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Archives for September 2007

The shame of smelly banks

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Robert Peston | 14:00 UK time, Wednesday, 26 September 2007


That no bank put in a bid for the three-month loans on offer from the Bank of England was wholly predictable. As I said in my note yesterday, if someone is charging you £6 for five-pound notes, but you can have them at £5.50 in the market down the road, what are you going to do?

The Bank was charging £6, in effect. And the only takers would have been those barred from the market.

So does the total absence of anyone wanting the Bank’s readies mean that the banking crisis is over, that it’s business as usual, that there are no residual liquidity problems for any small banks?

No, no and no.

Confidence is returning to markets. The rates being charged by banks for lending to each other have been on a steady downward path for a few days.

But credit is still pricier than it should be. And there remain serious challenges for smaller banks when endeavouring to finance their lending activities. They are succeeding by their skin of their teeth – but it isn’t easy.

The Bank of England isn’t abandoning the auctions. It will hold them on Wednesdays in each of the coming three weeks.

A reasonable criticism of the Bank is that it is charging too much for this money (see Banks' Scary Auction). The funds are attractive only for banks with the financial equivalent of devastating BO and which find it hard to raise funds from other banks. But, understandably, no bank dare admit it wants the Bank of England’s cash, because that would be the equivalent of sticking up a hand and shouting, “Look at me, I smell”.

However it makes sense for the bank to offer the money again in coming weeks, just in case the BO is a symptom of a rather more worrying condition.

Banks' scary auction

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Robert Peston | 14:45 UK time, Tuesday, 25 September 2007


How do you cause a run on a bank?

Well, according to the wags in the City, you put a brilliant economist and two former Whitehall permanent secretaries in charge of the Bank of England.

It's not the funniest joke ever and it's not fair. But it contains a grain of truth.

bank_of_england4.jpgThe Bank seems to have lost the feel it had for markets during the previous few years when successive deputy governors were former investment bankers (also, the previous Governor, Eddie George, had a nose for the important weather in the City, even though he was a Bank lifer).

So will the Bank redeem itself with tomorrow's £10bn auction of three-month loans?

Well, it has already injected just a bit more confidence in markets simply by announcing that it would be having the auction. Bankers are reassured that the Bank is at last prepared as a matter of routine to lend longer than overnight and against a much wider range of collateral than hitherto. By way of evidence, the interest rates at which bankers are prepared to lend to each other have come down.

But this very success could also spark disaster.

The Bank is charging a penal, minimum interest rate on the three-month money of base rate plus one percentage point, or 6.75 per cent.

Why? You all know the answer, so repeat after me: "moral hazard". Yes it is once again because of Mervyn King's understandable fixation on spanking the banks for getting us into this money-markets mess in the first place.

But here's the problem with his refusal to charge a market interest rate, as opposed to a punitive one. A bank would have to be truly desperate to want to take advantage of the pricey money - and heaven help said desperate bank if its identity were to leak.

The big banks, HSBC, Royal Bank of Scotland, Barclays and so on, are awash with cash and have no problem borrowing from other banks at the interbank market rate of 6.34 per cent. So it would be totally irrational for any of them to borrow from the Bank at 6.75 per cent and none of them will do so.

The only banks for whom it would be rational to take advantage of the Bank's auction would be those smaller banks in danger of running out of money and to which the other bigger banks don't dare lend.

In other words there will be a massive stigma attached to accessing the Bank's new facility. And for that reason, no bank would do so unless it were in pretty dire straits - which magnifies the stigma.

That said, in theory the names of any borrowers won't be disclosed. But I am not sure that's sustainable under Stock Exchange listing rules. Asking the Bank of England for this money is so plainly a massively price-sensitive event (it would knock the relevant bank's share price for six) that the borrowing bank would surely have to tell its shareholders that it had done so. Just remember how the share prices of Alliance & Leicester and Bradford & Bingley were pummelled by unsubstantiated rumours that they were running out of cash.

There's only one bank which can take advantage of the auction with impunity. And that's Northern Rock - simply because its reputation has already been smashed up by having received emergency loans from the Bank of England. In fact, it would probably be irrational for Northern Rock not to participate in the auction.

The risks of doing so for any other bank are daunting, to put it mildly.

Some bankers are therefore trying to gee themselves up with the thought that Mervyn King might yet have a Damascene conversion.

If at this last hour the Bank switched to charging a market rate, all the banks would be delighted to participate in the auction - because there would be neither be a prohibitive financial cost nor a devastating reputational one.

Taking stock of the Rock

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Robert Peston | 10:03 UK time, Sunday, 23 September 2007


Time to take stock of the astonishing consequences of Northern Rock’s decision to apply for emergency help from the Bank of England on September 13.

Here is where we are today:

1) The Government is underwriting all deposits in the British banking system; it has said that no depositor need fear the loss of a bean, thereby incurring a potential liability to the public purse on a mind-boggling scale.

2) The Treasury has very specifically insured almost all forms of lending to Northern Rock, so it has done what would normally be the unthinkable, which is to provide a public subsidy for the value of Northern Rock’s shares.

3) The Bank of England has belatedly provided the kind of three-month lending facility to the banks which it resisted doing just weeks ago – and which could well have prevented the crisis at Northern Rock, if it had been made available in early September.

4) The Chancellor has signalled that the existing system for insuring deposits at banks is to be swept away and replaced with one that gives greater protection and pays out with greater speed.

5) City confidence in the ability of the Bank of England to cope with this kind of crisis is very badly shaken.

This is the equivalent of the wreck of a city after an earthquake. So where does blame lie for this disaster? Here is the preliminary roll-call of responsibility:

a) If at the heart of Northern Rock’s problems was a business model that was too dependent on the money markets, then its management are first in line for criticism – and second in line are its non-executive directors, for failing to rein in the exuberance of management (and if you want an illustration of how blinkered they all were, both Northern Rock executives and non-executives were still buying shares in Northern Rock at the end of July and in early August).

b) Again, if the underlying cause was Northern Rock’s shaky business model, it is reasonable to ask whether the laudable aim of the City watchdog, the Financial Services Authority, to provide freedom for banks to innovate and flourish went too far in this case.

c) The Bank of England seems to have shown too little imagination in the way it provided funds or liquidity to money markets after they seized up on August 9. Its obsession with not rewarding banks for their bad behaviour seems to have made it blind to the option of flooding the market with cash, but making that cash expensive (both in terms of discounts or the “haircut” applied to collateral and a high interest rate). Such funds would have allowed Northern Rock, for example, to continue trading without the stigma of applying for an emergency loan. And Northern Rock would have been suitably spanked, because its profits would have been wiped out by the pricey terms of these funds. For what it’s worth, the Chancellor Alistair Darling signalled in The Times on Saturday that he would now favour a “more generalised system of bank support” along these lines – though the words “barn door”, “horse” and “bolted” come to mind.

d) Banks are bemused by how little direct contact they have had with the Bank of England during the money-markets turmoil of the summer. This may in part be due to an understandable desire by the Bank of England to avoid duplication of effort with the Financial Services Authority. However it is difficult to see how the Bank felt confident to refuse the agonised demands of the banks and the FSA for more liquidity to be pumped into the market – as the Bank consistently did – unless it had first-hand knowledge of the scale of the problems at individual banks. This may point either to a failure at the Bank or a failure of the tripartite alliance of Bank, FSA and Treasury (which was created by this Government around ten years ago and was supposed to be the optimal system for coping with banking crises).

e) The decision-making efficacy of the tripartite alliance doesn’t look brilliant in a second respect. There is something very odd about the Treasury sanctioning the Bank to provide lender-of-last-resort funds to Northern Rock when the Bank and the FSA were more-or-less persuaded that the inevitable consequence would be a run on Northern Rock (largely because of the inadequacies of the deposit-protection system). The four-day delay in announcing that the Government would not allow any depositors to lose money made their fears come true. A banking crisis was transformed into the national humiliation of the first run on a British bank for 141 years. Was this delay the result of Treasury reluctance to expose the public-sector balance sheet to the problems of Northern Rock? Were the Bank and the FSA poor in communicating their intimations of doom to the Treasury?

