Talking down the risk and upping the LTVs

Northern Rock are back in the game. The state-owned bank will again offer 90 percent mortgages. Andy Tate - Northern Rock Director - summed up the new sales strategy:

"Our new products, which will be offered within our prudent risk appetite and only to customers with good affordability, should appeal to those who have lower deposits and first time buyers."

Don't you just love the linguistics of financial irresponsibility; "prudent risk appetite" and "good affordability". Today's announcement is part of a process. Shortly, we will see another announcement where Northern Rock will be offering 95 percent mortgages, again using weasel words like prudent and affordable to justify the slide in lending standards.

The sad truth is that we have learnt very little from the collapse of Northern Rock. There are far too many people who want the bubble back.

Since no one is innocent, no one is guilty

After the greatest financial crisis in a hundred years, it might seem reasonable to expect some criminal prosecutions. Not so. Madoff is the only one that will carry the can. Everyone else receives a "get out of jail" card.

From the NY Times....

Late last week, word leaked out that Mr. Mozilo, who had co-founded Countrywide Financial in 1969 — and, for nearly 40 years, presided over its astonishing rise and its equally astonishing fall — would not be prosecuted by the Justice Department. Not for insider trading. Not for failing to disclose to investors his private worries about subprime loans. Not for helping to create a culture at Countrywide in which mortgage originators were rewarded for pushing fraudulent loans on borrowers.

In its article about the Justice Department’s decision, The Los Angeles Times said prosecutors had concluded that Mr. Mozilo’s actions “did not amount to criminal wrongdoing.”

Just months earlier, the Justice Department concluded that Joe Cassano shouldn’t take the fall for the financial crisis either. Mr. Cassano, you’ll recall, is the former head of the financial products unit of the American International Group, a man whose enthusiasm for credit-default swaps led, pretty directly, to the need for a huge government bailout of A.I.G. There was a time when it appeared that there was no way the government would let Mr. Cassano walk. But it did.

And then there’s Richard Fuld, the man who presided over Lehman Brothers’ demise. Though he was the subject of an investigation shortly after the Lehman bankruptcy, it appears that prosecutors are moving on.

Most of the other Wall Street bigwigs whose firms took unconscionable risks — risks that nearly brought the global financial system to its knees — aren’t even on Justice’s radar screen. Nor has there been a single indictment against any top executive at a subprime lender

.

Ten years ago, the Enron-dot.com collapsed. US prosecutors picked up a number of high profile villains. This time, the world is working under a new maxim - since no one was truly innocent in the run-up to the crisis, no one can be fairly singled out as being responsible. Therefore, no one is guilty.

RBS exercise restraint

First the bad news. RBS chairman - Sir Philip Hampton, conceded that last year more than 100 employees received compensation of at least £1 million. The good news is that the number was lower than the preceding year.

There is even more good news - bonus pool was less than £950 million. It could have been so much higher.

Stephen Hester, chief executive, summed it up perfectly "We have tried to exercise restraint."

Chinese wages - be afraid

Personal debt in the UK

Infographic by Money Debt & Credit

But we are only complying with the law

Shamed by their excessive use of tax avoidance schemes, Barclays have fallen back on the excuse of last resort; "we are only complying with the law".

As an aside, Barclays has a less than perfect record of following the requirements of UK legislation, as various judgements from the Financial Services Agency will attest. Moreover, UK corporate tax law is notoriously complex. It is an unequal struggle between the slick accountants from Barclays and the disaffected and underpaid tax inspectors of her Majesty's Customs and Excises.

Still, it is hard to understand why tax inspectors can't squeeze more corporate tax payments from Barclays. The company just reported their results online and 2010 was a very good year. Profits amounted to about £6 billion. Roughly speaking, around a third of these profits came from retail banking operations, the bulk of which were generated in the UK. The remainder came from Barclays capital, the investment banking operation primarily based in London.

For tax liabiilities, location matters. Corporate income tax, in theory, should be levied on the profits made by firms in a given geographical region. Judging by the financial statements, the majority of Barclays operations as well as their employees are based in the UK. Yet curiously these UK operations never seem to generate significant amounts of corporate income tax payments.

Barclays have tried to hide the paltry amounts of corporate tax payments by publishing the total tax amounts that the company paid over to the Exchequer. For example, they have included the amounts of PAYE paid by their employees. In 2009, the bank paid around £2 billion over to HM Revenue & Customers, although £113 million was corporation tax.

