"At long last, economists appreciate that private debt was the catalyst for the crisis"

Paul Ormerod in City AM:

A particularly interesting paper in the journal is by Atif Mian of Princeton and Amir Sufi of Chicago. Their focus is considerably wider than the crisis of the late 2000s in the United States. They quote empirical studies across some 50 countries with data going back to the 1960s. They found that a rise in household debt relative to the size of the economy is a good predictor of whether GDP growth will slow down.

Rickard Nyman, a computer scientist at UCL, and I applied machine learning algorithms to data on both public and private (households and commercial companies) sector debt in both the UK and America. We find that the recession of 2008 could have been predicted in the middle of 2007.

This is news? People have known about the 18-year credit/land price bubble cycle for over a century. Fred Harrison predicted the 2007-08 credit crunch in 1997. The Neo-Libs and Homeys like to airbrush this out of history and pretend that economic depressions are somehow random events.

Perhaps the most striking result is that public sector debt played little role in causing the crisis. The driving force was the very high levels of private sector debt.

Again, this ought to have been clear to anybody with half a brain. Labour's deficit spending was A Bad Thing, but clearly not the cause of the credit crunch. I can understand why Tory politicians claim that it was, but I am baffled why so many Labour politicians go along with the lie (a particularly twisted kind of Indian Bicycle Marketing).

A critic might say that this is simply a case of generals fighting the last war. True, we don’t know whether a completely different nasty event lies around the corner. But at long last, economists appreciate the fundamental importance of debt and finance in Western economies.

There'll be another credit crunch in 2025-26, full stop. That is the next 'war' and we haven't properly won the last one yet.

RBS boss Hester "desperate for people to have to borrow to eat"

From the BBC and the BBC:

Royal Bank of Scotland is "desperate" to lend to UK households who need to "borrow money for food", the bank's chief executive has claimed.

One in five UK households borrowed money or used savings to cover food costs in April, a Which? survey says. In an interview with the Sunday Times, Stephen Hester said RBS was sitting on £20bn in cash but economic worries meant businesses were not borrowing, so the RBS was seriously considering a move into payday loans.

"We are lending as much as we can," he said, adding that the bank could not "force companies to borrow. But it's not enough. If only the government could find a mechanism to push people's wages down and push rents up, then we'd be able to tap into a whole new market."

The Which? survey suggests the equivalent of five million households used credit cards, overdrafts or savings to buy food. Partly state-owned RBS reported a return to profit in its quarterly results on Friday. It announced pre-tax profits of £826m and said it lent a total of £13.2bn in the first three months of the year - £7.8bn of it to small businesses.

But like other banks it has abandoned its stated aim of supporting the UK's economic recovery by increasing business lending further because of far more lucrative lending opportunities, such as people's need to put food on the table.

The consumer group tracks the spending habits and behaviours of 2,000 people every month. Which? boss Richard Lloyd described the findings as "shocking". RBS boss Stephen Hester described the findings as "a godsend". The government said tax and benefit changes meant working households were now better off, while working households reported the opposite.

H/t BobE.

Reader's Letter Of The Day

Over at the YPP blog.

"Supernatural beings face disaster - even without an increase in loan rates"

From The Daily Mail:

Just when the outlook for the nation’s domestic finances seemed as it couldn’t get any worse – it has.

On top of fears that one million or more ‘zombie households’ face instant insolvency the moment interest rates return to normal comes new research today uncovering the risks faced by werewolves, vampires and Dr Frankenstein's monsters...

Jim is one of those who has talked to BDRC and Judy is another (their real names are unknown).

In his 50s, Jim is a werewolf enjoying a low-rate tracker but will need to find a six-figure sum to pay off the capital debt. "I am saving hard, but I keep waking up really tired with bits of dead animal scattered round the house," he said.

Judy is a vampire in her late 30s who owns a small plumbing business. "Trade is reasonable and I can drink blood from my customers, but I have no idea how I will ever clear the mortgage debt," she said.

BDRC director Tony Wornell said: "Just under 20 per cent of all home purchases are by supernatural and subhuman being who have taken our an an interest-only mortgage, either in the form of an old-style endowment mortgage - six per cent - or in the new interest-only loans - 13 per cent. There's no silver bullet."

Its survey found only 31 per cent had an investment plan that was on course to clear their debt, while eight per cent of the total either did not know or could only answer in grunts.