These are important questions. Hooray that they will be examined by the Treasury Select Committee. But arguably there should be a proper public enquiry of a wholly non-political sort.

However, if there is already a single glaring lesson of the Northern Rock debacle and the wider problems in money markets, it is that the global regulatory system has put too little emphasis on the risks of liquidity crises. As a matter of urgency new rules have to be drawn up to ensure that all banks have proper emergency plans in place to secure access to cash in the event that it becomes difficult to obtain through normal channels. Oh, and it might make sense for the Bank of England to review its own emergency procedures.

Mervyn - we're innocent

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Robert Peston | 16:20 UK time, Thursday, 20 September 2007


It is a matter of deep principle for Mervyn King that we all take responsibility for our financial mistakes.

Today he cited the case of a young woman who had borrowed too much.

mervyn_pa.jpgHer bank told her that it could not write off her debt, because that would encourage other customers to binge on borrowing in an unhealthy way.

A good thing too, Mr King said.

And it’s why, he added, that he has been resistant to the immense pressure from Britain’s banks for the Bank of England to pump an ocean of money into the banking system.

That, said King, would have been to reward them for their imprudent lending, when they should have been punished.

There can’t be one rule for customers and another for the banks.

Quite right, most of us would think.

Just the sort of thing we would want from a Governor.

So surely he has a view about who was to blame for the grotesque run on Northern Rock – which was swiftly followed by the Treasury writing a blank cheque for the depositors in all British banks, to ensure none of them need fear they could suffer losses in the current market turmoil.

Well when the Treasury Select Committee put this to him today, it turned out that no one was seriously at fault.

It was all due to the unintended consequences of well-meaning financial regulation.

Which, in a nutshell, is why Mr King’s stock is a long way from its all-time high in the City.

It’s all very well to lecture bankers that they need a sound thrashing for their naughtiness. But is Mr King really persuaded no individual at the Bank of England, the Treasury or the Financial Services Authority has made an important error of judgements since the merde started flying on August 9?

Fans love King

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Robert Peston | 09:24 UK time, Thursday, 20 September 2007


I was really struck yesterday at the torrent of support for Mervyn King from readers of my blog – and those messages are still coming in. If King is Jose Mourinho, the fans certainly don’t want him to quit.

But I now fear that the briefing by the Bank to me last night – to the effect that the decision to offer three-month loans against the security of mortgage-collateral would not have been enough to help Northern Rock – was disingenuous.

The first Bank auction may only be £10bn but future auctions could be bigger or smaller depending on demand and market conditions. Such a facility could have prevented the Rock hitting the rocks. And Northern Rock itself is absolutely persuaded that if these auctions had been available a few weeks ago, there would never have been the liquidity crisis which prompted it to go cap in hand to the bank for emergency help.

The role of King in the collapse of Lloyds TSB’s attempt to mount a rescue takeover of Northern Rock also needs examining.

Lloyds TSB offered £2 a share, which Rock’s board was minded to accept. And according to a senior, well-placed banker, Lloyds TSB believed initially that the Bank of England had signalled it would be prepared to provide some kind of guarantee of funding for Rock’s £113bn assets. Then the Bank changed its mind and said it could not be seen to be subsidising the deal.

The consequence was that the Rock then had to apply for succour from the Bank as lender of last resort. And the rest is the wrong kind of banking history.

So the criticism of the Bank of England is that it jeopardised confidence in the banking system so as not to face the charge that it was insuring Lloyds TSB’s shareholders against the full risks of a takeover – which could have been seen to be tilting the level playing field for takeovers and giving Lloyds the dangerous freedom to take undue risks with the Rock’s balance sheet.

The credibility of the Bank’s governor, Mervyn King, is in the balance. I have spoken to members of its "court" (the equivalent of its board of directors) and they are split on whether he will or should quit.

Unstable Governor

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Robert Peston | 17:15 UK time, Wednesday, 19 September 2007


One of the main functions of a central bank like the Bank of England is to provide liquidity - or funds - to banks to ensure the smooth running of the financial system and the economy.

bank_of_england3.jpgIt’s a bit like a water company - no one really notices its existence until there is difficulty getting stuff out of the taps.

Well, on August 9, the equivalent of the mains system in the banking market seized up.

Banks became reluctant to lend to each other and would only do so at relatively high interest rates.

Think of it as turning on a tap at home and only finding a trickle.

However, the Bank of England consistently said that its system for providing liquidity didn't need overhauling.

It claimed that to do so would be to bail out banks which had lent or invested in an injudicious way - and it had no intention of doing that.

It has now changed its mind.

The Bank has agreed to accept mortgages from banks as collateral against three month loans.


It's the equivalent of opening up a whole new reservoir in the water system.

But here's the humiliation for the Bank.

If it had done this three weeks ago when banks were clamouring, Northern Rock might never have feared that it was running out of money.

So it would not have had to approach the Bank of England for emergency support.

And there would never have been that infamous run on Northern Rock - the first run on a British bank for 140 years.

The possibility that the flight of capital from Northern Rock could have been avoided is seriously embarassing for the Governor of the Bank of England, Mervyn King, one of whose functions is to maintain financial stability.

Right now, stability may not be the correct word to describe his employment prospects.

IMPORTANT UPDATE: 19:59 The Bank of England has now told me that individual banks can only apply for £1.5bn each under the £10bn facility. It says that Northern Rock would have needed far greater funds - and that if this finance had been provided three weeks ago or so, the liquidity would not have eliminated the Rock's funding difficulties.

It is slightly odd that the Bank should divulge this to me now, because it failed to provide this detail (or any answer at all) when I asked this afternoon whether what it announced today could have provided succour to Northern Rock. So although the Bank of England has changed course in respect of the way it is prepared to tackle the crisis in the money markets, it is sticking to the position that it has no regrets about the way that it provided its initial support to Northern Rock.

Mervyn - still on Rocks

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Robert Peston | 08:03 UK time, Wednesday, 19 September 2007


What happened at Northern Rock, the first run on a British bank in living memory, has caused deep shame and embarrassment in the banking industry.

It is not the sort of thing that is supposed to happen here.

Senior bankers are livid and looking for someone to blame.

First in their sights is Mervyn King, Governor of the Bank of England.

His refusal to flood the banking system with cash over the past few weeks is the cause of the humiliation of their industry, or so they claim.

Just over a fortnight ago, the biggest UK banks – HSBC, Barclays, HBOS, Lloyds TSB and Royal Bank of Scotland – met with Hector Sants, chief executive of the Financial Services Authority.

Sants asked if there was anything the FSA could do to ease the conditions in the money markets.

They replied that there was little the FSA could do, but it would be helpful if the Bank of England would widen the collateral it was prepared to accept from banks in return for providing short-term funds.

The FSA communicated this demand to the Bank through the tripartite group of Treasury, Bank and FSA whose job is to steer the UK through financial crises.

Sants and the FSA’s chairman, Sir Callum McCarthy, were broadly sympathetic to the demands of the banks.

In a way, that is predictable. They are both former investment bankers, with a visceral understanding of markets.

However King – a world-class economist with an intellectual grasp of markets rather than an emotional one – said no.

He feared that he would in effect be bailing out some banks and financial institutions which – for the future safety of the financial system – ought to feel the pain of their imprudent lending and investments.

Minimising moral hazard is, for King, paramount.

What’s more King received representations from one or two banks which had taken the brave decision not to follow the pack into some of this dodgier lending and were therefore outraged at the idea that their injudicious rivals would be bailed out.

So the Bank stuck to its own rulebook of how much it would lend into the banking market and how it would do so.