This only adds to the mystery as to why corporate income tax payments are so low. High levels of PAYE payments point to high underlying salary payments. Normally, companies don't pay out massive wads of cash unless their workers are generating large profits. Aren't bank bonuses supposed to be tied to profits?

Companies have an incentive to hide those profits from the taxman. Otherwise, how could one explain the massive financial flows into the Cayman Islands; a barren rock in the middle of the Caribbean. Banks have taken advantage of the complexity of corporate income tax regulations. They have arranged their financial operations so that they are now effectively liberated of any responsibility to pay taxes.

However, our Parliament is sovereign. We can determine our own tax laws. If the political will was there, Barclays would not be able to avoid taxes in such a scandalous way.

One simple way forward would be for corporate income tax on banks to become a presumptive tax. At the end of every quarter, the bank would have to pay a fixed proportion of its PAYE contributions as an advance payment on future corporate income tax liabilities. A rate between five and 10 percent would be reasonable.

These funds could be held in escrow accounts. At the end of the year banks would have to justify why those profits should be allocated to offshore centres. If they can genuinely prove that the profits were generated through operations conducted abroad then they can receive a rebate on corporate tax payments. However, the level of proof required would have to be extremely high.

The idea isn't that radical. Presumptive taxation is quite common worldwide as well as advance payments on corporate income tax. It would offer a way of genuinely cracking down on these outrageous tax avoidance schemes that banks have abused for years. If Barclays don't like it, then they put all their ATMs on the Cayman Islands.

The monetary miracle is over

One should never underestimate the importance of luck. For almost a decade, the Bank of England proved to be very fortunate. It managed to simultaneously keep interest rates low, dramatically increase the money supply, and at the same time meet its inflation target.

How did it pull off this monetary miracle? The chart above provides a comprehensive explanation. It breaks the CPI inflation rate down into two components; the rate for services, which are mostly produced domestically; and rate for goods, which are almost entirely imported into the UK.

As the chart illustrates, prices for domestically produced services have grown fairly consistently at between three and four percent a year. This is far in excess of the Bank of England's inflation target. Prices of goods, on the other hand, were falling between 2000 and 2006, exerting powerful downward pressure on the aggregate inflation rate.

The reason for this negative inflation rate for goods is well understood. China industrialised, and exported huge quantities of clothes, footwear, and electronics. Prices for these items fell massively. In contrast, domestically produced prices increased rapidly in response the the extraordinary surge of Bank of England inspired monetary growth.

For many of us, this inflationary dichotomy between its goods and services will ring true. Anyone who regularly hired an accountant or chose to educate their children privately will be familiar with the four percent a year price hike.

So, it is fairly easy to see how the Bank of England got away with loose monetary policy and low inflation. Nevertheless, there is a more intriguing question embedded in this chart. To what extent did the surge in goods prices trigger a financial crisis?

To see how the turn-around in import prices might have precipitated the crisis, it is worth remembering how monetary policy worked in the past. In previous decades, rapid credit growth would have quickly fed through into prices. Eventually, interest rates would have increased, credit growth would have subsided, the economy would have slowed, and eventually inflation would have moderated.

This didn't happen in a decade before the crisis. Credit exploded while the overall inflation rate remains subdued on account of cheap imports. The Bank of England didn't feel obliged to raise rates, and the credit bubble just kept on growing.

Unfortunately, the old trade-off, like an unwelcome relative, returned in 2006. Inflationary pressures were building in the East,and import prices began to increase.

There were tentative signs of trouble in 2005. The Bank of England made a half-hearted attempt to raise interest rates to stem inflationary pressures. But the monetary policy committee took fright when it saw the property market weaken. Rather than tackle the growing inflationary menace, the committee buckled, reduced the bank rate and gave the housing bubble a new lease of life.

This weakness before the inflationary enemy resulted in renewed price pressures. In the early months of 2007, the Bank of England and its sister institutions in the US and Europe, were belatedly hiking interest rates.

This changing policy stance was sufficient to expose all the poor lending practices and financial sector abuses that had built up through the previous decade. Many banks, particularly small ones like Northern Rock, had cut interest margins to the bone and jacked up their leverage ratios. The slightest perturbation of interest rates and the financial system was in deep trouble.