Wornell added: "Many interest-only borrowers are not engaged with the end-game – what happens when their mortgage term finishes and they have to repay the capital? Every werewolf with such a mortgage needs a credible repayment plan. Simply sacrificing your bank manager is not a realistic option in this day and age."

Elsewhere in the financial graveyard, new figures from R3, the body representing vampire slayers, has found a rise from the grave of a number of people who are paying only the interest on their credit card statements – to 3.4 million against 2.9 million a year ago.

One ray of light is that the total number who are paying only interest on their overdrafts has declined over the same period, from 2.4 million to 2.2 million. The problem is that a ray of sunlight could reduce vampire borrowers to a heap of an ash-like substance, leaving them unable to keep up with repayments.

But figures last month from the Office for National Statistics showed the proportion of Dr Frankenstein's monsters who said they would be unable to meet an unexpected but unavoidable expense had risen from one in four in 2007 – at the start of the economic downturn – to two in five today. And a detailed Business Department report from 2011 found 23 per cent of the adult population either ‘constantly struggling to stop their limbs from detaching’ or ‘falling behind because their legs were sewn on wrong’.

The Bloodbank of England has expressed concern about the effect of large numbers of bloodthirsty borrowers roaming the streets on consumers’ willingness to spend - they are simply too scared to venture out to the shops for fear of being bitten, and City regulator Martin Wheatley, head of the new Financial Conduct Authority, described the £120  billion of unfunded interest-only mortgages as ‘a ticking time-bomb’.

Some, however, refuse to be spooked. Judy said: "I am not prepared to worry that far ahead – there are too many battles to be fought between now and the next full moon and too much killing to be done before then."

Britain's hard working and thrifty pensioners.

Spotted by Bob E in The Telegraph:

Many still owe hundreds of thousands of pounds on interest-only mortgages, caught between endowments that failed to deliver and lenders demanding repayment.

Those approaching retirement are hitting the milestone in poor financial shape, with nearly one in five expecting to be in debt on the day they receive their gold carriage clock.

Figures from Prudential released this week show that the average owed by [the one-in-five who retires in debt] is more than £31,000, spread over a mixture of credit cards, bank loans, overdrafts and mortgages. Twelve per cent of them do not expect that they will ever clear the debt, while it will eat into the income of others for several years before they pay it off.

The charity StepChange, formerly known as the Consumer Credit Counselling Service, said it had seen a 44pc increase since 2009 in the number of over-sixties contacting it with problems paying their mortgages. "With many older people taking higher levels of debt with them into retirement, this could be the start of a long-term trend," warned Delroy Corinaldi, a director of StepChange.

This is an advertorial for "equity release' schemes of course, but let's take the figures at face value.

From the comments:

alanr: Any pensioner that owes six-figure sums on an IO deal has likely been severely imprudent, rather than unlucky as you imply.

No no no no no Alan, you can't say that! Haven't you realised there is a determined effort underway to establish an "interest only mortgage miss-selling scandal" in order to push for some sort of bail out for all these "unlucky" and certainly not imprudent/stupid/greedy people?

How LIBOR works... (2)

Back in 2008, I posted up the following comment by Lola:

Boss of Bank A is looking at its balance sheet and saying: "Bloody Hell! If ours is that bad his (Bank B) must be even worse. So sod that for a game of soldiers, I am not lending to him at any price, well unless I can get a silly rate. Fred? Jack up the LIBOR rate by 500 bps."

Fred: "OK Boss."

Turns out we were wrong, the conversation actually goes something more like this:

Boss of Bank BARC.L is looking at its balance sheet and saying: "Bloody Hell! If ours is that bad his (Bank X) must be even worse. But we know that he knows that we know. If it gets out, we can sod this for a game of soldiers and nobody will lend to any of us at any price, well unless I can get a silly rate. Fred? Knock down the LIBOR rate by 500 bps. Right now, we don't care what it costs us."

Fred: "OK Boss."

Boss: "Oh, and find out if the fixed interest guys have offloaded some of the stuff they bought last month, there's got to be a few quid in it by now."

Fred: "They're already on it, Boss."

Lunatics took over the asylum

From The Daily Mail:

Bankers and politicians displayed the same symptoms as patients with mental health problems in the run up to the devastating credit crunch, scientists have revealed.

In the years before the crisis, scientists claim bankers, economists and politicians shared the characteristics of denial, omnipotence and triumphalism. The same symptoms are prevalent in psychologically disturbed individuals according to Professor Mark Stein, from Leicester University’s school of management.

