Sorting out the UK banking system, part 2/3

1. Having accepted that bonds are part-ownership and not a liability, and done all the netting off and contras from Part 1, we arrive at the more respectable balance sheet position shown below, with a healthy Basel ratio of 25% (i.e. £873 over £3,279). This deals with the first Big Myth, that UK banks are likely to go *pop* any second. I'll deal with the last Big Myth - that UK banks have to refinance or roll over £800 billion in bonds in the next few years - in part 3.

2. But let's now confront the second Big Myth - that we have to throw everything we can at propping up UK house prices, because if they fall by one single penny, the entire UK banking system will collapse. So let's do an extreme stress test and assume that UK house prices fall by half (which is unlikely to happen). I've pencilled in these write down percentages, and the resulting balance sheet will appear in Part 3 later today. Article continues below:
3. To see how undramatic the effect of a 50% house price crash would be, we have to remember that not all mortgages are 100% loan to value, i.e. if your loan-to-value ratio is 50% and prices fell by half, you would still not be in negative equity.

4. According to Table 2.17 of the Bank of England's latest Financial Stability Report, 59% of UK residential mortgages had a loan-to-value ratio of less than 50%, so subject to certain assumptions - that every borrower in negative equity declared him or herself bankrupt and handed back the keys (again, highly unlikely to happen), the total losses would be in the region of 15% to 20%. The same sort of figure applies to lending on commercial properties, and there is plenty of non-land related lending. In my 'write down' column, I have assumed a write down/loss of 20%, i.e. at the higher end.

5. Heck knows what's buried in 'Securities for sale'. It'll be a mixture of stuff that is worth what they say it is, second hand mortgages worth 80% of their face value (see 4.) and other US-origin sub-prime stuff that might be worthless. This averages out to 60% of current market value, so let's write this lot down by 40%.

5. For good measure, let's write down banks' own fixed assets - which include their commercial premises and 'good will' - by 10%.

6. You can't 'write down' customer deposits or trade debts as this would be open fraud and politically impossible.

7. And we have to keep track of the market value of all the bank shares and bank bonds in existence. Market value of the shares is explained in Part 1. I've assumed that bank bonds are trading, on average, at 80p in the £. Therefore the total 'enterprise value' of UK banks is £723 billion - the object of this exercise is to show that neither bond nor shareholders would particularly lose out if house prices crashed AND/OR if UK government bail outs were to be halted and reversed.