Car Finance Fun - seems a bit mad to me

Her Indoors bought one of those big white SUV cars two-and-a-half years ago on the never-never (HP or finance lease or PCP or whatever names they dream up for what is essentially the same thing).

I don't know the exact numbers, so I'll simplify a bit.
List price = £27,000
Deposit = £5,000
Three years @ £333 a month = £12,000
Final payment* = £12,000

* Depending on which whizz bang never-never scheme she's on,  this might be called 'loan outstanding', 'residual value', 'balloon payment', 'purchase option price' or whatever. She can also pay this  off over three years, @ £333 a month.

I've checked Autotrader and the second-hand value of that make and model is about £12,000 for three years old and £7,000 for six years old. Let's ignore VAT for now, it sort of nets off.

So if she sees it through, the total finance cost was negligible at £2,000 (works out at about 3% per annum) and she owns a car worth £7,000.
------------------------------------------------------
Here's where it gets weird, looking at it from the point of view of the dealer/manufacturer.

The chaps from the dealer rang her a couple of days ago, and said that if she pays another £1,000 she can swap it for a similar new big white SUV car (even though she's only two-and-a-half years into the initial three years) and the monthly payments stay the same. The current second hand value (two-and-a-half years) old is £14,000.

Let's assume this repeats itself, for ever. Every two-and-a-half years, she pays them £11,000 (£1,000 cash plus 30 months @ £333) and 'enjoys' £13,000's worth of depreciation (£27,000 list minus £14,000 residual)

The dealer/manufacturer collects £11,000 and loses £13,000 of depreciation, i.e. they give up £2,000 of the nominal profit margin when they sell the car, a kind of negative interest rate.

Popular delusions and 18 years on from the dotcom crash, like clockwork or coincidence?

Copy and paste from BTL over at Coindesk (click to enlarge)...

Responding to the thesis that the smart money may be about to run for the exit via selling bitcoin futures contracts, Dennis says:

"Even if I DID want to indulge in CME Bitcoin futures, why the hell would I want to settle in a rapidly devaluing fiat dollar??? As a trader, I don't even trade pairs with fiat any more. All of my trades today are for arbitrage on other cryptocurrencies."

To Dennis it doesn't matter if bitcoin is being pumped and dumped, because Dennis never wants to see his 'fiat' again anyway.  He's made his mind up it's worthless and he wants to keep his coins and tokens thank you very much.  

The comments over there are a goldmine, here's another taster:

I wanted to write something clever and witty, but I think I'll just repeat some of the above comments word for word.  At this level of irony and lack of self-awareness there's really nothing much I can add.

"Yeah, I read that no actually Bitcoin is involved in anything having to do with this new futures market.  So. Yeah. This whole new phase seems ridiculous."

"They create markets out of thin air and run a casino Las Vegas probably idolizes.  All the while they say everyone else is some sort of immoral degenerate gambler.  But yeah, the CME futures for Bitcoin have nothing to do with actual Bitcoin."

Killer Arguments Against LVT, Not (313)

Some more closely related KLNs are "House prices will plummet and millions will be trapped in negative equity" and "House prices will plummet and banks will go bankrupt

".

Firstly, as the LVT envisaged here would greatly reduce the tax payable by prospective and recent first-time buyers, so there is no reason to assume that house prices would change much.

Secondly, even if house prices fell by half, recent purchasers would have so much more extra post-tax income that they would be able to pay to pay off their mortgages in ten years, and they would be out of nequity after five years anyway.

Thirdly and slightly more radically, assuming that house prices fell by half, what would happen if all higher loan-to-value owner-occupiers' purchase mortgages were written down to the new reduced selling price of the home on which they are secured so that people can still sell their homes and walk away/start again if they so wish?

Let's assume that the 'losses' are split three ways: between borrower, bank and government/taxpayer generally.

a) Total outstanding residential mortgages in the UK are about £1,200 billion, of which approximately one-quarter relates to mortgage equity withdrawal and buy-to-let mortgages, which leaves £900 billion under consideration.

b) If you just look at principal, the numbers don't look too bad. Because of the fairly straight-line distribution of loans to value, the total principal amount of mortgages on which there would be a degree of write off is about £675 billion and the total write-off of principal would be one-third of that = £225 billion (or about 2% or 3% of what UK banks claim, probably spuriously, are their total assets).

c) That £675 billion is only part of the story of course. It is just a number on a bit of paper. What is actually relevant is the total future cash flows going from borrowers to banks. Assuming an interest rate of 4% and twenty years left to run, the total repayments for £675 billion in mortgages are £50 billion per annum, with total payments over the next 20 years of £1,000 billion.

d) The £450 billion replacement mortgages could be at a higher interest rate. So if these were at 6% interest, total annual repayments would be £40 billion, meaning that banks would receive £800 billion over the next 20 years, a loss to banks of £200 billion and a gain to borrowers of £200 billion.

e) The government could chip in (say) half that and give banks non-interest bearing government bonds with a nominal value of £100 billion which are redeemed at £5 billion a year for 20 years.

f) So borrowers would see their mortgage repayments fall by £10 billion a year or one-fifth (hooray); banks only have an annual shortfall of £5 billion (which they can easily recover by reining in salaries and bonuses at the top end) and the exercise only costs the taxpayer £5 billion a year for the next 20 years. Recent purchasers will end up paying the lion's share of that £5 billion in future, so it all pans out nicely.

Fun with functions: who's afraid of the big bad nequity?

1. One of the excuses which The Powers That Be use to prop up house prices is "the spectre of negative equity", which they know did for the Tories after 1992.

2. Now, as we remember from our lessons in finance, there is a fixed mathematical relationship between four variables: the principal amount of a loan, the term, the interest rate and the annual capital and interest payments required to pay it off. And these calculations are exactly the same for annuities (i.e. what you are supposed to spend your pension pot on). So if you know three of these variables, you can can calculate the missing one.