The rest of the story you know.

So here we are - four years on from the crisis - and inflation has hit 4 percent, and it is likely to go higher. The Bank of England now believes itself to be trapped. It fears to raise interest rates on account of what it thinks a rate hike might do to the frail recovery. As for dealing with inflation, it has no strategy. There is no plan, just a vague hope that somehow things will turn out alright in the long run.

In fact, there never was a plan. The only thing that kept inflation down for ten years before 2006 was luck and a flotilla of Chinese cargo ships packed full of goods.

A good day for senior management at Barclays; a terrible day for the rest of us

Yesterday, the consumer price index was published, showing that prices are rising at 4 percent a year. The governor the Bank of England tried to explain this outrageous number by suggesting that higher prices are due to temporary factors. He must have forgotten that UK inflation has been consistently above the two percent target since 2006. Perhaps Mr. King operates on another temporal dimension, but nearly five years of above target inflation doesn't sound that temporary to me.

Under normal circumstances, a responsible central bank wouldn't hestitate to raise interest rates in the face such an appalling degeneration of the inflationary environment. However, nothing is normal about current UK macroeconomic policy management. Yet, even as the inflation numbers deteriorate at an alarming rate, Mr. King continues to resist the idea of raising interest rates.

His reluctance stems from a belief that protecting the UK banking system is more important than confronting inflation. Banks are undercapitalised and keeping interest rates low boosts their profitability. Banks can now borrow funds from the central bank at 0.5 percent and buy a government bond for 4 percent. Making money has never been easier.

With such a benign monetary regime, it might be reasonable to think Mr King should expect some reciprocity from commercial banks. It would be helpful if banks shared his concerns about undercapitalisation. Profits could be pumped back into banks to strengthen their balance sheets.

Today, Barclays had an opportunity to respond to all that love and kindness from the Bank of England. It published their end of year results. What did Barclays do? They gave their staff a huge pay increase. Last year, staff costs increased by an astounding 20 percent.

As our collective living standards are slowly crushed by higher prices and stagnant wages, we can ponder on the delicious irony of that extraordinary pay increase. Our central bank has engineered a rapid increase in inflation, either by accident or design, so that Barclays bank can increase salaries, in real terms, by 16 percent.

How cheap dresses and fancy shoes led to the financial crisis

Fashion has never been cheaper.

Since 2000, the ratio of clothes and footwear prices to hourly earnings fell by almost 60 percent. Around half of that decline was due to the direct effects of lower prices; the other half came from higher nominal wages.

This chart illustrates this spectacular fall in the real price of clothing. It also demonstrates the extraordinary structural change that has occurred in the world economy over the last 10 years. There was a time, and it wasn't so long ago, that Britain had a textile industry. That industry has all but disappeared. Instead, all our clothes are produced overseas, mostly in East Asia, particularly in China.

This chart doesn't just highlight the disappearance of a single British industry and the rise of China as an economic superpower. It also explains how the Bank of England made some profound errors in the conduct of monetary policy. The bank wasn't looking too closely at the sudden profusion of style around Threadneedle street or the meteoric rise of Jimmy Choo. If they had noticed, they might have avoided the greatest economic and financial disaster for generations.

As clothing and footwear prices fell, it should have provided powerful downward pressure on the overall price level. Yet throughout the last decade, consumer prices continued to increase.

Until 2006, that increase was around 2 percent a year. Although this inflation rate doesn't sound too serious, it obscured huge shifts in relative prices. If clothes prices were falling sharply, other items had to be going up in order for the overall inflation rate to be two percent. In reality, cheap Chinese imports were hiding a lot of inflation.

Low headline inflation lulled the Bank of England into a false sense of security. It chose to ignore the fact that cheaper imports were distorting true underlying inflationary dynamics. Since the headline inflation rate was within its mandated target of two percent, all was well with the world. Therefore, the only sensible thing to do was to reduce interest rates to historically low levels.

This provoked a borrowing frenzy. The primary destination for cheap credit was the housing market. The Bank of England couldn't fail to notice the double digit increase in house prices. However, it argued that it wasn't the job of a central bank to target asset prices. The CPI was the thing that mattered, and that was under control.

