shareholders to provide the capital to take risks. Writing mortgages is inherently risky, and until banks restore their capital, they can’t write mortgages, house sales will be sluggish, and house prices will keep falling, and there will be more defaults, wiping out bank capital… perpetuating a vicious spiral.

Now, NR’s assets are very likely greater than its liabilities. Why should the UK state benefit? And why should short-sellers of NR and Bear stock benefit?

Ditto, Bear, though there is some doubt as to the value of its assets. But why should JPM Chase benefit?

Now, maybe the NR and Bear shareholders are less deserving than the UK state and JPM, but let’s just take a step back from all the judgementalism and emotion. Let’s try to be practical. There are two important questions to answer from a general public interest pov:

Q1. Will the nationalisation of NR and Bear takeover lead to more capital being put into these banks than would otherwise have been the case?

Q2. Will the nationalisation of NR and Bear takeover lead to more capital being put into the banking system as a whole than would otherwise have been the case?

A1. This is very easy to answer. No. It would be illegal for the UK Gov’t to put more capital into NR. That’s sorted! And if JPM wanted to raise more capital it could have done so anyway.

A2. OK, so far, we’re £700m of risk capital down on NR and $1000m on Bear. That’s ultimately a bit of a bummer for the old Ango-Saxon housing market, but not that much dosh in the great scheme of things. But, and here’s the $64billion question, is it now more or less likely that people will go to their 100% taxpayer guaranteed UK or US savings account, take the money out and buy shares in their bank instead? Well, my friends, I need hardly spell out the answer. Yours truly will not be buying any more bank shares in a hurry. And certainly not while short-sellers are trying to wipe out HBoS and LloydsTSB.

The domino effect is that the failures of NR and Bear have made further bank failures more, not less likely. Boils may have been lanced, but MRSA has infected the wounds.

Now, here’s the big idea.

Instead of saying the shareholders should be “wiped out”, a less face-spiting idea (not everyone’s nose is insured) might be to say: “the shareholders better put up some more capital or risk being wiped out”.

What I suggest is that in the event of the next NR or Bear the bank in question (could be anybody now) is taken into a sort of Chapter 11 for banks. Protected by the overseer (Fed, BoE, ECB) and ordered to raise more capital on pain of bankruptcy/firesale etc. I believe it is rational for at least some existing shareholders to invest more. The value of the bank is uncertain. If they don’t invest more they definitely have £0. If they do, they have the £x they put in, plus £y that the bank is actually worth. Unless they believe £y to be negative they should put up more dosh.

Like quite a few other people, I thought exactly this sort of capital raising exercise was what was happening in the case of NR, which is why my opinion of Messrs Brown and King is now unprintable.

I fundamentally do not believe that banks should be allowed to fail because they run out of liquidity alone, if shareholders are prepared to put up more capital. This is a recipe for dominoes to fall. The financial system should in any case be a machine to find out which risks were ultimately worth taking and which weren’t. For this to happen the game must finish. If only the biggest banks can survive each crisis, then even bigger losses are ultimately possible. Because, the way the game is being played now, at least some banks are going to fail in every crisis. And we have no way of knowing whether this was because the business they did was bad or not.

But the main point is that when we stop this childish game of punishing shareholders, we start to see that there are ways of getting more capital into the banking system.

If the Fed and the BoE end up holding vast mortgage portfolios, whilst no-one is writing mortgages, because they’re losing money year after year, and can’t raise capital, because investors see their stock as a gamble and not as an investment, then the taxpayer will really suffer.

I see no reason why house prices anywhere – US, UK, Europe – wouldn’t drop by 50, 60, 70% in such a scenario, before enough people could afford to buy property outright to arrest the fall.

So, Rob, if HBoS ever were in trouble, then I’d hope Merv and Gordo were having secret meetings. Put the kettle on, would you, Darling?