3. It is not very pleasant having a mortgage which is bigger than the value of your home but this is purely psychological.

4. The annual repayments have to be paid out of your annual income, not out of the value of the house - a mortgage doesn't automatically cost you more just because you are in nequity (glossing over the fact that the banks will bump up the interest rate). And banks don't like negative equity either, as only part of the loan counts as "secured", even though ultimately, loans are only secured on their borrowers' future earnings.

5. So what "the government" could do is allow house prices to fall by (say) a quarter and take any nequity-tainted mortgages off the banks' books. Borrowers are given a smaller replacement mortgage equal to the value of the house, and banks are given new government bonds with a nominal value equal to the existing principal (they do not have to recognise losses because there aren't any).

6. This need not be a get-out-of-jail-free card for borrowers... because the government can set the interest rate on the new loans slightly higher, so that the annual repayments (receipts, from the government's point of view) over the rest of the mortgage term are the same as they would have been at the old lower rate.

7. And the government could make a small mark-up on the deal as well. The interest rate which it has to pay (or which banks will demand) on government bonds is (say) 1% lower than the interest rate which normal borrowers were paying (because of better credit risk), and it can pool all these mark-ups to cover it against any actual losses incurred.

8. Here's the spreadsheet for you to muck about with. You can change the figures in the yellow boxes, the rest is functions (PMT and RATE).

What's the difference between "banks" and "debt collection agencies"?

A rallying cry of the Home-Owner-Ist élite over the past few years has been along the lines of this:

HOW DOES ONE shore up the balance sheets of Britain’s banks while encouraging more lending to cash-starved SMEs? Not since the riddle of the chicken and the egg has a puzzle so confounded the business, financial and political communities in the UK.

Corporate lending is essential for the expansion plans that are so vital to the economic recovery and job creation the government craves...

We know that the best source of cash for business expansion is retained profits and that the bulk of credit creation goes into asset price bubbles, but putting that to one side, where do people expect banks to get the money from? If a borrower is bringing forward consumption or investment, then somebody else (the ultimate lender) must be deferring it. That's where the money comes from.

1. Let's start from the other end and look at debt collection agencies. There are lots of different kinds of these with different names (discount house, debt factoring, invoice discounting) but let's just imagine a plain vanilla version. A productive business might not be very good at the nitty gritty of actual debt collection (sending chasing letters, applying to the County Court, contacting credit rating agencies and sending the heavies round etc) and it might see things as bad for customer relations, but on the other hand, it might want to provide goods or services on credit - gambling that the extra profits generated are in excess of the inevitable cost of bad debts.

2. So instead of selling strictly for cash only (coins and notes) and having a turnover of £1 million and net profits of £100,000, the productive business is happy to sell another £0.5 million on credit, increasing profits to £200,000 (marginal profits being higher than average profits). As long as no more than a fifth of those credit sales turn into bad debts, the business is happy.

3. The business then extricates itself from the messy business of debt collection by selling that £0.5 million to a debt collection agency for (say) £450,000 non-recourse up front and is ahead of the game. The debt collection agency in turn has to collect more than ninety per cent of those debts.

4. Now, perhaps that agency is so well run and has such a good reputation that the business doesn't actually need to receive its £450,000 immediately, it might be happy to leave the bulk of that on account with the agency to be withdrawn in stages as and when it needs it.

5. Taking a bit of a leap here and cheerfully ignoring the regulations on who is allowed to act as a "bank", imagine that Mr A wants to buy Mr B's house for £200,000 but doesn't have £200,000 ready cash (and Mr B does not want to immediately spend all that cash on another house). They could agree that Mr A moves in and pays Mr B the amount in instalments with interest over ten or twenty years.

6. But then Mr B is exposing himself to the risk of Mr A losing his job or being a bad payer, and then he has to go through the rigmarole of repossessing the house which is messy, expensive and unpleasant for all concerned. Or Mr B might decide in a few years' time that actually he wants £50,000 all in one go to buy himself a flash new car, but of course Mr A can't just stump up that amount of money.

7. There's no reason why Mr A and Mr B can't avail themselves of the agency's services. The agency collects the £200,000 in instalments with interest from Mr A over the next ten or twenty years, and because Mr B doesn't want to spend all the money at once, he is happy to leave his £200,000 on account with the agency, taking a share of the interest. And because the agency has entered into dozens or hundreds of such deals, the fact that a couple of the purchasers lose their job or turn out to be bad payers doesn't matter so much to the dozen or hundred vendors, it all averages out.

8. So there is a steady flow of cash income from the purchasers. Also, the cash withdrawn by all the vendors in any period will average out - some will want to make larger withdrawals to buy that flash new car, others will decide that they quite like earning interest and will not withdraw anything.

9. Having got this far, other people with spare cash (i.e. who have earned money but want to defer consumption) might think that placing their money on account with the agency to earn interest is a good deal, which increases the sources of cash inflow to the agency, and these deposits can be used e.g. to repay existing vendors.

10. Of course, if one man is deferring consumption/spending, somebody else must have brought forward consumption/spending, and the agency can now lend money to such people. The agency now no longer needs to wait until an individual transaction has taken place and a financial liability/asset has been created (like the sale on credit by Mr B to Mr A). By taking deposits and lending out the cash simultaneously, the agency is at the heart of the transaction (the acceleration and deferment of consumption/spending).

11. Once the agency's reputation is good enough, it won't need to wait to take deposits first - it can just give a "borrower" a piece of paper saying that the agency will credit the recipient (i.e. the business where the borrower spends his money) with that sum of money in his account, and the agency just has to gamble on those pieces of paper ending up in the hands of people who will not want to withdraw the cash immediately.

