6. The Banks
All the major banks are bankrupt. The reason that they are receiving Government support is to avoid the chaos that would occur if they went into liquidation, and because ultimately it is cheaper for the British Government to keep them going than it will be to pick up the pieces afterwards. Now a desperate situation for the banks is an impossible one. The question has to be how long the British Government can keep on taking money out of the general economy to support the financial sector by racking up debt that has to be passed on to future generations. Even more frightening is the thought that maybe the point has already been passed when this debt can ever be paid off.
At the moment the Government has no real option but to print money, which diminishes the wealth of the country, or to borrow money and to pay interest on the borrowing which is another way of diminishing the wealth of the nation. Soon no one will be prepared to loan the British Government money so it will have no option but to raise taxes even higher and to print ever increasing quantities of money just to support public expenditure. Even if the current economic problems were to miraculously vanish in 2 years time the wealth of the nation will have plunged. As the UK has no new ways left to generate real wealth there will have to be a further major drawdown in society's accumulated wealth over the next 10 years.
Governments can print money but banks effectively have the power to create money because they do not need to actually hold the cash that they loan. There is much talk about banks being encouraged to lend to one another which at first sight is bizarre because they have such massive holes in their balance sheets. What happened over the last 10 years, thanks to electronic transfers, was that banks and other financial institutions were theoretically lending money to each other that they did not really hold. The days when the banks just lent what their depositors gave them are long gone. If the money is available to them for a short time a bank can offer cash to another bank, take a charge and never actually do anything other than act as a guarantor. The banks also theoretically transferred money between their own departments. The size of the derivatives market shows that there have been some very strange accounting practises going on over the last ten years all based on theoretical money.
At the moment, no financial institution or bank knows what its real level of exposure is. Even the losses between major institutions are still in many cases unclear. It will be a long time before anyone can work out how much money was lent between different internal accounts and it is inevitable that many dubious accounting practices have still to be uncovered. Uncovering the truth of the situation will take a long time particularly as key employees have been trying to protect themselves. Hundreds of billions of Pounds, Euros and Dollars that were lent as sub-prime mortgages will never be recovered. Many prime mortgages are not as secure as they should be as the value of properties continue to fall and unemployment rises. A prime mortgage might have had a good deposit of say 25% but if house prices continue to fall to say 70, 60 or 50% of their 2007 value then many will move into the high-risk category. The current assumption is that most of the people who obtained a large mortgage at the top of the cycle can or will continue to make mortgage repayments. The Government is trying to make this an attractive proposition by dropping interest rates to ludicrously low levels. If these people were to decide that property prices will not rise for the indefinite future they may well elect to renege on their commitments and so transfer their loss to their bank and hence to the Government. The only other option is for the State to pay peoples mortgages for them.
If house prices were to fall by 50% then many of the mortgages that have been sold since 2000 will be suspect. If house prices fall back to the same level that they were in the mid 1990s then the potential loss for the British banks alone will be measured in hundreds of billions and there is no way that the banking sector or the Government, who now owns them, could absorb losses of this magnitude. This is just another reason why the World's Governments are so desperate to get borrowing going again. It is better that people with mortgages pay something and stay put rather than release their properties back onto the market and force prices down even further. As many banks now belong to the State, the Government can rig the market so that people can continue to support unrealistically large mortgages rather than walk away from these liabilities and throw themselves on the mercy of the State. Giving individuals a few thousand pounds a year is much less costly for the Government than having people asking local authorities to house them so again there are ulterior motives behind the Government's policies. Certainly flooding the bottom end of the market with lots of repossessed homes would be catastrophic particularly as the Government would have to pick up the bill now that it owns the banks or more correctly it now owns millions of properties. The only long term hope for the people who over stretched themselves is that there will be rapid inflation over the next 10 years so that their mortgages are brought back to a manageable level. Of course, this approach does mean that those who have money on deposit in a bank are subsidising someone else's borrowing. It also means that the State is benefiting because those people and organisations that have money on deposit in banks are providing money to reduce the Government's borrowing requirements by channelling money through the banks to the State as well as helping to keep the banking sector afloat.
A lot of the money that was borrowed in the last ten years was used to purchase property. All those that owned property and just remained where they were will just finish up back where they started. However millions of people borrowed billions of pounds against the anticipated increase in the value of their property and they are now watching their new found wealth vanishing. At first sight, the British Government does not need to get worried about a collapse in property prices. Private money was used by private individuals to buy private property. Unfortunately, the banks that were lending much of the money were really carrying the risk and they are now nursing such massive losses that they are technically bankrupt. The State has therefore had to get involved to bail out the banks which now means that the un-quantified bank losses are now a problem for the tax payer. Not only have those individuals and businesses who bought over priced property sustained a massive loss but now also the taxpayer. The Government is now engaging in politically motivated intervention to prevent these misguided people from losing their homes. This means that the banks cannot minimise their losses or even determine the extent of their exposure. Politically it may well be the right answer but in terms of getting the banking system going the best thing would be to shake out any losses, to deal with them and to then move on. The trouble now is that the British Government has taken control of the banks and politicians have a lamentable history of mismanaging businesses because they do not understand how markets work. Uncertainty is crippling and insisting that the banks live with such uncertainty makes them reluctant to behave normally. The Government is now over stretched so in the long term the whole population will have to suffer. Yet again money was used yesterday and the debt is now being transferred to tomorrow.