There was no recovery in banks willingness to lend to each other and - with a grim inevitability - Northern Rock started to fear it would run out of cash.

An attempt to sell itself to Lloyds TSB foundered on the Bank of England’s refusal to effectively subsidise the deal by providing guaranteed credit to finance Northern Rock’s loan book.

So Northern Rock had no option but to request an emergency loan from the Bank of England – which it was duly given last Thursday night.

What followed has been a shocking new chapter in the annals of banking history, as images of queues of anxious customers flashed across the world.

The Government too has been humiliated. All its reassurances to Northern Rock depositors were ignored, until - with all the appearance of panic - it ditched its existing limited insurance scheme for depositors by promising that no Northern Rock depositor would lose a penny.

The Chancellor, Alistair Darling, was bounced by the crisis into pledging that in a worst case of Northern Rock running out of funds, it would be nationalised.

So for many banks, King's purist refusal to provide succour to all of them eventually forced the new prime minister, Gordon Brown, to agree that £113bn of mortgages made by Northern Rock could go on the public sector balance sheet.

Again, that is just not the sort of thing that is supposed to happen in a well-functioning economy.

Is King at fault?

It is too early to say.

As of this moment, no depositor has actually lost any money.

And it is unclear precisely how much the seizing up of the money markets will slow down the wider economy.

More germanely, few would dispute that the Bank must take enormous care not to reward foolish lending or investing – because that would only encourage foolhardy institutions to behave even more stupidly next time, to the detriment of all our future wealth.

That said, top British bankers – who met the FSA again yesterday – are sickened that their industry, the very heart of the economy, should have been tarnished by those pictures of anxious depositors scrambling to withdraw funds.

Their anger at the Bank of England shows no sign of easing – and it is shared by one or two members of the Government.

For the sake of his reputation and that of the Bank, King has a lot of explaining to do.

Saving the banks

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Robert Peston | 08:00 UK time, Tuesday, 18 September 2007


If the run on Northern Rock isn’t stemmed by the Government’s decision to guarantee that no depositor will lose money, well then nothing will stem it.

The decision is without precedent. Historically, all British governments, regulators and the Bank of England have been persuaded that to “make whole” all savers would be to create a serious moral hazard problem.

northern_rock.jpgThey have believed it really important that Mr and Mrs Bloggins should live in fear that they could lose some money by having their savings in Northern Rock or any bank, in the rather naïve believe that the Blogginses and other depositors would put pressure on said bank to conduct its affairs in a prudent way.

The theory is, of course, utter nonsense in complex modern capital markets – where even the specialist watchdog, the Financial Services Authority, has difficulty understanding the precise risks being run by individual banks (as we have seen in recent weeks).

And in practice the puritanical theory that everyone has to lose something has led to the near-collapse of Northern Rock.


Because when Northern Rock was singled out as a vulnerable bank after it was given emergency support by the Bank of England, the one thing the Blogginses remembered was that the official deposit protection scheme only guaranteed that a portion of their savings would be safe – and they may also have recalled that it would be months before they received even this limited compensation, in the event that Northern Rock collapsed.

So even though Northern Rock was not bust, it was not rational for the Blogginses – and all those other savers – to keep their money in Northern Rock, once even the faintest question was raised about its viability.

What the Northern Rock panic demonstrated is the huge potential for there to be runs on banks, when savers have so many banks to choose from. And, if Northern Rock’s website had been a little less prone to falling over, it would also have shown how technology has increased the risk of capital flight in these circumstances.

mccarthy.jpgHowever, there is no point in providing this protection for simply Northern Rock or any other bank that faces a funding shortage in the current market turmoil (the chairman of the FSA, Sir Callum McCarthy confirmed to me last night - you can watch the interview here - that such protection was being extended to all other British banks).

The Government must swiftly legislate to formalise this new approach to the public insurance of savers’ money.

The good news is that senior officials tell me such legislation in on the cards.

However, some important details are yet to be worked out.

The Bank of England would like elements of the US model to be imported, such as a provision for all small depositors to receive their money within days of a bank going bust.

But perhaps the most important question is where the ceiling on insured deposits should be set.

In the current crisis, the Treasury is saying that no depositor will lose his or her money, no matter how big the deposit.

That is not sustainable as a general approach, because it would create a serious moral hazard issue. It would effectively be extending protection to sophisticated professional money-market players – which would have the effect of reducing the pressure on banks not to take excessive risks, because they could take comfort that the Government would pick up the tab if it all went wrong.

The pressure on banks not to take excessive risks must come from the substantial providers of capital, those who buy their shares, purchase their bonds or finance them in other ways through the wholesale money markets.

Make no mistake, Alistair Darling has bailed some or all of them out in the Northern Rock case. And that is a very unfortunate precedent.

If it became the general rule that all deposits were protected, well the financial system would soon go to hell in handcart. As one bank after another took stupid risks to inflate profits, they would all end up in public ownership.

The watchdog growls

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Robert Peston | 07:45 UK time, Tuesday, 18 September 2007


Last night I interviewed Sir Callum McCarthy, chairman of the City watchdog, the Financial Services Authority, about the run on Northern Rock and the wider crisis in the financial markets. McCarthy said the era of cheap money based on banks “mispricing risk” was probably over. That may push up the cost of borrowing for all of us. But in the long term, it should put the economy on a more sustainable footing.

You can watch the interview in full by clicking here.

Bank on the Rocks?

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Robert Peston | 10:20 UK time, Monday, 17 September 2007


I had to chuckle when I heard Will Hutton on Today this morning (you can listen to the interview here). Here was the leftish head of the Work Foundation making the same arguments about the need for the Bank to pump money into the financial system that I have been hearing from the uber-capitalists of the investment banks and the commercial banks for weeks.

The bankers want the cash from the Bank to ease the pain they are feeling from the injudicious way they invested their capital over the past few years. And, funnily enough, Hutton feels their pain too and thinks the Bank should have provided an analgesic weeks ago.

It’s is wrong of me to be flippant. There is an important debate to be had about the response of the Bank, the Financial Services Authority and the Treasury to the crisis in financial markets.

Simplifying slightly, the bankers and Hutton believe that some weeks ago all banks should have been allowed to borrow from the Bank of England more-or-less in the way that Northern Rock has been allowed to – and via a generalised special lending facility, rather than as an emergency loan to ward off imminent collapse.

What they argue is that if banks had been allowed to pledge all manner of assets of questionable value as collateral for Bank borrowing – Hutton mentioned the asset-backed commercial paper that no one wants to hold any longer – then there would have been enough liquidity or cash in the financial system to reverse the rise in market interest rates and also to encourage banks to lend to each other in the normal way.

Just possibly, Northern Rock would not then have faced a strike by the institutions that normally lend to it and would not have had to go cap-in-hand to the Bank.

That might be right. There is, for example, some evidence that conditions in the eurozone and US money-markets, where the central banks have been a bit freer with their injections of liquidity, have not been quite as tight as here.

Another possible argument against the way that the Bank used its lender-of-last resort powers to bail out Northern Rock is that the very act of saving it in this way also damaged it, possibly beyond repair. There is a huge stigma attached to requesting emergency funds in this way: Northern Rock was identified very publicly as a victim which therefore created the very anxiety among depositors that has led to the mass withdrawal of funds we’ve seen since Friday.

So the Bank may end up giving more financial help to replace the Rock’s lost deposits than it would have had to do if it had been less uptight up pumping cash into the banking system more widely and generously.

That’s the case against the Bank of England.

And I can understand why Hutton and the bankers are quite emotional about it: the pictures of those queues outside Northern Rock branches are quite shocking; they’re not really the sort of thing that ought to happen in one of the world’s largest and strongest economies.

There is however a powerful argument in the Bank of England’s favour.