Q: How does this agency's activities now differ in any way from the activities of "banks"?

A: They don't. The two are exactly the same.

So when the cheerleaders say that "we want to get banks lending to business again", they are just saying that instead of everybody and every business consuming (or reinvesting) what they produce as they go along (a perfectly imaginable and stable state of affairs), they want one group of people to get into as much debt as possible (by bringing consumption/spending forward) and for another group of people to defer as much consumption/investment as possible (an unstable state of affairs).

Just sayin', is all.

Economic Myths: Gearing up reduces the cost of capital

The myth* is as follows, and it perpetrated in particular by bankers:

"Companies (especially banks) like financing their activities with loans rather than with share capital, because the cost of share capital is higher."

i. Nonsense. There are ten million worthy articles, books and theses about the ideal mix of loans and shareholders' funds (share capital, retained profits) and the short answer is that a business, any business, exists to make a profit and then we have to invent rules as to how these profits are to be shared out.

ii. Once wages, expenses and taxes have been paid, the remaining profit goes to the "owners", be they sole traders, partners, members, shareholders or bondholders, these are just legal-contractual arrangements to say how profits will be split up and do not really affect the actual profits made by the actual business.

iii. Let's ignore borrowing from banks for the time being as this is negligible anyway and such lending to business as exists usually relates to land and buildings.

iv. With a sole trader, partnership, a building society or a co-operative, there usually isn't any split (in economic terms) between "owners' funds" and "loans from owners", the split only exists with companies limited by shares.

v. Now, some people like to play safe and prefer investing in corporate bonds because they are lower risk and lower return; other people like investing in shares because they are higher risk and higher return, so it makes sense for a business to tap both sources, but overall it all averages out. If there are more bonds, then they become riskier and demand higher returns, and with higher leverage, the shares also become riskier and demand higher returns, but they are fighting over the same pot and the size of the pot doesn't change.

Really, it is a principal-agent problem

vi. Senior managers of quoted companies are often paid according to how well the share price** is doing and not according to how well the underlying business is doing, so for them it makes sense to gamble and gear up by borrowing to fund expansion rather than using retained profits, or borrowing money to finance share buy backs etc. If the gamble fails, they gain or lose little, if it pays off, they get a disproportionate share.

vii. In particular, senior bankers (for whom share-price related bonuses are de rigeur) are wailing that higher capital requirements mean that their "cost of capital" increases. But the "cost of capital" is merely the sum total of profits paid out to its owners (shareholders and bondholders) and while at any point in time the payments/reward to £1 shareholders' funds is higher than the payments/reward to £1 of borrowing/bonds, shifting from bonds to shares does not increase the total "cost of capital".

How can it? "cost of capital" just means "profits" which are largely unaffected by these shenanigins i.e. if the business/bank uses more shareholders' funds, then the amount is pays bondholders goes down (in absolute terms and as a % of bonds outstanding) and the amount it pays shareholders goes up in absolute terms and down as a % of shareholders' funds. The total income and the total profits stay the same. It's like somebody complaining that his wages will go down if he gives his wife more housekeeping money. It's like a sole trader complaining about his own drawings from the business, or an owner-manager complaining that his salary is too high or his dividends are too high.

viii. So what these senior bankers really mean is that higher capital requirements mean that their bonuses would go down, is all.

* For further debunking of this and similar EM's particular to the banking sector, see this article in The Economist.

** The share price is in turn a nigh meaningless figure, being calculated on the basis of two consensus wild guesses - future profits and the appropriate discount rate. Future profits are unearned income in the literal sense that they have not been earned yet, and there is all sorts of other manipulation going on and people have to try and guess how successful any business or industry will be at lobbying for tax breaks, subsidies, regulations etc.

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.

Economic Myths: The value of shares is "capital"

First things first: I am in favour of free market economics, capitalism, private ownership of businesses and so on. The cheerleaders for rent-seekers in The City keep pushing the propaganda that the only way to achieve this is by having companies owned by shareholders, and the shares to be traded on The Stock Exchange:

That was obvious during the privatisation of British Telecom in 1984. Only a few thousand people in the UK owned shares. Downing Street aides figured that, to sell an £8bn company like BT, people would need educating. They visited the stock exchange to discuss circulating a leaflet. The stock exchange folk suggested printing perhaps 5,000. It was shockingly complacent: the government side had in mind a first run of 1,000,000 – with more to follow.

It is because of Big Bang, and the privatisation that it was able to bear, that we now have not thousands, but millions of shareholders with a real stake in the UK. That led to a huge change in attitudes towards business, and turned us, for the first time, into a capital-owning democracy.

Meanwhile, London bounced back as the world’s top financial centre. True, many City firms were snapped up by foreign firms, including many Americans who enjoyed looser regulation here than in the US. But the key for any industry, not just finance, is not who owns it but where the jobs and value are being created. Big Bang ensured the answer was – London...

People say Big Bang created a “loadsamoney” culture that persists today. No. (big fat lie - see point 11. below) It simply allowed more people to exploit new opportunities and profit from them.

This is lies and propaganda from start to finish. All of this could have been achieved much more efficiently without companies issuing shares. The far better way would have been to adopt the building society funding model.

1. The 'assets' side of any business is what it is: buildings, plant, machinery, stocks, patents and goodwill and so on, that would remain unchanged but there is no need for the net assets of the business (after deducting liabilities and borrowing) to be split up into shares and for those shares to be owned/freely traded by investors. It is far more transparent and efficient if the net assets are financed by deposits.