In a paper published today in The Sage Journal, he said the shared 'manic culture' caused world leaders to 'throw caution to the wind' which led to the financial disaster...

Which would all be bad enough, but as far as I can see, the same deluded beliefs are still prevalent.

This is not a crisis, a short term state of affairs which can be resolved by a one-off decisive action (see: Cuban missile crisis), this is the way the world is: Oh, if only we could bail out the banks once and for all. Oh, if only we can keep house prices high. Oh, if only we could pass off increases in the national debt as reductions in the annual deficit, or indeed as 'savage Tory cuts'. And so on.

Economic myths: UK household borrowing

The Independent has done a good summary of lending by UK banks, to whom and on what kind of loans most of their losses arose (above and beyond the fact that senior employees were ripping of the banks to the tune of £10 billion or £20 billion a year).

The figures all look perfectly plausible to me, yes, lending to UK household went up a lot in the decade leading up to the 'financial crisis' (which we knew about), but this was only a small part of the overall increase.

H/t Drewster at HPC.

David Blanchlower gives the game away

From City AM:

Mervyn King argued that “there seemed no reason to expect the worst recession since the 1930s” and nobody saw it coming because "no-one believed it would happen". Actually many people in the City did. They spotted that house price to earnings ratios had reached unsustainably high levels and the only way was down. Of course, banking crises are old as the hills; plus the 1929 Great Crash started in the Florida housing market.

Yup.

Even if you don't know the first thing about banking (and very few ever will, which puzzles me because it is very simple), you must know about house prices - what they are and how they are changing. Once land prices start rising rapidly (far more rapidly than rents), you know that there must be a credit bubble (the two go hand in hand). You know that bubbles always pop and that 'financial crises' can be very unpleasant indeed, particularly when the people in charge are in complete denial that there ever was a bubble in the first place and spend all their time (and our money) on trying to keep it inflated.

Blanchflower is one of the few people to point out that the 1929 crash was a spillover from the 1920s land price bubble in the USA (which continued the 18-year boom-bust cycle of the 19th century), which in turn was the result of a credit bubble (and the usual subsidies to land ownership). The stock market bubble, which popped in 1929 was the result of the people in charge trying to keep the land price bubble inflated.

There is the same level of denial about Japan's "lost decade". Most articles or textbooks refer to the Japanese share price bubble but ignore the Japanese land price bubble which happened at the same time, and which was far larger in magnitude, and involved a far greater amount of credit/indebtedness. And there is the same denial in the UK right now - there is a widely held delusion that if only we can "kick start" the housing market (i.e. get prices back up to 2007 levels with a combination of easier credit and yet more subsidies) that everything will magically turn out all right again.

"Skyscrapers linked with impending financial crashes"

From the BBC:

There is an "unhealthy correlation" between the building of skyscrapers and subsequent financial crashes, according to Barclays Capital. Examples include the Empire State building, built as the Great Depression was underway, and the current world's tallest, the Burj Khalifa, built just before Dubai almost went bust.

China is currently the biggest builder of skyscrapers, the bank said. India also has 14 skyscrapers under construction.

"Often the world's tallest buildings are simply the edifice of a broader skyscraper building boom, reflecting a widespread misallocation of capital and an impending economic correction," Barclays Capital analysts said. The bank noted that the world's first skyscraper, the Equitable Life building in New York, was completed in 1873 and coincided with a five-year recession. It was demolished in 1912...

That all seems perfectly plausible to me.

By and large, the height and density of buildings are primarily an indicator of relative land values in towns and cities. So you get the highest and densest buildings in the town centre* and then it gets lower and sparser as you move out into the suburbs.

The other thing which sky scrapers indicate is over-inflated egos, and credit bubbles inflate people's egos in the same way as they inflate the selling price of land.

So it's clear why credit bubbles mean more skyscrapers being built; credit bubbles always burst; hey presto, there's your correlation between skyscrapers and recessions.

Or the theory might be complete bunk, who knows?
--------------------------------
* UPDATE, prompted by JT's comment, I refer you to Jason Barr's empirical research looking at the economics of skyscrapers in Manhattan:

One also notices that within the skyline there are distinct “waves” of building heights, with height rising toward the "center". These waves reflect the endogenous relationship between strategic height, land values and agglomeration economies. Corporations need to be near each other to lower their business costs and increase demand, yet they also desire to stand out in the skyline.

Being close is valuable, which is reflected in property values in the center; large land costs, in turn, drives developers to build even higher if they are to get a return on their investment, as well as have their buildings stand out.

