Asset protection equals fiscal catastrophe

Brown and Darling have had free pass with this Asset Protection Scheme. This scam has the potential to become a fiscal catastrophe. The government is about to guarantee £500 billion of bad assets in the banking system. That is almost equivalent to the total stock of public sector net debt. This guarantee amounts to 34 percent of GDP. It is astounding how the government can be so cavalier with tax papers money without anyone questioning the merits of this scheme.

One thing is for sure; the Banks have a strong incentive to insure poor quality assets, which have a very high probability of going bad. Therefore it is inevitable that the public sector will end up holding a mountain of rotten assets. Therefore, the question isn't if the tax payer will lose money; it is how much will she lose.

Here is my back of the envelope calculation about the likely losses. Currently, the UK banking system is about 4.5 times GDP. Roughly speaking, that translates into about £6.5 trillion. Therefore, the Asset Protection Scheme will insure about 7-8 percent of bank assets. Assuming that the banks end up with a bad loan rate of about 3.5 percent of assets; the taxpayer could easily end up with a loss of £250 billion.

A 3.5 percent bad loan rate is almost certainly a conservative assumption. Should the recession deepen, the rate could be higher. We may even see banks soaking up 100percent of the Asset Protection Scheme with defaulted assets.

If there is one lesson that comes from this mess; it is this; we must regulate banks and prevent them from ever creating a mess like this again. This time, the sound bite "no more boom and bust" has to mean something. There can be no more bubbles; no more double digit house price inflation; and no more consumption booms driven by cheap credit.