2. Taking AstraZeneca at random (being the first company on the list of FTSE 100 constituents where most people would have a vague idea of what they actually do), it has a market capitalisation of £34 billion, divided into 1.27 billion shares worth currently £26.80 each. The LSE page for AZN publishes infinite amounts of detail about how the share price has changed, like the fact that those shares have fluctuated between £24.54 and £32.18 over the last 52 weeks - but nowhere does it mention the company's actual results or link to the company's financial statements.

3. If AZN were funded by deposits instead, there would be no need for any of this. The total deposits would add up to whatever AZN's shareholders' funds/reserves happen to be, which we can find out from their most recent accounts, which is $21.7 billion.

4. So if AZN were funded/owned by deposits/depositors instead of shares/shareholders:
* each shareholder would be credited with just over $17 for each share he owns and that $17 would be a very stable figure.
* That is your share of the real capital.
* The difference between the £17 (£11) per share real capital and the share price of £24 or £32 is not real capital, it is just random transfers of wealth which serve no purpose whatsoever, do not represent real wealth and certainly do not help to finance it (if anything, it does the reverse).
* The results for the first quarter of 2012 shows profits of $1.76 billion, which is a return of 8 cents for every $ invested.
* There would be no need for the directors to have a separate dividend policy, all that happens is that for every $1 you have on deposit, 8 cents is credited to you as your quarterly profit share.

5. If you are confident that AZN will continue to do well (compared to its peers) you put money on deposit with them ('buy'); or you leave your deposit + profit share untouched ('hold'); if you need cash, you can withdraw as much of your deposit + profit share as you like ('sell').

6. Sure, there may be short-term situations triggered by a bit of bad news when too many people rush to withdraw, in which case the directors can announce a freeze or limit on withdrawals, or levy a penalty charge on withdrawals, so for every $1 on deposit, you can withdraw 80 c and the other 20 c are forfeit, until the matter is resolved or the business is broken up and/or sold, but this is no worse than when trading in shares is suspended. And it is certainly far better to have invested $17 directly into AZN a few months ago and now to have $18 or $19 on deposit, than it is to have bought shares second hand for £32 which are now worth only £27

7. The upsides of this form of funding/ownership are that investors would pay a lot more attention to what really matters: actual profits, cash flows and net assets.

8. This is what leads to the most efficient allocation of real capital (buildings, machinery, patents etc). If another pharmaceuticals company is earning quarterly profits of 10 cents per $, then some people will withdraw money from AZN and deposit it with that other company. To finance these withdrawals, AZN will sell off or shut down its less profitable operations until the residual return on its core activities goes back up to 10 cents and it all evens out.

9. And none of this needs thousands and thousands of analysts and middlemen to manage people's savings, all creaming off their percentages. When you are deciding where to invest your savings, you just scan down the list of companies and look for those with the highest returns; assuming that most companies in each sector show similar returns, you then just spread your risk by depositing small amounts with lots of different companies to achieve diversification.

10. This would also be good for employee ownership. Instead of people earning money and then investing in shares directly, or more likely indirectly via pension funds or unit trusts etc, with all the costs, random transfers of wealth and lack of transparency, your employer could set up a deposit account for each employee and pay their salary into that (debit salary/expense, credit deposits). If you want to draw your whole salary each month, then do so. If you like the idea of taking a stake in your employer, you just draw a bit less and roll the balance forward.

11. "That all sounds splendid, Mr Wadsworth," the audience shouts "so where's the catch?" The catch is exactly the "loadsamoney" culture which the City cheerleaders deny exists. If AZN were depositor funded, it would only be a matter of time before some bright financial wizard came along and told depositors that they could make a fantastic windfall gain by converting to share capital: for every $17 (£11) you have on deposit, you will be given a shiny new share which you can sell for £27, no questions asked.

There would be no change to the net present value of the business, or of your stake in the business, but instead of you having to wait patiently for $5.44 cents (£3.40) to be added to your deposit of $17 (£11) each year, you would be able to take the next four-and-a-half years' worth of dividends all in one go (4.7 x £3.40 = £16, plus your £11 deposit = £27) by simply selling one share. Which is tantamount to saying that whoever buys your share has to wait four-and-a-half years until he actually breaks even again, and if that's not a "get rich quick" scheme I don't know what is.

12. I am still mulling over quite which policies a government could adopt to encourage all this. The knee-jerk response would be to simply retain corporation/income tax on the profits of businesses with publicly quoted/traded share capital and to abolish it for all other types of business (sole traders, partnerships, LLPs, depositor-funded, family-owned private limited companies etc), of course plc's would be free to convert to depositor-funded status if they so wished for no penalty; the shareholders just have a toss up between a higher net income in future or hanging on to their windfall gain now. The only tricky bit is how to deal with UK operations of foreign plc's, that's where you either get awful distortions or stupid loopholes.

Fakecharity Fun

From The Daily Mail (almost exactly five years ago):

Brown's £400m smash and grab on dormant bank accounts... More than £400 million in so-called dormant bank accounts is to be raided by the Government to fund charities, youth clubs, sports and community centres.

From The BBC (this morning):

A new financial institution set up by the UK government to finance charities and community groups has been launched.

Big Society Capital has £600m, of which the majority comes from unused cash in bank accounts that had been dormant for more than 15 years. The fund will back social enterprises that prove they can repay an investment through the income they generate...

Venture capitalist Sir Ronald Cohen, who is Big Society Capital's chairman, told the BBC that the fund's aim was to create a "thriving market for social investment"...

The fund has already agreed investments worth £3.6m in five separate schemes, including:

* Think Forward Social Impact, which helps young people into work and education

* Franchising Works, which trains the unemployed how to run a franchise business

* the Community Generation Fund, which supports the development of renewable energy infrastructure, such as solar panels and biomass boilers, for local communities.

According to Radio 4, the fund is going to be run by New Philanthropy Capital, yet another [privately owned] 'consultancy and think tank' which has the usual partners.

