Mervyn spanks banks
The headline news in today’s statement (pdf) by Mervyn King, Governor of the Bank of England, on turmoil in financial markets is his forecast that “effective borrowing rates facing households and companies will rise somewhat.”
It may be a statement of the bloomin’ obvious. But it confirms that the Bank of England is much less likely than it had been to increase its base lending rate for the simple reason that financial markets have done the work already.
We are already seeing signs – in Abbey’s upward tweaks of its tracker mortgage rates for new borrowers – that mortgage rates are rising.
It won’t be long before we see rate rises on other kinds of loans to individuals and companies. And because credit is in shorter supply than in recent years, those unlucky enough to be classified as riskier prospects may be refused loans altogether or may be charged an arm, leg and torso.
But King thinks it is “too soon… to quantify the impact on the economy as a whole”. However he’s clear that we face some uncomfortable weeks and months.
As I explained in a previous blog entry (Liars’ Loans), at the heart of the crisis are three characteristics of modern markets:
- A) securitisation that separated the origination of loans from the eventual ownership of those loans;
- B) bad lending on a colossal scale to US homebuyers with dodgy credit histories, the infamous sub-prime lending;
- C) and a classic maturity mismatch, as special financial vehicles purchased hundreds of billions of dollars of this stinky US debt and then financed their ownership of these long-term loans by issuing short-term securities known as asset-backed commercial paper.
When investors lost confidence in sub-prime debt, the price of that debt collapsed. Which in turn meant that as the asset-backed commercial paper has come up for repayment, the holders of it are either refusing to re-extend the credit or will only do so for very short periods.
In very broad terms, what has happened is that providers of finance from outside the banking system – hedge funds, pension funds, insurers and so on – have simply turned off the tap in respect of certain kinds of credit.
What that has caused is a massive call on banks to replace the lost funds, as official or de facto guarantors of the special financial vehicles.
All of a sudden they have been forced to use their own balance sheets to provide very significant loans to replace the asset-backed commercial paper that had been financing these vehicles, such as the SIVs and conduits I’ve been referring to extensively.
It is a reversal – probably only a temporary one, but nonetheless real – of disintermediation, the great financial phenomenon of the past 30 years, which saw banks become manufacturers of debt-products to be bought by others rather than kept on banks’ balance sheets.
Now, with banks’ demand for cash rising far faster than they had anticipated, it was inevitable that the price of that money should rise. And rates have had to rise even more because – in all the uncertainty – banks became fearful that other banks ability to repay loans was being impaired.
So where do we go from here?
Well King believes – and I agree with him – that we are living through a period of transition. At some point, a two-way market in asset-backed securities will re-emerge. When that happens some holders of those assets will take steep losses. And some clever-clogs will buy these assets for a knock-down, fear-driven price and will end up making a fortune.
As part of the same process, non-bank financial institutions will become less risk-averse again and will be prepared to purchase more diverse assets than just government bonds and high quality corporate debt.
But in the meantime, there will be a greater burden on the banks to finance a greater range of economic activity than they have done over the past few years.
During the journey towards a resumption of normal service, some banks – those who have behaved less stupidly hitherto and have stronger balance sheets – will clean up. They may become bigger and more profitable.
Others, with balance sheets weakened by their recent adventures will shrivel and even possibly disappear, probably by being acquired.
So what should the Bank of England do about all of this?
King is absolutely clear that the Bank should do nothing to bail out banks who failed to calculate properly the risks they were running in providing financial support to the investment vehicles which bought crappy assets with short term loans.
He is very reluctant to do what many bankers want him to do, which is to attempt to bring down interest rates for three-month interbank loans by lending them three-month money against the collateral of all those debt securities no one wants to buy at the moment.
He thinks – and I agree – that the Bank would in effect be underwriting the foolish, greedy behaviour of the banks that precipitated the crisis. In helping them out this time, he would be encouraging them to believe there is no cost to under-pricing risk, such that they would almost certainly repeat their mistakes, only next time on a more colossal scale.
That said, the Bank is delighted to ensure the banks have sufficient liquidity to finance their day-to-day needs. It has a legitimate role in ensuring the smooth functioning of the payments system. And it may well pump a bit more liquidity into the very short end of the market tomorrow.
Also, King confirms that the Bank is prepared, in its role as lender of last resort, to provide a special loan to any bank that faced temporary funding problems but was otherwise seen as solvent. It would wish to prevent the serious economic damage that resulted from a bank collapse. But it would charge a penalty interest rate for such support, in the hope that biting said bank would encourage all banking miscreants to rehabilitate.