Despite this neat excuse, the borrowing frenzy wasn't just confined to the bubblicious real estate sector. Lower interest rates also encouraged households to fund consumption expenditure with a huge increase in personal debt. Flat screen TVs, new cars, home extensions, and extravagant holidays to Asia were all funded by cheap loans from high street banks. Behind all this debt accumulation was the Bank of England, with its low interest rates, and a belief that inflation was under control.

Then, it all fell apart. There is no need to recycle the sequence of events that led to the financial crisis. It is suffice to say that from 2007 onwards, banks failed and households either could not or would not continue borrowing to finance consumption. Aggregage demand crashed, and GDP fell through the floor, taking a sizable chunk of tax revenues with it.

As the crisis unfolded, the Bank of England impotently tried to revive the economy with lower interest rates. Despite the dramatic cuts in the bank rate, the UK economy dived into the deepest recession since the war. The Bank of England was also suckered into resuscitating the banks, who quickly sucked in huge amounts of taxpayer’s money. Before you could say "Clements Ribeiro makes nicer dresses than Georges Chakra" every major economic indicator was pointing in the wrong direction.

What was it that drove Britain into this sorry mess? Superficially, it looks like interest rates. Search a little deeper and we see that for 10 years the Bank of England ignored the fact that clothing and footwear prices were falling in absolute terms. Instead, they focused on the aggregate price index and an inflation target that was almost certainly too high. This negligence gave them the justification for excessively low interest rates.

This chart has a twist. Since the beginning of 2009, clothing and footwear prices are no longer falling. In fact, over the last year, clothes and footwear prices have increased by two percent. While this is lower than the overall level of inflation, it points out that the Bank of England can no longer rely on low wages in China to keep UK inflation down.

Those days are over.

Turbo-charging the rhetoric

Polly Toynbee was at it again today. She produced another long whingeing article in the Guardian, complaining about cuts to local authority grants. She described the coalition's plans as "brutal" and a "turbocharged program for accelerating inequality".

I'm sure that her main proposition is right; Britain will be a more unequal country in five years than it is today. Unfortunately, in policy terms, that projection doesn't take us very far. In a more benign world, the coalition would have been quite happy to keep public expenditure at its current levels. Sadly, that option is not available.

The government's budget, like those of a household, is a matter of arithmetic. The government receives tax revenues, and makes expenditures. If the government spends more than it receives, then it has to borrow. At some point in the future, debt has to be repaid. Therefore, government borrowing is taking future taxes and using them today. History is full of examples of ruined economies where the government kept on borrowing and eventually "maxed out the credit card.

Mercifully, HMG's borrowing has not yet crossed the unsustainability threshold. Nevertheless, it would be wise to avoid any flirtation with the precipice. Instead, we need a thorough diagnosis of our present difficulties and a realistic policy framework that ensures long term budgetary stability.

This diagnosis will show that the immediate cause of our budgetary difficulties is taxation. True, government expenditure as a percent of GDP had been drifting upwards for at least a decade. However, it was the revenue collapse that wrecked the ship. When the housing bubble crashed, and the financial sector almost disintegrated, a huge proportion of government revenues disappeared, literally overnight.

The government lost revenue through various channels; Stamp duty revenues collapsed,. Corporate income tax fell sharply, as banks racked up huge losses. As house prices fell, people felt poorer and cut back on consumption expenditure, thus reducing VAT revenues. Lower consumption rippled into the labour market, increasing unemployment and reducing personal income tax revenues.

If this shock to revenue were temporary, then it might make sense to keep on spending and borrowing. However, over the last 20 years, the UK had become dangerously dependent on the financial sector. Banks are bloated and under capitalised. The balance sheets of UK financial institutions are riddled with dubious assets. UK banks would be unable to survive without the direct assistance of the Bank of England. In short, the financial sector is looking at decades of stagnation and tax revenues are unlikely to recover any time soon.

To be fair, Toynbee has an answer to this permanent loss revenues. They say we should aggressively tax the rich. For example, the bankers who caused this crisis, should be a particular focus of more vigorous revenue collection.

To which I say "go for it". If you think you can solve our budgetary problems by taxing Fred the Shred and his wicked banker mates, then you haven't examined the Treasury numbers close enough. Britain's bankers might be obscenely wealthy, but their ill gotten gains don't quite run into the tens of billions yet.