I have a particular grudge against NPC because I said something scathing about them on this 'blog a few years ago and promptly received an angry email denial which merely confirmed what I suspected*. At a guess, I'd say this is a front organisation for Goldman Sachs or similar. The UK branch of NCP was set up by a US 'fund' called Friends of New Philanthropy Capital, which as you can see received $1.4 million in funds back in 2007, passed the whole lot on to NCP in the UK to get it going, and has done practically nothing since.

* I have - inevitably - sometimes maligned people undeservedly. If people send me an email to set things straight, I am always happy to delete or amend the original post. But sometimes people make things worse for themselves.

Crossing the irony horizon to reach irony singularity

From yesterday's Evening Standard*:

City chiefs warned that the Square Mile's success as a financial centre is threatened by an explosion in the number of offices being converted into homes. They attacked government plans to scrap the need for planning consent to change commercial premises into residences as a "nuclear option" that risks huge harm...

The corporation warned [sic] that if it lost control over the number and location of residential developments, the commercial character of the City would come under threat from "short-term market forces"...

If more flats were interspersed among office blocks, just a few homeowners could stymy "large-scale and valuable" new schemes by objecting to them on issues such as the impact on light. The corporation is calling for either the City to be exempt from this change to planning consent or for a strong statement to encourage conversion of vacant offices into homes.

* See also Drewster's comments #2 and #6 regarding this article at HousepriceCrash

More wilful misreporting of Greek bail out

by The Metro:

After more than 12 hours of gruelling talks, eurozone ministers agreed a £200billion rescue deal that would save the country from bankruptcy.*

As part of the plan, £90billion of debt will be wiped out and interest rates on loans will be slashed. A further £108billion will also be loaned to the country to help it get back on its feet.

In exchange, Greece has agreed to cut pay, public sector jobs and spending as well as find £270 million of savings** in this year’s national budget. Next month, the IMF will decide how much to contribute to the package but if it is the same as last time, Britain could be made to hand over £1.6 billion***.

Nope, you cannot add £90 billion to £108 billion; you have to deduct £108 billion from £200 billion to arrive at the real answer +/- £90 billion, which is the value of debts from which Greece has been released.

What happened was that the EU/ECB/IMF gave existing existing creditors (who were owed £200 billion) £108 billion and told them to clear off, so now Greece owes the EU/ECB/IMF £108 billion instead of owing the existing creditors £200 billion.

* Countries can't and don't go bankrupt. They either default or are subsumed into a larger country, by consent or by force.

** To put £270 million into perspective, Greece's population and GDP are approx. one-fifth of the UK's, in other words, £270 million in their terms is £1.4 billion in our terms, i.e. still peanuts.

*** We will, hopefully, get most of that £1.6 billion back, sooner or later, as it is a loan not a gift; further, the chances are that this £1.6 billion will end up being paid to UK banks anyway. So this is not A Good Thing but it is hardly A Disaster, given the scale of UK bank bail outs so far.

Debt For Equity Swap Of The Week: Santander

From FT Alphaville:

Since Unicredit is doing this rights issue to meet the European Banking Authority’s target for banks to meet a nine per cent core capital ratio by June – it’s also worth mentioning in passing Santander’s announcement on Monday that it’s met the EBA goal. Modestly hooting that it’s "one of the world’s most solid and well-capitalised banks", Santander says it’s found €15bn of additional capital via the following:

- EUR 6,829 million through Valores Santander.

- EUR 1,943 million through the exchange of preferred shares for ordinary new shares.

- EUR 1,660 million through the application of the Santander Dividendo Elección program (scrip dividend) at the time of the final dividend corresponding to fiscal year 2011.

- EUR 4,890 million through organic capital generation and the transfer of certain stakes, mainly in Chile and Brazil.

Interesting to note that the "Valores Santander" portion is made up of converting retail bonds that were originally issued in 2007 into shares during October 2012. As the WSJ has reported, it’s been anything but “valores” for Santander retail investors who bought these securities.

Yes, it's tough, but better them than the taxpayer, eh?

Splitting the zero

Two common misconceptions about banking are that:
a) Banks can create money out of thin air.
b) Banks take money from depositors and then lend it to borrowers.

There is a small element of truth to either, but clearly they are contradictory
a) If banks can create money out of thin air, then how could there ever be a run on a bank? How could banks ever be short of 'capital'?
b) Why would banks bother waiting for people to deposit money before lending it on if they can just create it?

So there must be 'something else' which most people have overlooked which bridges the gap between the misconceptions. That 'something else' is a golden rule of economics generally which is that for every liability there is an asset. It is not true to say that for every asset there is a liability*, but it is certainly true to say that for every financial asset there is a financial liability (and liabilities are of course usually financial liabilities as most debts are to be repaid in cash rather than in kind, i.e. if you have been paid in advance to do a job).

In bookkeeping, there is also the 'balance sheet rule' says that any corporate entity has both assets and liabilities and they net off to precisely £nil. Yes of course, successful companies have share capital and retained profits, which do not have to be paid out, but those are still liabilities - that money (or that value) does not belong to the company, it belongs to its shareholders.

