Goldman Sachs grows its balance sheet by almost 7 percent

It is just like old times.....

US Household wealth: where did it go?

Where did all that housing wealth go?

In the last four years, US home equity - the difference between the market value of homes and the outstanding stock of mortgage debt - has fallen by half. In terms of wealth destruction, there have been few parallels outside of war. The nominal value of housing wealth today is now at the same level it was back in the late 1990s. In terms of wealth accumulation, it is as if the US housing bubble had never happened.

This chart tells the deeper story than just simple post-bubble wealth destruction. During the bubble years, US homeowners remortgaged and extracted billions of dollars that was spent to sustain personal consumption. Lurking beneath the crazy house price appreciation of the last decade was a lethal accumulation of household indebtedness.  Households might have thought they were becoming richer. In reality, they were promising away their future incomes.

Here lies the treacherous asymmetry between home valuations and mortgage loans. House prices are ephemeral, flighty and fundamentally subjective. Debt, on the other hand, is merciless and exact. It must be paid.

Crashing household wealth also goes a long way towards explaining the ferocity of the recent US recession. There is a rough and ready empirical rule relating household consumption to wealth. Most economists agree that if wealth increases by one dollar, personal consumption increases by three or four cents.

If household wealth isn't fluctuating by much, then this wealth effect is quite muted. If, on the other hand, household wealth crashes by 50 percent, then GDP is going to take an almighty hit. So when house prices are racing upwards, the economy booms as everyone thinks they're getting richer. But when they crash, a recession is inevitable.

There is nothing new in any of this. Economists have understood the relationship between economic fluctuations and household wealth since the 1950s. The really interesting question is why would policymakers, in particular the Fed and the Bank of England, allow house prices to continue to rise, knowing the risks inherent when they inevitably crash? They can not plead ignorance.

Stopping a housing bubble isn't difficult. It can be done in one of two ways; raise interest rates or impose lending restrictions on banks, preventing them from writing mortgages to fuel the bubble. All that is needed is the will to do so.  However, bubbles are great while they last, and the pain they create is marked down for payment somewhere in the distant future. 

If this restatement about the dangers of asset bubbles seems a little too retrospective, take a look at food or oil prices today, which are now beginning to rise sharply. Also, examine recent developments in certain property markets in continental Europe, for example, Paris or Vienna. We still live in a world of asset price bubbles. Interest rates are too low, and we're bouncing from one crisis to another. We never seem to learn, or rather they would prefer to accrue the short run benefits of asset appreciation, and leave the consequences to the future.

Whatever happened to self certified loans?

Before the financial crisis, the UK banking system offered around 750 self certified mortgage products. By the beginning of 2010, all those products had disappeared. The self certified mortgage is no more.

UK banks seem to learn something about lending. It was a simple lesson, but costly one. When writing out a loan, it's usually worthwhile to check out the documentation offered by the borrower.

UK inflation expectations continue to rise

Last week, the Bank of England published the latest quarterly survey of public attitudes to inflation. It wasn't good. People seem to be bracing themselves for higher prices next year.

Here are the main highlights from the survey:

• When asked to give the current rate of inflation, respondents gave a median answer of 3.9 percent, compared with 3.6 percent in August.
• Median expectations of the rate of inflation over the coming year were 3.9 percent, compared with 3.4 percent in August.
• When asked about expected inflation in the twelve months after that, respondents gave a median answer of 3.2 percent, compared with 2.9 percent in August.
• When asked about the future path of interest rates, just over half  of respondents expected rates to rise over the next 12 months.

Running out of credit

In the aftermath of the financial crisis, consumer credit was regularly offered as one of the prime reasons behind the downfall of UK banks. UK consumers were encouraged to go on a plastic-fueled shopping spree that ultimately created a nation of debt-serfs, who couldn't repay the banks.

The story, however, was only partly true. Yes, consumers were crushed by high levels of debt, but no, the Banks hadn't been pushing individuals to over use their credits.

UK banks had become wary of consumer credit long before the credit crunch. Gross consumer lending peaked around seven years ago. Since then, banks have been quietly reducing the flows of new lending.

Banks engineered this contraction of credit by massively hiking interest rates on credit cards. You would have to be either mad or desperate to run a balance on card.

With default rates rising, banks had become wary of overextended maxed out consumers. Home equity loans and remortgaging, where consumers used their homes as collatoral, seemed a much safer proposition.

Ironically, the credit crunch has prompted banks to reverse their previous policy of reducing their exposure to consumers. For the last 18 months or so, gross consumer lending has been rising.

Credit card debtors generously help out the banking sector

The Bank of England may have cut interest rates, reducing funding costs for banks, but you won't see that generosity extended to credit card debt serfs. The spread between LIBOR and credit card interest rates has increased by well over 600 basis points.

It is probably a good thing, hopefully discouraging a further unsustainable increase in household debt. Also, the increased spread presumably increases the profitability of credit cards, and helps banks cover their huge losses speculating on those hopelessly mis-priced asset backed securities. In effect, credit card debtors are providing their very own bank bailout.

Personally, I am grateful to those credit card debtors for this generous assistance to our beleaguered banks. It means less of a burden for taxpayers.

MPC - there is no end to the madness...

Today, the MPC decided to leave interest rates unchanged. However, the bank will continue to pump out the cash.

The BoE's original money creation ceiling of £125 billion should be reached next month. Today's statement hinted that the Bank might want a further authorization to create even more cash.

In summary, there is no end to the madness.