The first is that the Northern Rock was an accident waiting to happen. It was far too dependent on the money markets to finance the growth in its lending. And if the Bank had pumped a ton of money into the system to allow Northern Rock to weather this particular storm unscathed, there is a significant risk that Northern Rock would have faced bigger, uglier and scarier problems in the months and years ahead.

The second is that if the Bank had allowed all the banks to dump asset-backed commercial paper and mortgage assets on it in return for loans priced at the base rate plus a bit, a mountain of dodgy assets might have ended up on its books – and with no certainty that normal service in the money markets would have resumed.

In the process, the investment banks and commercial banks would have learned a dangerous lesson, which is that so long as their foolish lending and trading is on a big enough scale, the Bank will rush in to prevent them suffering undue losses.

At least in the case of the Northern Rock bailout, the Bank knows there is an upper limit of how much cash it would have to pump in – which is probably around £20bn in the highly unlikely case that every retail depositor were to take out his or her last penny.

To be clear, I am not yet arguing that the Bank and FSA handled this crisis in an optimum way.

Much will depend on what happens to Northern Rock over the coming days – and also whether there is contagion in the form of a loss of depositors’ confidence in other lending banks.

Northern Rock’s woes are a bit worse than just a little local difficulty. But it is premature to say that the Bank of England’s conduct has turned a crisis into something a good deal worse.

UPDATE 17:15 According to well placed banking sources, this afternoon’s massive Alliance & Leicester share price fall does not reflect any run on the bank’s deposits, either by ordinary customers or by other banks and financial institutions.

Like all banks, A&L is suffering from the illiquidity of the inter-bank market, but is much less dependent on other banks and institutions for funding than Northern Rock.

A&L itself believes simply that it has been targeted by hedge funds looking to profit from identifying the next banking victim, which have been short-selling the stock.

It and other small banks – like Bradford & Bingley, whose shares are also down sharply, though not as much – will remain vulnerable to this kind of negative speculation unless and until the Bank of England succeeds in restoring confidence to wholesale money markets.

"Rock can't be sold"

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Robert Peston | 09:29 UK time, Sunday, 16 September 2007


For all the talk – including by me (see my earlier comment, Rock or Crock) – about how Northern Rock must surely soon find itself under new ownership, I have learned that it cannot be taken over by another bank in the absence of a major policy shift by the Bank of England.

Here is why.

Bankers tell me that Northern Rock spent a good deal of the summer exploring whether any big bank was prepared to acquire it lock, stock and online accounts. It had appointed the leading investment bank, Merrill Lynch, to sound out possible buyers.

There was, I am told, interest in a possible deal from substantial international banks.

But – and here’s the important point – the seizing up of interbank markets proved an insuperable obstacle.

No other bank wanted to take on the responsibility for financing Northern Rock’s total assets of more than £100bn at a time when it is very hard and very expensive to obtain funds from the money markets and banks.

So it was the realisation on the part of Northern Rock’s board last week that selling the bank had become impossible in current market conditions which actually persuaded the board to approach the Bank of England and ask for access to emergency loans.

Plainly, a takeover would have been a less humiliating option. But it just couldn’t be done.

Here’s the great banking Catch 22 of our time.

The Bank of England under its governor, Mervyn King, takes a very purist line to exercising its role as lender of last resort.

It is prepared to bail out a bank like Northern Rock to prevent serious damage to the banking system and the wider economy, although only on condition that the Financial Services Authority deems said cash-strapped bank to be solvent.

However in their words and deeds, King and the Bank of England have made it clear throughout the crisis in credit markets that they are not prepared to make good the losses of those they think have behaved imprudently or injudiciously.

Mervyn King wants to spank banks and other financial institutions, in the hope that they’ll learn from their mistakes.

He is obsessed with moral hazard, and understandably so.

So the emergency lending facility can be used by Northern Rock as an independent bank to stop it from falling over while its worried depositors remove their cash.

But it cannot be used to prevent holders of Northern Rock’s bonds or shares suffering losses that stem from their decision to invest in a bank whose basic business model turned out to flawed.

What follows from that?

Well, the Bank of England would remove the emergency lending facility more-or-less the moment it was taken over by a bigger bank.

If it didn’t do that, the Bank of England could be accused of subsidising the sale of Northern Rock and propping up the value of Northern Rock’s shares and bonds, which is the last thing it wants to do.

But, as Northern Rock found out when looking for a buyer this summer, no bank has the confidence to buy Northern Rock and attempt to refinance its balance sheet on the money markets in the normal way.

The world’s biggest banks are finding it challenging even to fund their own assets in our malfunctioning financial markets. And if they didn’t want to absorb Northern Rock’s very substantial balance sheet just a few days ago, they are going to be even less keen now, after so much cash has been withdrawn by anxious Northern Rock customers from their branch, postal and online accounts.

As I said, it is the banking Catch 22 of our time: Northern Rock can’t be sold without a guarantee of funding from the Bank of England, but the Bank is refusing to provide such funding to facilitate a sale.

Maybe some kind of compromise, transitional arrangements can be agreed.

The Bank cannot have enjoyed witnessing the damage being wreaked to Northern Rock’s reputation by all those images of anxious and irate customers queuing outside branches.

Northern Rock’s brand is being tainted, possibly beyond repair.

For all the confidence of the Financial Service Authority’s confidence that Northern Rock is solvent, its basic long term commercial viability is being eroded. At some point, what starts as a liquidity crisis risks becoming something worse.

So here is the choice that may confront the Bank of England and the Chancellor of the Exchequer soon.

They could choose to continue along the path they have taken. This could see them injecting many many billions of pounds into Northern Rock for an indefinite period. They would in effect be choosing to enter the mortgage business and Northern Rock would almost be nationalised.

Over time, Northern Rock would probably wither as a business, to the detriment of its many employees.

Or the Bank and Chancellor could grit their teeth, swallow their pride and allow public funds to facilitate a takeover.

I cannot predict which way they will jump. When I interviewed the Chancellor Alistair Darling yesterday, he evinced great confidence in the actions of the Bank.

That said, in all the turmoil and uncertainty, Northern Rock’s share price is probably still heading in a direction that will not amuse its shareholders.

UPDATE 12:15 Withdrawals from Northern Rock are now just under £2bn, following yesterday’s withdrawals. In fact this is a bit less than the authorities – the Financial Services Authority, Bank of England and Treasury – had expected. They had been braced for £2bn on Friday alone. However, they cannot be sure much more will be withdrawn in the coming days, especially from holders of Northern Rock’s postal accounts (there was almost £10bn in these accounts as of June 30).

One piece of good news is that there does not appear to have been a loss of confidence in other mortgage banks or building societies. Much of the money withdrawn by Northern Rock customers has been put into other mortgage banks and former building societies, such as Alliance & Leicester and Bradford & Bingley, as well as the bigger banks. Although the risk of contagion has not been eliminated, so far there is no great sign of it.

I have also learned that Northern Rock was close to selling itself to another big bank before it finally asked for support from the Bank of England. There were two banks very interested in acquiring Northern Rock. They did a detailed investigation of Northern Rock’s business and determined that it was fundamentally sound (as it happens, the FSA has to an extent relied on their investigations in its subsequent determination that Northern Rock is solvent).

However these potential bidders were concerned about doing such a big deal at a time when there is turmoil in money markets, when it is difficult and expensive to raise money from other banks and financial institutions. They therefore sought guarantees from the Bank of England that it would supply facilities to fund Northern Rock’s assets, in the event that money was impossible to obtain on the market.

The Bank refused to provide such guarantees. As I've said, it did not want to be seen to be bailing out Northern Rock’s shareholders and bondholders. It feels they need to feel the pain and suffer the losses of their mistake in backing a bank, Northern Rock, whose strategy was flawed.

So the bidders walked away. And the Bank decided on a simpler strategy of simply providing emergency loans to Northern Rock as an independent entity.

