Thursday, 22 January 2009

Fixin' the banks - made simple

Instead of explaining the book-keeping entries, the finer details of the Companies Act, TUPE regulations and capital adequacy ratios, I'll try explaining it with pictures.

1. First up is the current situation: on its 'assets' side, a typical bank has good, reliable borrowers, who can easily repay the interest and repayments out of ordinary income or profits and where the assets on which the loan is secured are double the amount of the loan ... all the way down to wacky investments in US sub-prime mortgages that have been endlessly sliced and diced and where the recoverable amount is a fraction of what the bank paid for it. On the 'liabilities' side, deposits have to be repaid in full (morally rather than legally, but there is a taxpayer-guarantee of the first £50,000 per borrower) and shareholders rank last, there is no legal obligation to pay them anything, they just get what's left after everybody else has been paid off. I've ignored fixed assets (branch offices, telephones, computers) as their value is minuscule in the scheme of things.

2. Then you snip off the top bit from the bottom bit roughly where the dashed line is - whether that is by (1) depositors and good borrowers simply transferring their business to a new bank; (2) a corporate demerger; (3) a sale of trade and assets (like the transfer of Bradford & Bingley's deposits, branch offices and employees to Santander, that seems to have gone without a hitch) or even (4) massive write down of the worthless loans (shaded dark grey) combined with a radical debt-for-equity swap (and subsequent reduction in share capital) is neither here nor there.

3. The top bit then becomes a new Good Bank, which looks a heck of a lot like a well-run building society used to do - they borrow spare cash from people with a bit of spare cash and lend it out to sensible borrowers at sensible income multiples and demand at least a 25% deposit, or corresponding security from a business.

4. Unless you have gone for option (4) (write down of assets and debt for equity swap etc), then you also end up with Bad Bank. This bank is a 'closed fund' - it makes no new mortgage advances but collects as much as it can from existing borrowers who aren't able to remortgage elsewhere and dishes out the receipts between the original shareholders and the bondholders of the bank we started off with until there's nothing left.

5. And there's not a penny of taxpayers' money involved, no nationalisation, nothing. Capitalism is about risk and reward - there were reckless lenders and reckless borrowers, who should share the losses, I don't see why ordinary depositors, sensible borrrowers or the taxpayer should get dragged into this.


marksany said...

Sounds good, but doesn't this depend on a balance between good assets and good liabilities? Do we have a situation where there are many more good liabilities than there are good assets.

Anton Howes said...


You swap as much debt-for-equity as needed once assets have been revalued (lower).
There aren't really any "good liabilities" - you pay off as much debt as possible (preferably without getting savers with deposits to take part in the swap - but there are enough larger creditors for this not to happen in most cases I think).

marksany said...

AH - thanks for the explanation. So you still need to find someone willing to accept equity in lieu of payment, but then the alternative is default.

I meant "good" liabilities in the eye of the investor- I consider my cash ISA to be good and my RBS shares (sniff) to be "bad." From the bank's point of view, cash ISA's are a bad liability, because they have to pay out.


Mark Wadsworth said...

AH, good explanation.

MA, the distinction is not between 'good' and 'bad' liabilities so much as between 'blameless in this whole debacle' (i.e. ordinary deposits, ISAs, savings accounts) and 'asking for trouble' (investing in AAA rated mortgage backed securities via a Netherlands Antilles based hedge fund which has leveraged up via further bank borrowings).

Remember always that the blameless people can turn up at the bank and demand instant repayment, and that the 'good' borrowers can remortgage elsewhere at the drop of a hat. One way or another, they'll end up with the Good Bank.

John Pickworth said...

Then the question becomes... why aren't we doing this?

Lola said...

John P @ 05:01 - Exactly. Every day that goes by is another shed of our wealth down the tubes. Guido says £1m per hour on government unfunded spending alone. Plus all the commercial negative cashflow from the banks.

BTW - ISA's = horrible deceit. Cash ISA's in particular. Nearly everyone I look at ends up with the offering institution pocketing the tax relief.

Mark Wadsworth said...

JP, it's either cock up or conspiracy, you decide. On balance I suspect the latter - the government loves nationalising stuff with our money, and the corporatists at the banks love a bit of free money.

L, I agree on cash ISAs, that's a different topic.

Anonymous said...

"why aren't we doing this?"

According to the financial genius running the country and saving the world - and interviewed on Today this morning - because printing money, doing a Weimar on sterling and ruining the economy is "the right thing to do" and, oh yes, in case we'd forgotten "it's all the fault of the US".

Anton Howes said...