He explains that on the one hand, builders want to build as high as possible, to maximise rental income, fair enough. By and large, rental values decline slightly with height (longer lift journeys etc) and construction costs rise disproportionately with height. So there is a cut-off height above which it makes no sense building, but hubris (esp. during a credit boom) makes people want to add a dozen floors too many, and credit booms also lead builders to underestimate the cost of capital tied up in those extra floors.

He can thus identify the "too tall" buildings, and lists the top fifteen "too tall" buildings on page 27. As you'd expect, their construction dates match peaks of the eighteen-year credit cycles, two in 1908-13; seven in 1926 - 1933; then a bit of a gap for WW2 which threw the cycles out of kilter (or dampened the one which would have happened in the late 1940s); two in 1960 - 61; three in 1972 - 77; and an odd one out in 1987.

Excellent summary of how debt-for-equity swaps would work with banks.

Andrew Lilico has a lengthy article in today's CityAM. The idea and the justification are blindingly simple and obvious, of course, but presumably, having won the argument as to why, he has spent the last few years bogged down explaining to people how it would work in practice, so he goes into a good level of detail.

The key to it is this:

... the bank gets new capital – new shares – out of its bondholders, instead of the government injecting taxpayer funds ("recapitalisation" – or, not to mince words, partial nationalisation). So the bank isn’t shut down. The depositors can still withdraw their money. The bank carries on making loans. But it has new owners – the former bondholders – and it has fewer debts (because some of its bonds have gone, converted into equity).

Such a debt-equity conversion can be done very quickly – over a weekend, say, or certainly in no more than a fortnight. If it ends up taking any time, then there is the question of how to maintain service to depositors. That can be done by taking a distressed bank into special administration. When a normal company goes bust, it is taken over by administrators. The administrators in the case of banks would be the Bank of England or the Treasury.

Which is pretty much what I've been saying all along.

You're all in this together!

Surprisingly honest

From George Osborne's speech, available at HM Treasury:

... these events did not come out of the blue. They all have the same root cause.

Debt.

In particular, a massive overhang of debt from a decade-long boom when economic growth was based on unsustainable household borrowing, unrealistic house prices, dangerously high banking leverage, and a failure of governments to put their public finances in order.

Unfortunately, the UK was perhaps the most eager participant in this boom, with the most indebted households, the biggest housing bubble, the most over-leveraged banks and the largest budget deficit of them all.

History teaches us that recovery from this sort of debt-driven, financial balance-sheet recession was always going to be choppy and difficult.

That's all refreshingly honest, coming from a politician, especially one who's actually in power and could do something about it. Problem is, he and his ilk have absolutely no intention of reducing household borrowing, allowing house prices to fall, making banks sort themselves out or reducing his own government deficit, but hey.

Via Dill at HPC.

Extend And Pretend Fun

Exhibit One

Up to 300,000 cash-strapped households have switched more than £60bn of mortgage debt from repayment into risky interest-only deals over the past three years to help cover their living costs.

Analysis of Financial Services Authority (FSA) data demonstrates just how desperate families have become as they contend with what Mervyn King, the Governor of the Bank of England, has described as the most dramatic squeeze on family finances since the 1920s.

With the average UK mortgage at £109,000 and average borrowing costs at 3.5pc, switching from repayment to interest-only saves households roughly £230 a month. But although the move may help families with their immediate cash-flow problems, concerns have been raised about how the debts will be repaid. Darren Winder, UK economist at Oriel, said: "For someone who's trying to alleviate monthly cash flow pressure, moving to interest-only makes sense. But it does raise questions about how that loan gets repaid."

From other sources, it appears that three million borrowers are on interest-only mortgages, which is about a quarter of all mortgages.

Exhibit Two:

Lender forbearance – where banks shift homeowners onto interest-only deals, extend their mortgage term, or even permit payment holidays – now accounts for 63pc of all troubled home loans, according to the Financial Services Authority (FSA).

Although forbearance can help households, the FSA is concerned banks are using it to flatter their numbers by reducing bad debt provisions.

In a guidance note on "forbearance and impairment provisions", it said: "We believe that there is scope for considerable improvement in firms' interpretation of the disclosure requirements." A spokesman added that "there are concerns" about banks' use of forbearance.

Exhibit Three

Companies including Taylor Wimpey, Persimmon and Barratt have injected huge sums into the market in the form of shared-equity schemes to help customers get on the property ladder.