UPDATE 19:31 The Bank of England tells me that the emergency lending facility would in fact be transferred to any new owner of Northern Rock. However once the facility expires (and the Bank will not give me the expiry date) there is no guarantee it would be extended for the new owner. So most bidding banks will remain nervous about taking on a balance sheet of Northern Rock’s size with the risk hanging over it of needing to refinance a large chunk of loans from the Bank of England at short notice in markets which may remain frozen. So negotiating a takeover of Northern Rock will not be easy. Even so, I detect a desire on the part of the authorities to see Northern Rock under new ownership sooner rather than later, so long as the strictures of good central banking are not thrown out of the window.

UPDATE 21:30 Sorry, I forgot to mention that - as the Sunday Times says today - Lloyds TSB was the bank which came closest to buying Northern Rock, before the Bank of England agreed the emergency facility. Right now, Lloyds TSB is no longer interested in buying the bank, but that could change.

Rock - the numbers

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Robert Peston | 10:17 UK time, Saturday, 15 September 2007


Northern Rock’s depositors are nervous. That’s quite understandable. Some £1bn was withdrawn by customers yesterday, much of it from bank branches.

That represents a big chunk of the £5.6bn held in what Northern Rock calls branch accounts (as of the bank’s June 30 balance sheet).

There is a further £9.9bn in postal accounts – and presumably Northern Rock will be learning from today’s mailbag the scale of withdrawals from these accounts.

Then there is £4bn in internet accounts.

Holders of these have been anxiously emailing me saying that it has been almost impossible to log-on to their savings accounts over the past 24 hours, so – again – it is unclear what scale of transfer there has yet been out of these.

But just how worried should Northern Rock’s depositors actually be?

Well there are a number of different ways of answering that.

I am going to start by looking at the support the Bank of England has promised to provide and seeing whether it would be enough to pay out every single depositor, in the unlikely worst case that they all decided to withdraw their cash.

This is not as straightforward as you might expect, because the Bank has given only limited details of the emergency lending facility it is providing.

What I have learned is that the bank is lending against the collateral of mortgages made by Northern Rock.

However, it is not prepared to lend Northern Rock £1 for every £1 of mortgage pledged to it as security.

My understanding is that it wants more than £105p of collateral for each £1 it lends.

Now, Northern Rock’s balance sheet of June 30 this year shows that it has £31bn of residential property loans not subject to securitisation – which in theory are available to be pledged to the Bank.

But a further note to the accounts shows that £10.2bn of these have already been pledged, to providers of funds via financial instruments called covered bonds.

So there’s only £21bn of these straightforward mortgages available to the Rock as possible security for loans from the Bank of England. At a 5 per cent discount, the Bank would probably lend just under £20bn against these.

That’s not very encouraging, because retail deposits – which include the branch deposits, internet accounts and so on that I have already mentioned – actually total £24bn.

Also, there is a further £5.8bn described as “other customer accounts”. And there are “deposits by banks” of £3.7bn.

So total deposits are nudging £34bn – which on the face of it is a bit more than assets that could in effect be swapped for hard cash at the Bank of England.

So does the Rock have other assets it could pledge? Well it has £6bn of residential buy-to-let loans not subject to securitisation and therefore useable as collateral.

And it has £7.8bn of unsecured loans also not subject to securitisation.

Buy-to-let loans and unsecured loans are always seen as lower quality than residential mortgages. So if the Bank is prepared to accept them as security at all, it would probably demand a much greater discount to asset-value than 5 per cent when lending against these.

So I am going to make the heroic assumption that Northern Rock could probably borrower a further £11bn or so against its buy-to-let and unsecured book.

That gives us a running total of something like £30bn that could be obtained from the Bank, if all this stuff was pledged to it. Which is still not enough to pay out every single depositor in the highly unlikely meltdown case.

Now its June 30 balance sheet also shows that it has other higher quality assets – but in the past few weeks some of these will have been liquidated or pledged as Northern Rock endeavoured to weather the financial turmoil and looked for ways to finance its lending.

But for what its worth, as of June 30 Northern Rock had securities “available for sale” totalling £8bn and loans to other banks of just under £7bn.

Bottom line is that I estimate that Northern Rock has just about sufficient free assets to raise funds in the extreme and very unlikely case that every single one of its depositors wanted its money back.

Which helps to explain why the Financial Services Authority has described Northern Rock as solvent.

But on the basis at which the Bank of England is prepared to lend, depositors’ funds seem to be only just about covered by loans that could be provided by the Bank.

That said, there is a bigger political reason why Northern Rock may well now be one of the safest banks in the world.

Here the important point is that the Financial Services Authority has declared Northern Rock to be basically sound, the victim of temporary and exceptional maket conditions.

And the Chancellor, Alistair Darling, has very publicly endorsed the FSA’s analysis and said there is no reason for Northern Rock’s depositors to panic.

So in the unlikely event that a black hole did emerge at Northern Rock, the Government would be under enormous moral pressure to pay out 100 pence in the pound to Northern’s retail depositors, as opposed to the less generous terms available under the official deposit protection scheme.

UPDATE SEPT 15 16:00 It turns out that withdrawals from the website represented the biggest flight out of Northern Rock on Friday, in spite of the technical problems experienced by many holders of online accounts. Which is predictable, in that it is so much less hassle to go online than to queue outside (so long as you are actually able to log on). In an age when funds can be transferred with the click of a mouse, it is even harder for a bank to hang on to funds after any kind of knock to its reputation.

Rock or crock?

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Robert Peston | 00:41 UK time, Friday, 14 September 2007


The good news is that the Chancellor, the Financial Services Authority and the Bank of England don't believe Northern Rock is an unviable business.

northern_rock_pa.jpgIf they thought the Rock – or Northern Crock as it’s been dubbed in the markets – was an intrinisically bad bank, they would not have agreed to rescue it by providing emergency funding.

Such the was unambiguous implication of the Bank Governor’s statement to the Treasury Select Committee on Wednesday on the circumstances in which the Bank is prepared to act as lender of last resort to a troubled institution.

But that’s the end of the good news.

What Mervyn King also said is that the Bank will only provide funds to a troubled institution in this way if the risk of a collapse could lead to “serious economic damage”.

Certainly Northern Rock – with £24bn of retail depositors’ funds and £113bn of loans and other assets on its books – is big enough to wreak a fair amount of havoc, were it to fall over.

Anyway, none of us – not even Northern Rock’s depositors – probably need to panic that the Bank has had to step in.

But does that mean that Northern’s customers and shareholders have no reason to feel aggrieved at Northern’s management?

Is it anyone’s fault that Northern fears it cannot raise sufficient funds from its traditional commercial sources right now?

Well, Northern is the victim of exceptional market conditions.

Few could have predicted that problems thousands of miles away in the US housing market – notably the losses on loans to American homebuyers with dodgy credit histories – would have made investors and financial institutions wary about financing Northern Rock’s very different and very British homeloans business.

But actually that doesn’t let Northern’s management off the hook.

Banks have to expect the unexpected in the way they manage their balance sheets.

To use the ghastly City jargon, they are supposed to “stress test” their businesses all the time to ensure they can survive the market’s equivalent of a nuclear strike.

Northern’s stress tests were not stressful enough.

But perhaps the biggest criticism to be made of this bank is it massively increased its mortgage lending at the beginning of this year, when most economists were forecasting a slowdown in the housing market and when interest rates were already rising in a way that squeezed its profit margins.

In the first six months of 2007, its net lending rose 47 per cent to just under £11bn. And at June 30, it had a further £6.2bn pipeline of loans that had been agreed with customers but not yet delivered.

So it is unsurprising that other financial institutions might feel that these mortgages were provided too late in the housing-market cycle to be quite as rock solid as loans made a few years ago.

What’s perhaps even more embarrassing for Northern is that in its interim statement made earlier this summer, it was explicit that it continued to lend even as the interest rate environment turned against it.