From the BoE's press release....

The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to continue with its programme of asset purchases totalling £125 billion financed by the issuance of central bank reserves.

The Committee expects that the announced programme will take another month to complete. The Committee will review the scale of the programme again at its August meeting, alongside its latest inflation projections.

The race to the bottom

A simple question - have the dramatic cuts in interest rates worked? The evidence in favour is not compelling. The world is in recession.

I know; things would have been much worse if central banks hadn't acted.

Keep on doing what you are doing

There were many reasons why we got into this crisis; poor financial sector regulation, distorted incentives, bonuses, speculation, excessive risk-taking. However, there is one reason that doesn't get enough attention; the policy remit of the Bank of England.

When the BoE became fully independent, the government gave it an inflation target. It said to the bank "go chase down the consumer price index. Make sure it doesn't increase by more than 2 percent a year". Ominously, the government didn't say keep asset prices under control and avoid speculative bubbles.

The BoE happily went along with this new target. Keeping inflation under control would be easy. Moreover, the Bank added an air of modesty to their objection about preventing speculation. It echoed the claim by Greenspan that it could not properly identify bubbles. Speculation was something that could only be ascertained once the crash had actually happened, and then it would be too late.

For about eight years, the BoE claimed that it had beaten inflation. It met the target and told the rest of us that everything was under control. House prices, it occasionally acknowledged, were increasing at double digit rates. So too was the money supply, but this didn't matter because the CPI was nailed down. Furthermore, the BoE managed to do this with historically low interest rates. In short, they implicitly told us "sit back, relax and if you feel like it, take out a loan."

However, the truth was that the CPI was declining because of the extraordinary increase in the world supply of cheap manufactured goods, mainly coming out of China and other emerging market economies.

During these years, the CPI should have been negative; a fact that the BoE were happy to ignore. Domestically determined prices were increasing sharply. (If you want proof, just take a look at the price of UK rail tickets or the council tax.) Putting a cap on this hidden inflation would have required higher interest rates, which would have put an end to the housing bubble.

The rest of the story we know. Throughout the decade, Banks were taking on too much risk, households were borrowing silly amounts of money and the housing market was out of control. This sorry mess hit the wall in August 2007. So far, the UK taxpayer has been forced to pump in 90 percent of GDP into the financial sector, just to prevent it from collapsing.

Have policy maker learnt anything from this dreadful experience? It seems not. Later this month, the Treasury will publish a White Paper on financial services. In principle, this offers an opportunity to extend the BoE's target to stabilising asset prices and preventing bubbles.

However, for the New Labour radicals that manage the Treasury, this idea is too extreme. They want to keep things pretty much as they are. The BoE will continue to target the CPI and asset prices can do what they want. In principle there is nothing to prevent a recurrence of the current crisis.

It is very much a case of "keep on doing what you are doing". So, is everyone ready? We have a one way ticket back to Bubbleville.

Merkel attacks quantitative easing

At last, a European politician has stood up and denounced the collective madness that has gripped the developed world's central banks.

Speaking in a conference in Berlin, Angela Merkel, the German Chancellor, attacked the reckless money creation of the Fed and the Bank of England.

This is how she outlined the problem:

"What other central banks have been doing must stop now. I am very sceptical about the extent of the Fed’s actions and the way the Bank of England has carved its own little line in Europe.

Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds. We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.”

Stress test results out tomorrow

It is like waiting for exam results; will the US banks get the grades they need to continue trading?

Actually, this stress test is turning out to be a bit like UK A Level results. Everybody passes with A grades, but only a select few get into Oxford. All US banks will be told that they aren't insolvent, but nevertheless, they need more capital. Only a select few will be told that they are fine.

Here is how the FT assessed the likely outcome of tomorrow's stress test announcement....

US financial stocks soared on Wednesday as investors expressed relief the capital shortfalls identified by the government’s “stress tests” at large banks such as Citigroup and Bank of America were not as big as some had feared.

The bank rally occurred as news of the capital needs of the 19 banks involved in the tests leaked out during the day, ahead of the official release of the results on Thursday.

Citi, BofA and Morgan Stanley were among the big names that will have to raise equity following the completion of the tests, while JPMorgan Chase, Goldman Sachs and American Express are among those that will not need additional capital, people familiar with the situation said.

Citi and BofA emerged as the banks with the biggest capital shortfalls, with Citi’s equity needs projected to be more than $50bn and BofA requiring about $34bn in fresh equity.

However, BofA’s capital deficit is more pressing because Citi has already agreed to bolster its balance sheet by converting preferred shares owned by the government and other investors and selling non-core businesses.

UK external debt - 400 percent of GDP

In general, I don't like posting other people's charts. I prefer to do my own, thank you very much. However, there are charts that are so important that they need to be produced in their original format. A recent chart on the Spectator website is such a chart.

The Spectator asks what is the true level of UK external debt, both private and public. The answer is horrifying. Britain owes the rest of the world. It is not 40percent (the level of public sector debt) but 400 percent of GDP. Furthermore, it is the highest in the G7 by some margin.

So what is the plan? Gordon "I saved the world" Brown wants banks to lend more, while the governments runs up an 8 percent of GDP fiscal deficit next year.

Make no mistake, we are on the road to total ruin.

UK investment collapses

Oh lordy, this means trouble. In the 3rd quarter of 2008, UK investment fell by almost 6 percent. Those early BoE rate cuts had absolutely no effect on capital formation.

Monetary policy is broken, my friends. The MPC have lost control.

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