This leaves the government with an unenviable choice. Does it continue borrowing, wistfully hoping that revenues will eventually recover? Or does it do the difficult thing, and reduce expenditures in line with available revenues?

We can all put on a sad face, and complain about the terrible inequality that characterises modern Britain. Unfortunately, our budgetary difficulties are a more immediate problem. A painful adjustment is inevitable. However, the longer we delay, the larger the government debt stock will be, and a greater will be the adjustment.

The food price shock - lets talk timing before we blame the weather

Over the weekend, I wrote a post on the recent surge in world food prices. Happily, it turned up as a link on a number of websites, so was one of my more widely read pieces. The post argued that the recent food price shock was primarily due to the world wide decline in interest rates.

This isn't a terribly popular view. The prevailing wisdom says that world food markets have undergone a radical structural change. On the demand side, Asia is growing, both in economic terms and waist bands. The continent is munching on burgers and pastries and it now firmly on the road towards obesity; a path that Western economies have been treading for nearly half a century.

There have also been a couple of well publicised supply problems. Certain commodities, such as sugar, and to a lesser extent, wheat have suffered bad harvests. As a practical matter, most of these shocks have been quite recent are therefore likely to affect future rather than current supply. Nevertheless, these poor harvests have been described in apocalyptic terms. The end times are near, and judgement day will soon be upon us. Climate change has wrecked agriculture from the Russian steppe to snowy mountains in Australia.

To summarize, there are three parts to the conventional view; higher world demand, supply shocks, and climate change. How seriously should we take these arguments.

Lets pick the easiest off first - climate change. I am fairly agnostic about whether the world is warming up. I just don't know. I am not a meteorologist. Nevertheless, I know one thing. This process, if true, will take many decades. Climate change won't burst upon us in six months and wreck our food supply.

The Asian demand argument is also unconvincing. Why? Take a look at the chart above. It traces out the UK CPI price index for all food items, divided by average earnings. This chart tells us how much food costs in terms of the price of UK labour.

The chart tells us that between 1996 and 2007, food in the UK became a lot cheaper relative to labour. There could be some honest debate about the precise turning point. Nevertheless, the chart points out that food prices rose sharply relative to UK wage rates as soon as the financial crisis took hold. So where is the Asian growth story in this picture. I would say it isn't there. Asia was growing rapidly throughout the decade before the crisis and food was becoming cheaper; much cheaper.

Now, I know that this chart is picking up a lot of other things; like the sterling depreciation, and the recession. My point is just about timing. Just to make that point one more time, could Asian growth explain that chart.? Could the weather in Russia or the floods in Australia? Call me a weathergirl, but I don't think so.

The last argument - the supply shocks - is the most difficult. There have been shocks, and prices should rise in response. The issue is one of magnitude - should these shocks have generated double digit increases? All commodity prices are on the rise, including those that have experienced no such supply shocks.

Supply shocks are in the mix, but it is monetary policy that is baking the inflationary pie. There is lots of liquidity pouring into commodity markets. Speculators are doing their thing; responding to incentives, and trying to turn a buck. Meanwhile, the rest of us are paying more for our food.

Yes, there is plenty of waste in the Equalities Commission

For decades, there was a long standing suspicion that government departments waste huge amounts of taxpayers money. However, the data was never there to confirm this view.

That has now changed. The coalition has forced government departments to publish their expenditures over £500. Everything is online now.

Today, I downloaded the December expenditure for the Equalities and Human Rights Commission. Then I set myself the task of cutting at least 7 percent of their expenditures without reducing staffing costs.

In December, the Commission spent £1.7 million. Around 30 percent went on salaries, 25 percent on grants and a staggering 17 percent on rent (lets hope that latter amount was a quarterly not monthly bill).

The seven percent target could have been achieved if the Commission had introduced: a) a staff travel ban; b) stopped "monitoring" the media and Parliament, c) cancelled a conference, d) cancelled some electronic subscriptions, e) stopped translating their documents, and e) fired an overpaid Barrister. The details are presented in the table above.

One job lost for a 7 percent reduction in expenditures, I am sure it is possible.

One last question, do you think the Commission's "media" monitoring also picks up this blog?

Bankers have no shame (part 233)

Bankers profited when the bubble was roaring. Now, JP Morgan will chew on the gristle and bones. It is going to starting dealing in distressed housing debt.