So Northern Rock may not be going bust.

But its reputation has been badly damaged.

Which normally means that there will be a clear out of top management and also that the business may well be sold.

Scything the City

Robert Peston | 07:45 UK time, Thursday, 13 September 2007


The humungous bonuses trousered by many investment bankers may seem a trifle de trop.

But it’s not a stress-free existence. They live in an eat-or-be-eaten world and are in work for as long as they are economically productive - and barely a second longer.

So brutal redundancies are now only days and weeks away, as it becomes commonly accepted that the turmoil in financial markets will depress certain lines of business for months if not years.

The boss of one investment bank tells me he expects a first wave of job cuts that will see individual banks reduce their headcounts between 5 and 15 per cent.

And he says he wouldn't be surprised if that was followed just a few months later by a second wave of similar or even greater magnitude.

First out the door will be many of the creators of the current crisis: the manufacturers and traders of assorted asset-backed securities that you can hardly give away right now; all those debt whiz-kids who engineered the poisonous collateralised debt and loan obligations; the banking servants of a hedge-fund world that’s shrinking fast and of a private-equity industry in cryogenic storage.

Should we weep for their plight? Some of you will scoff at the thought. It’s a big hello to schadenfreude.

Actually, there could be one or two benign consequences from the slaughter of the not-so-innocent, such as a deceleration in the rampant inflation of central London property (okay, I know this is not a universal good).

But don't think we'll get away scot-free.

The economy called Britain is built on financial services (though more by accident than design). Something over a third of our overall economic growth has been generated in recent times by the City and financial services.

Lean times in the City means slower growth, less wealth to spread around and a substantial dip in the Treasury's tithe.

When the bubble is pricked, no umbrella is big enough – we all become a bit damp.

Mervyn spanks banks

Robert Peston | 12:34 UK time, Wednesday, 12 September 2007


Mervyn KingThe 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.

Bank of EnglandSo 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.

Getting business right

Robert Peston | 12:29 UK time, Wednesday, 12 September 2007


Are we at the BBC a little too prone to present business stories from the consumers' perspective, as opposed to that of the employer, employee or owner and investor? I think so, as did a review chaired by the economist Sir Alan Budd for the BBC Trust - and last weekend I appeared on the BBC's Newswatch programme to talk about it.

An edited version of the interview went out on the show, but if you missed it, or you'd like to know more, you can watch the full interview by clicking here. I'd be interested to know your thoughts.

Sainsbury's new deal

Robert Peston | 13:30 UK time, Tuesday, 11 September 2007


Any day now the attempt by Delta Two to acquire J Sainsbury will either become a formal takeover or it will implode.

My hunch is that this investment vehicle of the Qatari state will sweeten the terms just enough for the Sainsbury board to recommend the offer.

What has been at issue is not the price. That will remain at the mooted level of 600p per share or £10.4bn for the lot. The enterprise value for the bought-out business, to include its existing debt of £1.6bn, would be £12bn.

It has been the amount of equity to be deployed by the Qataris, as opposed to debt, that has for weeks been preventing the board from giving its assent.

Negotiations have reached make or break.

sainsbury_afp.jpgHere is my prediction. The amount of pure equity in the deal will rise from around £3.1bn to about £3.8bn. The pref element will be unchanged at £500m and there will be a reduction in payment in kind notes from £1bn to around £700m.

The net effect will be to increase the equity element of the deal from £4.6bn to circa £5bn - and there will be a reduction in the prospective indebtedness of the bought-out Sainsbury from £7.4bn to £7bn.

That matters for two reasons. First, the supermarket chain's eponymous founding family - which controls 18 per cent of the stock - was reluctant to sell out if there was a risk that their baby would be drowned in debt.

Second, the competition authorities would be concerned if Sainsbury's future ability to compete with Tesco and Asda were impaired by the burden of debt repayments.

So is Delta Two doing enough to satisfy the Office of Fair Trading that there would be no need for a formal investigation by the Competition Commission?

It's touch and go. One relevant factor is that the Competition Commission is nearing the end of a wide-ranging review of the supermarket industry, which - inter alia - will address the question of whether Tesco has or may become too powerful.

It would be hard for the OFT to wave through the Sainsbury takeover if there were a risk that its ability to keep up the pressure on Tesco would be constrained.

Make no mistake, £7bn is a big chunk of debt. Annual interest payments alone for Sainsbury would increase from a few tens of million pounds right now to around £500m, or well over half earnings before interest, depreciation and amortisation.

The increased debt would wipe out a substantial part of Sainsbury's cash flow. And if Tesco or Asda were feeling especially ruthless (when would they ever?) they could slash prices in an attempt to wipe out Sainsbury's cash flow altogether and hobble it for the long term.

Now the Qataris may protest that they would never allow Sainsbury to be crippled. They may wish to point out that as an oil rich sovereign state, they have almost limitless resources to invest in Sainsbury.

But that may be disingenuous. The crucial point is that they have chosen to construct this deal in the way that a private equity buyer would have done, by loading it up with tons of debt.

In other words they are reserving the right to allow Sainsbury to go bust.

If the Qataris really wanted to hold Sainsbury for the very long term, they would have bought it with closer to 100 per cent equity - because in the long term the returns from an equity-heavy structure would converge with the proposed leveraged structure.

In choosing to take the leveraged route, the Qataris leave the Office of Fair Trading little choice but to view them as normal commercial owners.

So the Catch 22 for the Qataris in choosing to use aggressive financing techniques to maximise short term equity returns is that they have also increased the probability that they may never harvest those returns - because the Office of Fair Trading may feel obliged to throw a spanner in the works.

The OFT will, of course, take account of advice from Justin King, Sainsbury's chief executive. I expect him to tell the competition watchdog that the group can thrive even if yoked to £7bn of debt.

However he'll be £10m or so wealthier if the takeover takes place. I am sure King would never knowingly permit his judgement about the merits of the deal to be impaired by the attractions of that glorious payday. But the OFT may spot a conflict of interest.

Too close to home

Robert Peston | 18:33 UK time, Monday, 10 September 2007


The collapse of a small mortgage lender, Victoria Mortgages, may seem neither here nor there in the scale of things.

The City watchdog, the Financial Services Authority, has tried to play down the significance of Victoria’s passing.

And in one sense, the FSA’s relaxed demeanour is reasonable.

Victoria was simply a vehicle for collecting mortgages from British housebuyers with less than perfect credit histories and then turning them into bonds for consumption by investors.

Last year it sold around £500m of mortgages. Even so, the only people who should be seriously inconvenienced or damaged by its demise are the 381 customers with current mortgage offers from Victoria that are yet to receive their money.

But what did for Victoria is a trend of wider significance – investors’ loss of appetite for this species of debt and the refusal of an unnamed bank to underwrite Victoria’s loan book pending any re-awakening of investors’ hunger.

Victoria is a microcosm of the wider credit squeeze, viz the reluctance of banks to lend to other financial institutions and the evaporation of demand for certain kinds of bonds and tradeable debt.

Here’s why Victoria’s demise matters: it operates in markets that directly affect you and me, in contrast to the special investment vehicles and hedge funds which have been the main British victims of the turmoil so far.

The Bank of England and the Financial Services Authority will be hoping that what has happened to Victoria is not the start of a trend. To state the obvious, they would be less relaxed if a larger household name mortgage bank were to have difficulty raising finance from banks or the money markets.

Time to drop ABN bids?

Robert Peston | 13:45 UK time, Friday, 7 September 2007


Imagine two Premier League teams playing a high pressure football match when an electrical storm strikes. The onset is rapid and two players on each side are hit by lightning and are stretchered off.

What do you think would happen? Would the game be continued or would it be abandoned?

Well there is something of a storm in the banking world. And in a way it is worse than my fictitious one, because it is not only curtailing the career prospects of bankers but is wreaking havoc on the value of banking assets.