Onus Probandy had another crack at explaining how banking and double entry bookkeeping work using his analogy of splitting the zero again recently, but he made it a bit complicated by using the ECB to illustrate the point.

i. A far simpler way of explaining banking, the golden rule, double entry bookkeeping and 'splitting the zero' is to remind people what happens when you go to the bank to take out a personal loan for (say) £10,000.

ii. Assuming you pass the credit checks etc, the bank creates two accounts for you - a deposit account and a loan account, and it simultaneously credits £10,000 to the deposit account and debits £10,000 from the loan account. No coins and notes change hands, nobody had to deposit money first, nothing, the banks just 'splits the zero'.

iii. So you, the customer, now have a financial asset (£10,000 in your deposit account, which you can withdraw and spend) and an equal and opposite financial liability (£10,000 owed on your loan account, which you will have to repay).

iv. As mentioned above, a golden rule is that one man's financial asset is another man's financial liability*. So your asset (the deposit account) is a liability from the bank's point of view (you can wander into the bank and withdraw cash, or you can make payments to other from that account), and your liability (the loan account) is the bank's asset (they will receive money from you in future as you pay off the principal and interest).

v. We can illustrate this by drawing up a balance sheet at each stage for you and for the bank, see 1) and 2) below.

vi. The balance sheet in 3) is the overall picture taking you and the bank together, you can draw diagonal lines between your asset and the bank's liability (the deposit account) and your liability and the bank's asset (the loan account). The overall position immediately after the loan is made is still a big fat £nil on all sides.

vii. "Why do the banks lend money then?" you may ask, "Their net wealth does not increase when they split the zero." Well, that's because they can charge you 6% interest on the loan and they only pay you 2% interest on the deposit. Of course, you will withdraw the money from the deposit account, spend it in the shops and the shop keeper (or his suppliers, employees etc) will pay it back in to the banking system as a deposit. So until and unless the loan is repaid, the bank will be earning £400 in interest margin. Whether you repay your loan or whether the shop keeper in turn repays a loan he had taken out earlier makes no difference - at this stage, the assets and liabilities merge into one and turn back into zero again.

viii. So what banks really want to do is to ensure that the two sides never merge into zero again, by tricking people into taking out ever larger loans, and making sure that loans are only repaid by somebody else taking out an even bigger loan. There are only so many flat screen TVs you can buy and so many foreign holidays you can go on before either
a) you reach the limit of your own willingness to get further into debt or
b) the bank no longer sees you as a good credit risk.
So the tried and tested method is house price bubbles. There is no such thing as net land wealth, of course*, so all a house price bubble means is that banks are earning more and more money for doing nothing but carry out a huge great confidence trick.* Footnote: The modified rule that for every asset there is a liability (as it applies to financial assets and financial liabilities) also applies to land, because one man's rental income is another man's rental expense; even if you are an owner-occupier, the land only has value to you because being excluded from that plot places an equal and opposite burden on 'everybody else'; alternatively, the value to you is that you alone are not subject to this burden.

By analogy, let's imagine that the playground bully takes ten pence from every other child in your class every day, that's the bully's asset/income and every other child's liability/expense. But one day, you do him a favour (like giving him an alibi), and so he stops taking money from you. You might consider yourself to be ten pence a day richer than all the other children, and indeed you are, but only because you are neither payer nor recipient of ten pence (like an owner-occupier). If the bully later gets expelled, you cease to be ten pence a day richer than all the other children and your 'wealth' disappears.

The modified rule clearly does not apply to buildings and improvements on land, as there is no such thing as a negative building or a negative improvement, and if one person builds a building, he does not impose a burden on other people. He might diminish the rental value of neighbouring plots of land by building the building, and most bits of land ultimately belong to other people (who thus might feel themselves burdened by the building), but...
a) Unless the planning department is staffed by complete idiots, the increase in the rental value of his land/buildings is at least equal to the fall in the rental value of neighbouring plots (so worst case, total rental values are the same) and
b) More subtly, by reducing the rental value of those neighbouring plot, he also reduces the burden which being excluded from those plots places on 'everybody else'.
The new building is real net wealth and the change in net land wealth is precisely zero because it was zero before and is still zero afterwards.

Schadenfreude ist die schönste Freude!

Spotted by Denis Cooper in the FT:

Germany saw one of its poorest debt sales on Wednesday in what was seen as a failed auction by many market participants amid fears the eurozone’s debt crisis is spreading all the way to Berlin.

Marc Ostwald, at Monument, said "I cannot recall a worse auction ... If Germany can only manage this sort of participation, what hope for the rest. Yields are at completely the wrong level."

Mr Oswald said the bid-to-cover ratio was only 0.65 times as the German debt agency sold just €3.644bn of its new 10-year Bund of the €6bn targeted.

Chuckle, chuckle, tee hee, people are starting to worry about the German government having to bail out all the other Euro-zone countries.

As Denis points out, Germany hasn't had a failed bond auction for nearly three years.

More financial illiteracy fun with Northern Rock

From The Telegraph:

Richard Branson’s Virgin Money has been accused of “asset stripping” following leaked details about the structure of Northern Rock’s sale. The sale of Northern Rock, which netted the Government £747m in cash is being part funded by existing cash in the bank itself. More than £250m of “excess capital” will be taken out from Northern Rock to help pay for the bank.

Oh dear, oh dear, oh dear, where to start?

When a company is being bought/sold, it is fairly usual to agree a target net asset value for the company in advance, and the purchase price paid on completion is adjusted up or down if the actual net asset value at the date of completion happens to be higher or lower than the target (which it usually is). So if the current owner of the company whips out £1,000 on the day before completion, it is of no advantage to him and the purchaser isn't bothered because the final selling price is then adjusted downwards by £1,000.

So VM paid £747 million for a company (or group of companies) with a net asset value of £912 million*. If NR really had £250 million in spare cash sloshing about, then in theory the government could have taken out that money and agreed a lower selling price of £497. Whether the government takes out the money and accepts a lower selling price or VM takes out the money and pays a higher selling price does not make the blindest bit of difference.

* NR's balance sheet total as at 30 June 2011, minus six months' anticipated losses to date of completion January 2012 minus £150 million in bonds which the government has allotted to itself.

Via MBK.