Yeah, you still need to find someone. Often however they end up exchanging debt for shares worth more than the debt. e.g. £1 debt for £1.01 of shares.
From what I've seen, this is what happens when businesses do it. I'm not sure banks can at the moment under current legislation. If they can't, then that definitely needs to change!

JP: I'd say it comes down to self-interest and behavioural economics in the end. Debt-for-Equity is currently used as a model for some businesses when they go bankrupt. Once you've started guaranteeing stuff, there's no more incentive to do it. As for the government, it's probably incompetence and misunderstanding of the problem despite extensive media coverage (particularly in the FT - just look at that possible demi-genius Willem Buiter!)

marksany said...

AH - I agree. I'd add - at the moment, no one knows what a bank share is worth. They don't have a functional business model anymore.

Mark Wadsworth said...

JP, don't forget that in the absence of government guarantees, £1 nominal of bank debt might be worth 50p or something. Deposits balances were always guaranteed £35k or £50 per person, fair enough, but not all the RMBS and CDO crapola.

MA, bank shares are effectively worthless. RBS for example have fallen 98% over the last two years. Who cares if they fall 100%?

marksany said...

If the bank shares are worth zero (and I agree, they may as well be) can you still do a debt for equity swap?

Mark Wadsworth said...

MA, yes of course.

Shares = value of business minus amount owed on bonds, so the current situation is thus:

£nil = £100 minus £100.

If you convert £10 of bonds to shares (which, by definition reduces the amount owed on bonds by £10), the situation would be thus:

£10 = £100 minus £90.

Anonymous said...

Good stuff but I think you'll find that the banks have been more imprudent that you have realised. Funding from RMBS issues and from "covered bonds" rank ahead of (unsecured) retail and wholesale depositors in modern banks' liability structures. Sadly, the contractual reality is that depositors have probably been left with some of the worst assets that the banks own. It's a scandal, but there you have it. The banks, under cover of the government-guaranteed "too big to fail'ness", have stuffed their depositors and consequently stuffed the taxpayers too. The government unintentionally, and the mainstream banks less unintentionally, did away with the level playing field, by giving privileged guarantees against failure to existing banks eliminating any possible prudent competition, and creating the conditions for the bubble and current bust.

Mark Wadsworth said...

JA, "Funding from RMBS issues and from "covered bonds" rank ahead of (unsecured) retail and wholesale depositors in modern banks' liability structures."

Maybe the fine print says that, but once a company is put into administration, the clock is reset. The administrator would just transfer all deposit accounts to a new bank (like transferring B&B branches and deposit accounts to Santander - there are real life examples for all of this).

This triggers a liability on the transferee bank - as debts incurred in administration rank in priority to everything else (as a general rule), this would have to be repaid first - which would happen automatically if the old bank simply hiked its mortgage interest rates - the 'good' borrowers would simply remortgage with the new bank and it would all net off (basic bookkeeping).

This was the model that the Northern Rock was pursuing, rather successfully it must be said, until the government decided a few months ago that it was more important to slow down the house price crash than to get taxpayers' money back.

Anonymous said...

You might say "fine print" but investors in RMBS and covered bonds would say "legal contracts". Government-backed administration that breaks voluntary contracts is expropriation of someone. In the case of Northern Rock, RMBS (via the Granite securitisation vehicle) and Covered Bondholders are being paid according to schedule. Unsecured depositors have been guaranteed as losses on the mortgages, commecial loans and other Treasury "securities" are paid for by the taxpayer. More or less the same is true for B&B. The unsecured depositors were able to leave behind all the assets, good or bad. The secured funders also seem to be OK inside the UKFI government holding company. Again, the taxpayers are taking the hit on any B&B losses. If we want to avoid banking crises in the future then we have to let banks fail, wiht hits to creditors in order of their security. Only if this happens will future generations of deposit-holders understand to avoid grossly-overleveraged banks. It is tough love, governments may fall due to it, but if we don't learn our lessons then we will be doomed to repeat these situations.

Mark Wadsworth said...

JA, maybe. But isn't part of what triggered the NR collapse the fact that it is guaranteeing the losses on the loans it had sort-of sold on to Granite? Is it up to Granite to bear those losses or not?

Anonymous said...

It is true that NRK did, at first, retain the "first loss" piece of the loans sold to Granite, like other banks. Later it even sold the first loss piece too. So it is up to Granite to bear the losses. However, Granite has the "best" stuff, or at least what was thought of as the best stuff, the worst is left with the shareholders, debt capital holders and then any other unsecured creditors (you and me now that the government has guaranteed all other unsecured retail and wholesale deposits). Granite debt holders are not out of the woods yet as the depth of the house price crash and recession in the UK even begin to hurt their securities.

Barnacle Bill said...

Thanks Mark.