JPMorgan Asset Management (JPMAM) is taking on the challenge of selling distressed real estate by launching a small fund for institutional investors. J.P. Morgan Global Asset Management Real Estate Assets has launched Junius Real Estate Partners, which will, in part, purchase distressed debt left over from the housing bubble burst in 2008, an event that nearly caused the U.S. financial markets to collapse.

JPMorgan will launch a new distressed real estate fund, although critics say that the firm itself is, in part, the very reason why so much real estate in the U.S. is distressed.The bank is betting that the new fund will do well because it will act as a boutique, even though it is wholly owned by JPMorgan, and will only have seven or eight employees. The employees will have a direct stake in the new subsidiary.

How the US healthcare industry tried to spin Michael Moore's film Sicko

How US corporations create fake foundations to spin debate.

Just what we need right now; an oil price bubble

The crisis in Egypt is doing wonders for the price of oil. As demonstrators filled the streets of Cairo, the price of Brent crude hit $100 a barrel, its highest level for two years.

However, it would be misleading to think that the political crises in North Africa is the main driver behind the recent spike in oil prices. The crisis has helped over the last month or so, but the market has been trending upwards since the summer.

Cheap money, lots of speculation and a growing expectations of inflation - these are the factors driving the price of oil higher.

UK property market; less than two percent of post codes report a price increase

More evidence of a weakening UK property market; in January less than two percent of postcodes saw an increase in home prices.

(Data is from the Hometrack January 2011 report)

We need new generals

How Lehman brought down the pro-western governments in North Africa

The world is always throwing up surprises. Did the leaders of Tunisia and Egypt think that their regimes could be threatened by the collapse of a highly leveraged bank like Lehman? Yet, that seems to be what is happening.

The casuality is straightforward. When Lehman crashed, central banks cut interest rates to prevent Wall Street banks and hedge funds from going under. As soon as the immediate risk of a financial meltdown subsided, these low rates unleashed a speculative bubble in commodities.

The consequences can be seen in the chart above that illustrates the FAO's world food price index. Since December 2008, world food prices have increased by 55 percent. Some items have increased much faster; sugar is up 148 percent, cooking oil is up 116 percent.

These increases can not be explained by falling supply or increasing demand. The price changes are too large and over a very short time period. No, it is the derivatives market. Speculators borrow cheaply and seeking higher yields, speculate on commodities futures. This speculative trade pushes commodity prices up, creating a massive surge in inflation.

The social and political implications of this speculation in developing countries is devastating. Regimes in places like Tunisia, Egypt and Yemen were always highly unstable. With double digit food inflation, they are crumbling. Moreover, this crisis is unlikely to stop in North Africa. Dare I mention the P word? - P---stan and their red hot nuclear arsenal.

There is now a conflict emerging between the strategic interests of Western governments and those of Wall Street and the City of London. The balance sheets of Western banks remain fragile. They need low interest rates to maintain cheap sources of financing. Global stability, on the other hand, requires higher interest rates to defuse the speculative bubbles in commodities.

Currently, this conflict is at its sharpest in Egypt. Should Mubarak fall, thirty years of carefully crafted US diplomacy in the Middle East will be destroyed. Anyone who thinks that Egypt will effortlessly transform into a thriving western democracy while food prices are crippling the urban poor is living out of fantasy.

Two years on from the Lehman collapse, what has the bailout achieved? Economies in western economies have crashed; their governments have become loaded up with debt, and inflation has ripped apart the tenuous living standards of the poor in the developing world. Yet, Goldman, JP Morgan and Merrill continue as if nothing has changed.

The world is too fragile to absorb another speculative bubble. However, that is what this extended period of low interest rates has unleashed. It has destabilised North Africa and other regions could follow. Who could have seen that when Lehman filed for bankruptcy?

Wasn't 2007 the year that the financial crash started, or did I imagine it?

You have to love Goldman; part of the the recent huge bonus payments are for performances dating back to 2007. Didn't the bank nearly go bust less than 12 months later.

Whatever the performance, Goldman execs get paid.

Houses stay on the market longer

Earlier this week, Hometrack published their January survey of the housing market. Over the next day or so, I will post some of their latest numbers. The first chart looks at the average time a house stays on the market. Currently, the average is 10.2 weeks; up from 10.0 in December 2010