€440 billion bail out fund actually has less than €3.5 billion

Compiled by Denis Cooper, lengthy but worth a read:
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The EFSF "bail-out fund" does not actually have anything like the €440 billion which the media keep describing as its "firepower", its "reserves" or its "funds" as Robert Peston pretends here.

The EFSF operates by borrowing money and lending it on. Its subscribed share capital was minimal - less than €29 million, and I do mean million not billion, as can be checked on page 4 of the Articles of Incorporation.

So far it has borrowed a total of €13 billion through three bond issues (you may have to go click 'I agree' to get to that screen) and it has disbursed a total of €9.5 billion to Portugal and Ireland, on which basis it will presently have less than €3.5 billion to hand.

It's not an EU body; in fact it's a Special Purpose Vehicle, a private company, as explained in here

A1 - What is the EFSF?

The European Financial Stability Facility (EFSF) is a company which was agreed by the countries that share the euro on May 9th 2010 and incorporated in Luxembourg under Luxembourgish law on June 7th 2010. The EFSF’s objective is to preserve financial stability of Europe’s monetary union by providing temporary financial assistance to euro area Member States if needed.

On June 24, the Head of Government and State agreed to increase EFSF’s scope of activity and increase its guarantee commitments from €440 billion to €780 billion which corresponds to a lending capacity of €440 billion and on July 21, the Heads of Government and State agreed to further increase EFSF’s scope of activity.

Describing the EFSF as SPV1, one of the two options being considered is to set up a second SPV, call it SPV2, as explained in this official factsheet.

Under this model, a special purpose vehicle (SPV) would be created centrally or in the beneficiary member state, combining public and private capital and funding for extending loans for bank recapitalisation (via a Member State) and/or for buying bonds in the primary and secondary market.

The SPV structure would be set up so as to attract a broad class of international public and private investors with different risk/return appetites. The EFSF would provide the equity tranche of the vehicle and hence absorb the first proportion of losses incurred by the vehicle.

So SPV2 would also operate by borrowing money with SPV1 in effect indemnifying those "international public and private investors" against losses if SPV2 loses money on its business of "extending loans for bank recapitalisation ... and/or for buying bonds in the primary and secondary market", but with SPV1 only indemnifying the SPV2 investors for consequential losses on their investments up to maybe 20%.

As investors are already becoming wary of the bonds issued by SPV1, when it has only borrowed €13 billion so far - which have lost between 3% and 5% in value as at a couple weeks ago - how likely is that they'll believe that if they lent SPV2 say €1 trillion to keep Italy, Spain etc afloat, and if/when that bail-out attempt failed SPV2 suffered losses of say €200 billion, nevertheless SPV1 could then borrow €200 billion from investors to make sure that the SPV2 investors were paid on time and in full?

And given the 50% losses on Greek bonds, how likely is it that under those circumstances the losses incurred by SPV2 would exceed the 20% guaranteed by SPV1, even if it could borrow enough to meet that guarantee? On the whole I think I'll keep my money in the building society, rather than investing any of it in either SPV1 or SPV2.

Sense and nonsense on 'credit easing'

From the front page of City AM:

Terry Smith, chief executive of Tullett Prebon, said: "So-called ‘credit easing’ is totally misconceived. If you thought the banks were bad at lending, wait until you see what happens when the government try it."

Yup, nail, head. But what's this in the very next paragraph..?

Currently, the market for commercial paper issued by Britain’s smaller firms is virtually non-existent (1) and the cost of borrowing is prohibitively high. (2) The government claims that by buying bonds it will push down yields (3) and encourage private investors to follow suit, (4) thus growing the entire market.

1) True but irrelevant: this happens because the 'legal and professional fees' are so huge, you're looking at tens of thousands of pounds per issue, so if you want to raise £100,000 it's a non-starter; if you want to raise £1 million, it's well worth considering.

2) No it isn't.

3) True, probably. See also "sub-prime debt" (which is what Allister Heath describes it as on the very next page), it works fine until it goes horribly wrong.

4) Woah! If yields go down, this makes it less attractive for private investors. It may be that some sort of government guarantees make it more attractive and hence push down yields, but this is either a subsidy to bond holders or a subsidy to over-ambitious or struggling businesses, and it's difficult deciding which is worse.

Fun Online Polls: Business Finance and car washes

Thanks to everybody who took part in last week's Fun Online Poll, results as follows:

What are the best sources of finance for small and medium-sized businesses?

Retained profits - 44 votes
The owners' own money - 41 votes
Bank loans secured on land and buildings - 19 votes
Unsecured bank loans - 7 votes
Asset finance such as hire purchase - 5 votes
Government grants - 3 votes
Other, please specify - 6 votes

Ho hum.

I'd completely agree with the first two, and as Jaffa pointed out, after a few years of trading, there is no difference between them.

I'm relieved to see how few voted for 'Government grants', which don't make sense to me (or Lola). Not only is the government is notoriously bad at picking winners but such grants can only be funded out of higher taxes on everybody else, which is a distortion on both sides of the equation and eats in to the best type of finance - retained profits.

I don't know why so many people went for 'loans secured on land and buildings'; if you borrow money to buy land, then you aren't investing in 'the business' you are just paying interest (rent) the purchase price of the building (which in itself is pre-paid rent). None of that money goes into the business (this doesn't apply to loans to build the physical building - see below). And if a not-so successful business doesn't make retained profits and has to borrow on the strength of unearned income (latent capital gains on land and buildings) then that's another distortion - far better for banks to lend to businesses on the strength of the underlying business and not on the back of windfall capital gains.

Finally, I'm a bit disappointed that so few choose 'asset finance' (which include financing the cost of the actual building, but not the land). For these purposes, it doesn't make any difference whether you rent a car, finance lease it or buy it on hire purchase, you make your money by using the car in the business, and not by simply owning a car (unless you run a car-hire business, of course). Sean in the comments concurred.
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Sticking with cars, how often do you wash yours?