However Barclays and a consortium of banks led by Royal Bank of Scotland have not abandoned their big match.

abnamro_ap.jpgThey continue to battle each other to acquire control of another big bank, ABN Amro of the Netherlands.

Are they right to continue? Shouldn't their non-executive directors and shareholders be asking some challenging questions about whether it is sensible to contemplate the substantial management challenge of integrating ABN - a huge and complex international bank - at a time when valuing even their own assets is tricky.

RBS can't argue that the risks are significantly less for it than for Barclays just because it would carve up ABN and share the bits with its two partners, Santander and Fortis. The part that RBS would retain is the division of ABN in the eye of the storm, its global wholesaling and investment banking operations.

Charting the storm

It is probably worth rehearsing the nature of this storm again, though I have charted its course in a series of blogs over the past eight months.

Its most conspicuous current manifestation is that banks are reluctant to lend substantial sums to each other, they are hoarding cash. As a result, interest rates in the interbank market - the price of money borrowed by banks from banks - has risen sharply, so that they are much higher relative to official lending rates than they would be in normal circumstances.

That is gradually filtering through to tighter credit conditions and higher interest rates in what we think of as the real world, viz the price for loans paid by you and me.

Underlying these strange climactic conditions is a collapse in investors' confidence in certain kinds of loans, known in banking parlance as assets. These are loans to US homeowners with poor credit histories, the infamous sub-prime loans. But also they are loans to companies bought with buckets of debt, typically businesses acquired by private equity.

But that is only half the story. These rather basic loans have been converted by investment banks' alchemists into all sorts of other forms of debt, often via so-called structured credit vehicles called collateralised debt and loan obligations.

And in the process of finding buyers for these newfangled securities, the banks have doubly exposed themselves by guaranteeing much of it, either through underwriting the original debt or by providing borrowing facilities to purchasers of it.

Foolishly they have encouraged the acquirers of these securities to buy them with more borrowed money. Debt has been purchasing debt.

What the banks have helped construct is an inverted pyramid of borrowing. By way of an image, think of a tiny cone of equity supporting a colossal and rickety edifice constructed out of loans of varying maturities and degrees of risk.

As more and more debt has been heaped on top, there has been a corresponding rise in the danger of the whole thing imploding.

Greenspan's False Confidence

To put it another way, securitisation - the process of converting loans into securities for sale to investors - has not insulated banks from economic shocks in the way its advocates (led by the legendary Alan Greenspan) have claimed.

In fact securitisation, with loans made in one country sold to investors in another, is actually causing the current shocks to ripple far more widely than would have been the case when banking was a simpler business.

In particular, as I pointed out in my blog Liars' Loans, the collapse in value of many of these tradable loans or securities has led to a very serious run in a huge debt market, that for asset-backed commercial paper.

This commercial paper is being redeemed on an unprecedented scale. In just the coming week, the banks will be asked to stump up £65bn to refinance European commercial paper - or risk seeing a firesale of other assets that would have dire consequences.

Warning for Barclays and RBS

Make no mistake, I am not forecasting that any big bank will become insolvent. Please don't panic. But the probability of a serious worldwide financial crisis has risen.

One possible ghastly outcome would be similar to what happened in Japan in the 1990s. Banks would be forced to hold assets they thought were sellable as long-term loans on their own balance sheets. That would tie up their capital resources and prevent them extending credit to perfectly decent borrowing prospects. And that would significantly depress economic activity.

I don't think anyone can assess with accuracy the likelihood of the financial system seizing up like that for months or even years. But if that risk is a serious one, shouldn't the management of all big banks be devoting their efforts to ensuring their own institutions are in the best possible shape rather than embarking on new adventures?

In these testing times, no banker would surely want to double the strain on their resources and resourcefulness by merging with a bank of similar size to their own. But that is what Barclays and the RBS consortium apparently still wish to do, in their pursuit of ABN.

But for how much longer, I wonder?

Bank primes money pump

Robert Peston | 16:30 UK time, Wednesday, 5 September 2007


The Bank of England’s stiff upper lip has relaxed just a fraction. For the first time since the global financial system seized up more than a month ago, it has taken what looks awfully like evasive action.

mervyn_king_ap.jpgIt is endeavouring to relieve the upward pressure on short-term interest rates that has been caused by the global squeeze on credit by doing two related things – whose combined effect represents a commitment to pump up to £5.4bn of short term loans into the banking system.

That said, the Bank is insistent that it is acting within published guidelines: it has not rewritten its own rules about its role in the money markets.

Or to put it another way, it is still drawing a distinction between its own behaviour and that of the US and Eurozone central banks – both of which have behaved in a more exceptional way.

For me, however, that is a nice distinction. What it has announced today is hardly trivial. It is probably more significant than tomorrow’s monthly statement by the Bank’s Monetary Policy Committee on the base lending rate.

Having injected liquidity into the system today, I would be staggered if the MPC did anything but keep the base rate on hold.

What exactly has the Bank done?

First, it has agreed that banks can deposit £17.6bn in the coming month at the Bank of England – a rise of 6 per cent or just under £1bn from the reserve target of the past month.

Banks can draw on these facilities as and when they need cash in the coming days.

That may not sound terribly significant, unless you are versed in the arcana of central banking. But the point is that the Bank of England actually provides these reserves to the banks via loans to them backed by gilts and other collateral.

An increase in the reserve requirement is in effect an increase in lending to banks at the base lending rate of 5.75 per cent.

It represents a significant increase in the liquidity of the banking system – and relieves pressure on the banks to borrow at the higher penalty rate of 6.75 per cent.

Second, if that isn’t enough to bring down overnight borrowing rates, the Bank will supply up to a further 25 per cent of the aggregate reserves target in its so-called open market operation next Thursday.

Or to put it another way, it is prepared to lend banks a further £4.4bn at the base lending rate.

In crude terms, the Bank is basically providing additional cheap finance to the banks to meet any short term requirements they might face.

The Bank’s explicit aim is to bring down the rates which banks charge each other for overnight borrowing to something closer to the bank base rate.

It insists its actions are not specifically aimed at bringing down the three-month Libor rate for loans between banks, which has been at more than one percentage point above the base rate – much more than usual.

That said, any increase in liquidity in the banking system should – in theory – have some effect on longer term rates such as three-month Libor.

The market for three-month money is not totally discrete from the market for overnight money. So what the Bank has done may ameliorate the horrible conditions in money markets.

But it won’t bring the crisis to an end. On its own, these measures won’t suddenly persuade banks to start lending to each other and other financial institutions with the alacrity of yore.

Banks’ pyramid scheme

Robert Peston | 09:44 UK time, Wednesday, 5 September 2007


Back to school today. But those noisy boys from private equity, who were hyperactive last term and should have been on Ritalin, are curiously subdued.

In all my many years as a journalist, I have never seen an industry suspend activities with the speed and scale of what has happened to private equity – except when there has been a strike or industrial action.

Actually, private equity is in a way the victim of a strike, a strike of lenders.

Financing for big takeovers by private equity firms has evaporated.

Why did it happen? Nothing terribly sinister or complicated. It is simply that private equity firms became too cocky and ambitious for their own good.

In the first half of this year, they transacted so many big deals requiring so much debt-finance that eventually – as June turned to July – the financial markets simply could not and would not absorb all the debt being issued.

Who is to blame? Partly the firms themselves – but also the big international banks, like Barclays Capital, Royal Bank of Scotland, Citigroup, JP Morgan, and Deutsche Bank.

These underwrote the debt, on the assumption that they could then sell it to investors via artificial financial constructs, the so-called structured credit vehicles (the collective noun for those collateralised loan and debt obligations I’ve been banging on about).

But what they seem to have failed to notice was quite how much additional debt they were expecting these investors to buy. By the middle of the year, the big banks had agreed to provide somewhere between $300bn and $400bn of debt to new private-equity deals, which was six or seven times the amount of such debt placed in a typical year until very recently.