The massive increase in borrowing was not just a British event. It happened all around the World although usually to a lesser extent than in the UK. The price of a house has nothing to do with what it is worth but rather what a bank or building society will lend. When the banks were freely lending money for mortgages all they were doing was buying over priced property. The bulk of the increase in property prices came from banks out bidding each other and even competing with themselves internally. Providing that they were getting enough in repayments to pay for the cost of the borrowed money all was well. They were not asking if this was logical or what would happen if interest rates went up. The banks soon became the owners of a vast amount of inventory and were competing with each other to talk up an already overheated market. Unfortunately as soon as confidence in the system was lost it had to implode because in reality all they were doing was competing with one another for a limited supply of property. The banks were all engaged in supporting speculative borrowing in the certain knowledge that inflation would keep devaluing the quantity of their debt and because of the massive increase in the value of property. As soon as the day of reckoning came, the banks realised that they were sitting on grossly overvalued assets. They cannot sell these overvalued assets because there is no one who will pay the full initial purchase price. However, the banks were just being used by the Government to soak up monetary inflation. This is why the Government was so quick to guarantee the liquidity of the banks when things came unstuck.
The Government does not expect the banks to balance their books - they cannot, – they are bankrupt and it is only public money that is keeping them going. The British Government is fully aware that some of the money that the banks were using was largely theoretical which is why it is not overly concerned about the ultimate size of the debt. It is like an individual investing his life savings buying a rare bulb in the Dutch tulip frenzy. The object was worth little and when reality dawned some individuals lost everything but the majority were all right and a lot of money had changed hands which appeared as increased wealth and which the Government was able to tap. The Dotcom bubble around 2000 was the same. Some people made a fortune and some lost everything. There was nothing substantial there and in the end $5 trillion vanished from company values. This was useful because it wiped out a lot of inflation. UK institutions have lent a lot of money to developing countries. If these countries fail to meet the repayment terms then this money will be lost. Again the British Government will just print more money to replace that which has been lost. With all the money that has and will be 'destroyed' in the next couple of years the British Government will be able to allow even more new money to be printed.
With the banks in its control the British Government will be much better able to control the way in which the economy operates and will be able to channel extra money out of circulation. It will also effectively control the banks portfolios which are worth trillions of pounds. It also means that the British Government will not be competing with the banks when it issues gilts. It also gives the British Government the right to levy an indirect tax on those that use the banking sector. The British Government is supporting the banks by issuing bonds paying 3% and then lending this money to the banks at an interest rate of 12%. The banks are then supposed to go back into private ownership within 5 years. Remembering that all businesses are struggling at the moment, only the British Government can believe that this is a practical proposition. One can only assume that the Civil Servants who put this plan together, are still convinced that the banks can yield the same level of profits that they did in say 2006. Expecting the banks to struggle with massive repayments to the State and to expect them to behave in a generous way with their customers is ludicrous. It is clear that no bank is going to be able to pay such massive rates of interest to the British Government and do anything other than to have to pass the cost of this borrowing on to those who it lends too. It also means that depositors who place their money in a bank will never get a fair rate of return. The banks are still receiving money for businesses and individuals but looking after them cannot be their primary concern. That being the case the outcome of the current arrangement is that the banking system will remain locked in State control for the foreseeable future and those who use the banking sector will effectively be paying the Government for the privilege. In other words the difference between what the Government pays for the money that it lends the banks and the rate that it charges the banks is a useful source of income for the Chancellor.
The losses associated with repossessed homes in the UK could easily exceed £ 300 bn by the end of 2010 unless the British Government intervenes in the system and supports those who are in arrears. Normally this would be unthinkable but with losses like this and with the British Government effectively owning the banks commercial reality will be set aside and the market will be manipulated for political ends. The liability will still be there but the Government will have to enable people to remain in their homes and to keep them repaying their mortgages. Of course, this is only an option if interest rates are held down and if unemployment stays low. The flaw here is that unemployment is rising and price inflation will not stay low for very long and then the Government will have no option other than to manipulate the official data in a most outrageous way. This will cause serious social unrest from people who are expecting their pensions, their pay or their support from the State to match inflation.
If the pound gets into serious difficulty then the Government will have to increase the interest rate back to a more traditional level of say 10% to appease the financial institutions and the IMF. The problem then will be that millions of extra people will not be able to meet their mortgage repayments. Many people will be better off just walking away from their property. The Government will then have no option other than to go into some form of shared ownership with all those people who are in a distressed condition and to give unqualified and unlimited subsidies to anyone who needs them. This will be a massive liability that will stretch the British Government to breaking point.
Published: January 2009