Vote here or use the widget in the sidebar.

Fun Online Polls: Russian Roulette and small business lending

Last week's Fun Online Poll was an experiment, which might or might not have proved anything (I suspect it does, but you'd think I was mad if I told you what).

Faced with the following choice, 109 people actually pulled the trigger (which is surprising enough) and 29% of you were killed as a result, which is even more surprising as statistically, assuming people fire at random, only about 17% of you would be dead:

Russian Roulette
	Chamber One
	Chamber Two
	Chamber Three
	Chamber Four
	Chamber Five
	Chamber Six

The best comment was by Jer: "Dead. In retrospect, and I know it's easy to say it now... but I suppose it was actually quite foolish to pull the trigger..." If you've already taken part, you can see the results here, if not, then please take a pot shot first.
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And lo, to this week's poll. The Vickers saga rumbles on and the bankers and their shills are bleating that it will push up the costs of lending to 'small and medium-sized businesses', cost jobs etc. Well, firstly it won't, and secondly, bank lending is not a particularly important source of finance to 'small or medium-sized businesses' and is more or less nothing if you exclude lending secured on the owner's home or on other land and buildings.

So that's this week's Fun Online Poll: "What are the best sources of finance for small and medium-sized businesses?"

Vote here or use the widget in the sidebar. You can choose as few or as many answers as you like.

Wilfully misquoted report of the day

Various sources, including inevitably the banking shills at City AM are going in to bat for the banks:

FORCING structural reform on banks could slash the UK’s GDP growth by 0.3 per cent, according to an independent forecaster...

The Item Club, a body run by accountancy Ernst & Young, says in a new report today that proposals from John Vickers’ Independent Commission on Banking (ICB) will choke off credit to the UK economy, more-than-reversing last quarter’s anaemic growth of 0.2 per cent.

Vickers is preparing to release a report next Monday that will recommend forcing banks to ringfence their retail operations from their investment banking arms. Banks would have to capitalise the two subsidiaries separately, which the Item Club estimates will push up the cost of funding for investment banks by 100 basis points.

That in turn could cause “fragile” banks to increase the cost of their loans to corporates by 150 basis points...

For sure, the idea of splitting 'retail' banking from 'investment' banking is a nonsense because although you can probably define 'retail' banking (making loans to households and small and medium-sized enterprises; taking deposits), to bracket in everything else as 'investment' banking is insane, because that includes some activities which are nigh on risk-free and hugely lucrative as well as things which are insanely risky and anything in between. So it's administratively unenforceable anyway, even if there were any point to it.
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But Item Club didn't say anything of the sort. Their report makes it quite clear that an increase in interest charged to large corporates would only happen if the loans are outside the ringfence in the first place. it then works through a series of further estimates and assumptions (they also rely on logical or factual errors made by others), descending into guesswork to arrive at a possible figure for interest rate increases and the impact on the economy, and admits that banks are unlikely to be able to impose such higher interest rates on large corporates anyway.

The report also points out that interest being charged to people borrowing from the ringfenced division will pay slightly lower interest costs, so by and large this would all cancel out anyway (to the extent that any of it is even measurable). It's a bit long winded, but make up your own mind:

The rationale for the ringfence is that the authorities could credibly commit to allowing the riskier investment banking division to fail if it ran into trouble. These reforms could therefore lead to credit-rating downgrades for the investment banking divisions, given that the main credit-ratings agencies incorporate the impact of implicit government support within their main ratings of UK banks. Financial markets would also be likely to impose higher funding costs and demand higher capital levels, which could have a significant impact on the profitability of these divisions.

In contrast, funding costs within the retail ringfence could decline marginally, as investors perceive that the government has essentially confirmed that the retail businesses would not be allowed to fail under any circumstances.

For this exercise we have therefore assumed that any repricing of lending will only occur within loan books positioned outside the ringfence.

Although the interim report did not make any firm recommendations for the design of the ringfence, it would most likely include household lending and small business loans within the retail operation, while large corporate loans would sit outside the ringfence due to their close ties with the investment banking division. With this in mind, borrowing costs for these large companies could rise substantially.

A simple exercise can illustrate the potential impact on the UK economy.

First, we have assumed that the investment banking divisions face an increase in wholesale funding costs of around 100bp. Clearly, this estimate is subject to a high degree of uncertainty, as it is difficult to forecast the reaction of financial markets to the reforms, but we feel it is a reasonable assumption given the scope of ringfencing we have described.

Second, we assume that the loss of implicit government backing for the investment banking divisions and the restrictions on the ability of the ring fenced entity to fund other activities of the group prompts financial markets to demand that they maintain a core Tier One Capital ratio in the region of 14%. As all the universal banks in the UK already hold core Tier One Capital ratios in the region of 10%, it would represent a rise of around 4% points. Based on BIS estimates, the effect of a 1% rise in bank capital requirements would be a 13 basis point increase in borrowing costs facing the economy, so this 4% rise implies an increase in lending costs of around 50 basis points.

If we assume that the banks pass on all these lending costs through higher pricing of loans, the combined effect would be a 150bp rise in lending costs to large corporates. Using the HM Treasury Model, we have estimated that a 150 basis point increase in lending costs facing the whole economy would lower the level of GDP in the UK by around 1.2% in the absence of offsetting monetary policy actions. As large corporate loans represent less than 25% of overall lending, however, this implies a GDP loss in the region of just 0.3%.

This estimate may also be overstating the effect as large businesses have access to alternative sources of funds from debt and equity issuance in the capital markets, as well as being able to borrow from foreign
banks.

We can therefore conclude from this analysis that the impact of ringfencing on the wider UK economy isn’t likely to be vast.