Details of the massive sums housebuilders have had to carry on their balance sheets came as it emerged the Council of Mortgage Lenders is coming under pressure to ease the supply of finance to first-time buyers by reintroducing 95pc mortgages.

Figures from the Home Builders Federation (HBF) reveal that £835m of shared equity loans were made available between January 2008 and February this year, resulting in 28,000 sales. Under the schemes, housebuilders help customers get together a deposit to buy homes.

The Government has also supported the market with it own shared-equity schemes including HomeBuy Direct and FirstBuy. Much of the shared-equity funding supplied by housebuilders has been done in partnership with Government schemes.

All articles from The Telegraph, spotter's badge MBK.

That's one way of looking at it...

... Mr K drew my attention to Tullett Prebon's lastest Strategy Note

Government and opposition alike base their thinking on the assumption that, by one means or another, growth can be restored. We see no reason whatever to assume this. To focus on the deficit is to ignore the fact that the British economy had become debt dependant long before the financial crisis.

Together, private and public borrowing has averaged 11.2% of GDP since 2003. Over the past decade, borrowing has driven up output in financial services (+123%), construction (+27%) and real estate (+26%), whilst lavish public spending has propelled expansion in health (+35%), education (+27%) and public administration and defence (+22%).

Real output in all other industries is now 5% lower than it was ten years ago.

Between them, real estate, finance, health, education, construction and public administration are six of Britain’s eight largest industries, and account for more than 58% of output. Yet the future prospects for at least five of these six sectors are grim, because:

- Public sector spending cuts are modest, but growth is now a thing of the past
- Net mortgage borrowing, critical to the real estate and construction sectors, has crashed, from £113bn in 2007-08 to a derisory £3bn last year.
- The aggregate of private (mortgage and credit) borrowing has now turned negative.

That sectors which account for 58% of output are hamstrung in this way leads us to believe that the fiscal and economic outlook is drastically worse than is generally assumed...

Interesting statistics in yesterday's Evening Standard

Splendid Chart Of The Day

From 24 Dash:

New mortgage lending fell to a record low in 2010 and advances are expected to drop further during the coming year, figures showed today.

Net lending, which strips out redemptions and repayments, totalled just £8.15 billion during the year, down from £11.33 billion in 2009 and the lowest level since the Bank of England's records began in 1987. [wot?]

The market finished the year on the back foot, with net lending contracting by £298 million during December, as homeowners repaid more than lenders advanced.

As we all well know, changes in house prices are largely a function of how easy it is to get a mortgage of how much, and not changes in their intrinsic value. I linked to this over at HPC and Khards hit back with this beauty from MoneyWeek (I hope it shows up OK): Seeing as net mortgage lending is going to be plus/minus nothing for the foreseeable future, that does seem to suggest that there will be further falls in house prices for the time being.

Sorting out the UK banking system, part 3/3

1. OK. We assumed a catastrophic house price collapse of 50% and mass bankruptcies - or at least a debt jubilee - in Part 2 earlier today. The resulting consolidated balance sheet of the UK banking system is shown below, and as you can see, the consolidated total assets are still looking positive, albeit down from £873 billion to £36 billion.

2. The next Big Myth is that banks have to refinance £800 billion in bonds in the next few years (the actual figure of £800 billion is correct), and they are unlikely to get this so the government will have to throw another £800 billion of taxpayers' finest at them. Let's assume that the banks really can't afford to repay these loans (which does indeed seem impossible) but similarly that they can't borrow new money either.

So let's turn to our old friend: the debt-for-equity swap. As long as the underlying business has some value and will make more money by continuing under new ownership than it would from being broken up, a debt-for-equity swap is always the most viable option. As to all this Basel-style capital adequacy nonsense, see footnote D.

3. We've also got to show that neither shareholders nor bondholders are somehow being robbed, and that they are no worse off than before - as the balance sheet shows, there is no reason to assume that they would be. See footnotes below:

Footnotes:

A. The total value of all the bonds and shares was £723 billion before the hypothetical house price crash and balance sheet restructuring (see Part 2). For company law/insolvency law reasons, all the bonds would be converted into shares, and the former bondholders would acquire a majority of the issued shares. Twenty five 'new' shares would be issued to bondholders for every eleven 'old' shares (the shares would thereafter be identical, or 'rank pari passu' as they say in the trade).