And then there was the banks’ second bizarre manifestation of short-sightedness.

Not only were they financing the private-equity takeovers, they were also financing (underwriting) the structured credit vehicles.

In other words, they were on both sides of equation: they were creating both the market for the private-equity debt via the structured credit vehicles and the debt itself.

Does that seem as bonkers to you as it does to me?

It looks a bit like a pyramid selling scheme – except for the surreal twist that one part of a big bank is selling to another bit of the same bank!

What went wrong (as if you had to be told) is that the banks suddenly took fright about their exposure to structured credit vehicles (because of contagion from sub-prime and all that). So they stopped financing these vehicles, which in turn had less money to buy the private-equity debt. The banks then couldn't sell the private-equity debt, because they had forced the buyers to shut up shop!

It is one of those occasions when it is quite impossible not to say "you couldn't make it up".

Who are the victims of this craziness? Well it looks like being the big banks and their shareholders (oh dear, that’s you and me if we’re saving for a pension).

The point is that they are stuck with between $300bn and $400bn of unplaced private equity debt, whose market value is considerably less than the price they paid for it.

And they still have considerable exposure to all those structured credit vehicles – whose true value is anyone’s guess.

Their theoretical losses on all of this – on a mark-to-market basis – would run to many tens of billions of dollars. Which would not be enough to break any big bank, but would be a bit of an embarrassment.

At the moment, Barclays, RBS and their ilk are insisting that their woes are simply the result of “abnormal” market conditions which – they hope and pray – can’t last more than a few weeks.

Theirs is the Micawberish “something-will-turn-up” approach to banking.

But what if investors’ appetite for all this debt isn’t restored promptly?

Well then the banks have an uncomfortable choice.

They can hold the debt for months and even years, in the belief that the borrowers are fundamentally good credits. But in the meantime, their own capacity to underwrite new deals would be constrained – which would delay the recovery on which they (and we) all depend. Think about what happened to the Japanese economy in the 1990s when its banks refused to recognise the imprudence of their lending.

Or the banks could sell all that debt at below par – which would mean they would have to suffer the short sharp shock of realised losses.

The world’s most successful investment bank, Goldman Sachs, has made its bet about what the banks will do. It has recently raised a substantial sum from investors to buy this debt as and when banks flog it for 90 cents in the dollar.

Mervyn’s muddle

Robert Peston | 09:30 UK time, Tuesday, 4 September 2007


The Bank of England has conspicuously and gamely resisted the temptation to follow the lead of the European Central Bank and US Federal Reserve by pumping cheap money into the London banking system in response to the collapse of confidence in credit markets.

bank_of_england2.jpgIt has stuck with its business-as-usual system that if a bank needs extra funds at the close of business for any reason, that bank can only borrow from the Bank of England’s emergency facilities at a one percentage point premium to the base rate.

But here’s the funny thing. The current base rate, which is supposed to be the reference point for the interest rates that affect all of us, is 5.75 per cent. But the benchmark commercial rate for lending between banks, three-month sterling LIBOR, is 6.74 per cent.

Now in normal market conditions three-month LIBOR has typically been about 0.125 per cent higher than the base rate.

So what’s really striking is that three-month LIBOR has converged with the Bank’s emergency lending rate of 6.75 per cent.

Or to put it another way, that emergency lending rate has become the new reference point for the British economy.

And, in the current crazy market conditions, that’s a rational phenomenon.

Why? Because banks don’t want to lend to each other, or to other institutions, because they are not sure what’s under the bonnet of those borrowers (it’s the toxic fumes from sub-prime and CDOs that’s still putting them off).

In such circumstances, the benchmark interest rate for the economy has naturally become the emergency lending rate of the lender of last resort, the Bank of England.

And it will stay that way, unless and until banks somehow regain their poise and confidence – or the Bank of England provides copious additional loans at a lower rate.

So there is quite a risk that mortgage rates will rise and what businesses pay for finance will increase too.

But to state the bloomin’ obvious, the system is not supposed to work that way.

It is the base rate that is supposed to anchor the economy, not the emergency lending rate.

mervyn_afp2.jpgSo the Bank of England has something of a dilemma.

It is rightly reluctant to slash interest rates and be seen to be bailing out all those negligent hedge funds and investment banks whose avarice precipitated the current crisis.

But it surely doesn’t want to penalise all of us, in the form of a sharp economic slowdown, just to teach those hedgies and bankers a lesson.

I don’t suppose Mervyn King, the Bank’s Governor, looks for divine intervention terribly often. He may require it this time.

Justice and markets

Robert Peston | 10:30 UK time, Monday, 3 September 2007


Gordon Brown told us on the Today programme this morning not to worry about the ill-effects of sickness in credit markets because “transparency and regulation” would see us right.

Which might have been an early-morning attempt at wry humour, but I’m not so sure.

The Prime Minister's transparency and regulation are an aspiration, not a description.

The parts of the financial system which incubated the virus – the darkling, fetid jungles occupied by hedge funds and structured investment vehicles dealing in collateralised debt obligations and other complex products – are opaque and largely free from the kind of direct supervisory controls that constrain banks and financial institutions dealing directly with the public.

None of this would matter if the vast majority of us were unaffected by this malaise, if we could be detached bystanders. But the price of trillions of dollars of financial assets is determined in the darkling jungles and those assets are held by the banks on which we rely.

With a collapse in asset prices, there has been a generalised erosion of confidence in credit markets. That in turn has led to a steep rise in short-term interest rates, not the ones set by central banks but the ones that really matter, the "Libor" rates that reflect the actual price at which commercial financial institutions are prepared to lend money.

Borrowing costs for businesses and consumers are rising.

Which is why central bankers have been pumping money into the global economy and will continue to do so – to try to ward off the evil of recession.

Those central bankers are in agonies of confusion, as evinced by the many weird and wonderful things they’ve been saying at their annual shindig in Jackson Hole, Wyoming. They are torn between their duty to keep the global economy on track and their anathema for bailing out negligent investment bankers and hedgies responsible for this mess.

So quite an important question is whether those who behaved especially irresponsibly are paying a steep penalty. If the culprits are being punished, the global financial system would now self-correct. And there would be no need for Gordon Brown, other government heads, central banks and regulators to steamroller in and impose new restrictions on the free operation of markets.

Have the great investment banks, commercial banks and hedge funds learned their lesson? Can we be confident that they won’t do it again?

Just asking the question makes me sound silly.

Yes, bonuses won’t be so bulgy this year and quite a few financial rocket scientists – especially those specialising in radioactive collateralised debt obligations (CDOs) – have already been given the boot.

And yes, a couple of state-backed German banks, a few hedge funds, and some structured investment vehicles have suffered serious losses.

Also there are certain markets that have more or less evaporated (for now):

a) it is impossible to raise finance for a leveraged private-equity takeover, that boom has fizzled;

b) more-or-less all CDOs are being treated as toxic by investors, even those that might be palatable;

c) the enormous asset-backed commercial paper market is shrivelling to nothingness before our very eyes.

But let’s also not forget that the spoils of the boom that preceded this bust were on a mind-boggling scale and were largely pocketed by a few thousand hedge-fund owners and investment bankers. Many of those have cashed in tens of millions dollars each and are barely bruised by the recent turmoil.

For most participants in this market, the moral is pretty clear: they all got rich, and never mind the current mayhem. When a semblance of normal service is resumed, why not do it all over again, but perhaps with even greater gusto?

What’s more, where there is mayhem, there is opportunity. The smarties at Goldman, Morgan Stanley, Barclays Capital and the others are expected to coin it from clearing up the mess they in part created – through a business euphemistically called “restructuring”.

And they, plus the hedgies, have been raising lots of new capital to buy distressed financial assets, whose distress was caused by… yeah, you guessed it.

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