B. Banks will be charging mortgage interest rates of 4.5% on average - a bit higher than now, but they don't need to worry about house prices crashing any more because they already have done. They'll still be paying a miserly 1.5% interest rate on deposits, and still have typical running costs of 1%, so their maintainable profits from the £1,800 billion average customer balances (deposits or loans) will be about £36 billion per annum. If you don't mind, I'll gloss over corporation tax liabilities and ignore any residual income from the £571 billion worth of 'securities for sale' and the income from their trading or investment banking divisions, which will net off to very little.

C. UK banks' price earnings ratios are currently between 9 and 30. Let's pencil in a price/earnings ratio of 20.1 (it might be higher; it might be lower), which we multiply by the £36 billion maintainable earnings to arrive at a total market capitalisation of £723 billion, which is exactly what is was before we started - this is hardly surprising as the markets have already factored in what will inevitably happen.

In other words, if you own £10,000's worth of UK bank bonds or 'old' shares today, once the dust has settled, you will end up owning about £10,000's worth of shares afterwards. What's not to like?

D. Of course, having shareholder's funds of £36 billion to support total assets of £2,442 billion is far too low. But we are looking at the bottom of the cycle. If we want UK banks to have a ratio of at least 6%, then they'll just have to stop paying dividends for three years, hey presto, job done. Under the circumstances, whether profits are paid out as dividends or retained in the business has relatively little impact, see also 'Berkshire Hathaway' or 'Microsoft'.

Or they can speed up this process by flogging off the 'securities for sale' for £571 billion (they may well get far more than that, of course), which reduces total assets to £1,871 billion - combined with three years' retained profits, they'd have a capital ratio of 10% which is more than adequate.

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.

Sorting out the UK banking system, part 1/3

1. One of the Big Myths put about by bankers and politicians is that 'banks are too big to fail', because if you add up all their balance sheet totals, you end up with a figure of £6,000 or £7,000 billion, which is four or five times the UK's GDP. This is because every bank owes all the other banks vast amounts of money, and because of accounting rules that force you to show closely related assets and liabilities (i.e. derivatives) gross, rather than netting them off to a small, manageable figure.

2. Another Big Myth is that if house prices fall, banks will somehow disappear in a puff of smoke and savers won't get their money back (let alone bondholders or shareholders), which I will deal with in Parts 2 and 3 of today's mini-series.

3. So I have printed off the balance sheets of the five largest UK banks (see footnotes) and done all the netting off for you, which gives a more realistic balance sheet total for the UK banking system of £3,602 billion (still more than twice GDP, but that figure can be whittled down further). Article continues below:


4. I trust it's obvious where all the QE money went - straight back back into the Bank of England!

5. This balance sheet total is still overstated, so I have proposed a couple of further contra entries:

a) The UK government has lent the banks a couple of hundred billion to bail them out, which is included in 'bonds' but it also holds a couple of hundred of billion of the banks' money at the Bank of England (so it has lent money and borrowed it back again). Then there's the deferred tax asset which I can't be bothered to explain. Let's net all these off to nothing.

b) According to their individual balance sheets, total UK bank borrowing from other banks is £359 billion and total UK bank lending to other banks is £238 billion, which I have already netted down to £121 billion. We can only assume that the net figure is borrowed from non-UK banks, so let's net that off with 'Securities for sale', which includes all the mortgage-backed bonds and rubbish from other banks, primarily from the USA, i.e. repay them with their own rubbish. Also known as 'doing an Iceland'.

I'll show the effect of these contras and also look at the impact of a house price crash in Part 2 later today,
------------------------------
Footnotes:

A. Balance sheets downloaded from here:
Royal Bank of Scotland
Barclays, page 19, pdf
Lloyds Banking Group
HSBC, page 357, pdf
Nationwide, page 40, pdf

B. I didn't include Abbey, which is part of Santander, and of course Nationwide is a building society, not a bank. I only included the 53.7% of HSBC which relates to European operations but not smaller UK banks and building societies. By and large, the overs and unders will net off - Barclays has quite sizeable non-UK operations and what we get is a fair picture of the UK banking system as a whole.

C. There is of course no clear dividing line between 'customer deposits' and 'bonds', but a dividing line has to be drawn somewhere between true liabilities and ownership. For example, if you borrow £50,000 from your uncle to set up in business, and a year or two later you have also run up unpaid invoices of £50,000 it is up to the bankruptcy courts to decide that your uncle is part-owner of the business and that your suppliers are normal trade creditors.

D. I added up the market capitalisation of the four banks using Yahoo Finance's numbers to arrive at the market value of the shares. Nationwide doesn't have a market capitalisation, so I have assumed this to be £nil.