FSA screw it up again

The FSA is irredeemably compromised. It has been captured by the financial services industry. As such, taxpayers can not rely on it to properly supervise banks. It must be abolished, with all its powers returned to the Bank of England.

This story from the FT, which highlights the government's disapointment with the FSA's so called crackdown on bonuses, further emphasises the need to abolish this pathetic institution as soon as possible.

Senior cabinet ministers are so disappointed with the Financial Services Authority’s new pay rules, released this week, they are considering whether legislation may be needed to crack down on bankers’ bonuses.

A number of ministers, including Lord Mandelson, the business secretary, are understood to be unhappy with the City regulator’s remuneration code, which toned down some earlier suggested measures.

Lord Mandelson thinks the guidelines, intended to reduce reckless risk-taking, have failed to reflect public concerns that the City is returning to “business as usual” after receiving billions in state support.

“Excessive risk taking had the results that we saw. Ordinary businesses are paying the price,” he said in an interview. “We have not heard the last word on this subject.”

His views are shared by other senior ministers, who suggest legislation may be needed to control short-term incentives for bankers unless the FSA shows it can pursue a tougher line.

Its both fascinating and horrible

Isn't it fascinating how quickly the rhetoric of politicians can change.

For years, the part time politicos on the monetary policy committee talked tough about monetary policy. They told us that central banks needed have credible counter inflationary strategies. They needed to be independent of governments, and relentlessly pursue price stability, regardless of the electoral needs of ruling parties.

Today's data on reserve balances tells of the horrible reality of central banking in the UK. Reserve balances of the Bank of England is not a rhetorical device; it is not cheap speech given at dinner of local business leaders. It is a key monetary policy instrument, which can be used for good or evil.

Today's MPC have been captured by the dark side. Reserve balances highlight the true inflationary intentions of the UK central bank. The BoE have created balances on an unprecedented scale, and used them to buy up government paper. In a few short months, the bank has injected around 10 percent of GDP in new money into the economy. Give that surge in liquidity about a year or two, and we will feel its full force in the inflation data.

As the reserve balanc number has increased, the old speechs about central bank independence have died away. There is no more talk of prudent monetary policy. Instead, central bankers talk of spectres like deflation and credit contractions.

And what about the credibility of the Bank of England? Where is its once proud independence. Naughty boys have word that begins with the letter B that seem to capture the essence of the relationship. I will use a more polite analogy, the BoE has become the Government's poodle.

Icesave - paying for other people's mistakes

Frankly, the UK does not come out of the Icesave collapse terribly well.

It used anti-terrorism laws to pressurize a small country to pay up on the debts of one of its bankrupt banks.

When these laws were passed, did anyone think that they would be used to settle a financial dispute? If New Labour are prepared to misuse this law in such a scandalous manner, how far would they go if they were really threatened?

It was classic Gordon Brown: "by any means necessary."

The FSA - technically capable, but politically weak

As the UK learns to live in the post-bubble world of collapsing asset prices and failing banks, there is some value in playing the blame game. How did we get into this mess and who was responsible? Perhaps, if we knew the answers to those questions, we might avoid a similar crisis in the future.

Today, the Telegraph provided an interesting insight into the role of the FSA during build-up of the commercial property bubble:

In a letter to the Chancellor on last month's collapse of Dunfermline, FSA chairman Lord Turner listed warnings made over five years from 2003 against "the dangers of commercial property lending", the risks of buy-to-let and "the dangers of mortgage book acquisitions".

Despite the FSA's concerns, Dunfermline was allowed to increase its commercial property book five-fold to £628m between 2004 and 2008 and buy mortgage books worth £467m from Lehman Brothers and GMAC. The watchdog finally intervened in October 2007 to prevent Dunfermline acquiring another £160m mortgage book from Credit Suisse.

Dunfermline was not alone in ignoring FSA recommendations. Seven of the top 15 mutuals increased their commercial property books by 15pc or more between 2006 and 2007, according to data from accountants KPMG.

The article reveals four interesting facts about the crisis. First, the FSA knew that weak regional banks, like the Dunfermline, were taking on excessive risks. Second, the FSA warned banks about the dangers. Third, the banks ignored those warnings. Finally, the FSA did nothing as the banks plunged further into the murky world of commercial property lending.

Does this help us answer our earlier questions? It tells us that the FSA has the technical competence to identify excessive risk taking by banks. However, it does not have the political willpower to restrict banks from making crazy lending decisions.

In other words, the FSA knew what was happening but failed to do anything about it.

FSA and the price of failure

Michael Fallon, MP for Sevenoaks and deputy chairman of the Treasury Select Committee, on the UK Banking crisis and the FSA.....

In the end, this was a failure of regulation and of government. Take Brown’s own creation, the Financial Services Authority (FSA). This super-quango employs 2,500 staff, costs us a staggering £415 million a year, and is supposed to supervise the banks. So far, five out of the big 10 banks have crashed – that’s some supervision.

More proof of FSA incompetence

Why does this not surprise me:

The City watchdog was warned that Icelandic bank Kaupthing was not "fit and proper" to run the UK bank Singer & Friedlander, MPs were told today. Tony Shearer, former chief executive of Singer & Friedlander (S&F), said he contacted the Financial Services Authority about his doubts in April 2005 during the takeover of the group by Kaupthing.

He said he and fellow directors took "every step that they thought was reasonable" to alert the FSA that they did not think Kaupthing was "fit and proper to run a UK bank". Overall, five of the seven members of the board made their concerns known in some way.

(From the Independent)

Isn't it about time that there was a public enquiry into the activities of the FSA. What exactly were they doing during all those bubble years?

So farewell, leveraged buy out loans

It wasn't just the housing market where banks were injecting silly amounts of money without fully understanding the risks. The leveraged buyout business was another favourite for reckless bankers.

The idea of a leveraged buyout is straightforward. A speculator raises huge money, either by issuing junk bonds or taking out loans, and then uses the money to take over a controlling interest in a target company. The speculator doesn't actually put up much of her own money -hence the title leveraged. Therefore, the speculator needs a ready source of credit. Until the credit crunch rolled into town, banks have been all too ready to provide money for these highly risky projects.

The leveraged buyout business has a long and grim history of financial failures. Towards the end of the 1980s, many buyouts proved to be highly unprofitable, leading to a number of horrific bankruptcies.

The chart above illustrates the explosive growth of leveraged buyout loans. In order to make the years comparable, the half yearly amounts have been inflation adjusted. The business peaked during the first half of 2007, and it has been sliding ever since. The stock of new loans during the first half of 2008 has fallen back to the level of 2004. It is likely that the market will have totally evaporated by the end of this year.

Leveraged buyout loans raises an old issue - bank supervision. Why did regulators allow banks to get involved in such a dangerous business?

So farewell, B&B

This morning's newspapers report that the Treasury is on the verge of nationalizing the Bradford and Bingley. Government intervention is inevitable. On Saturday, the bank experienced significant withdrawals of cash from its branches and online bank. By Monday, withdrawls would have snowballed into a full-scale run.

The bank reached the end of the road on August 29 when it published its half yearly interim results. Few were surprised to hear the bank report losses of ₤26 million. The arrears situation was deteriorating. The share price kept falling. Despite the recent rights issue and management claims of being well capitalized, no one was buying the happy talk from the B&B management. Last week, the credit rating agencies acknowledged that the bank was in trouble and belatedly downgraded the bank.

Thankfully, the B&B isn't in quite the same league as Northern Rock. As of June 30, the bank held about ₤52 billion of assets, of which around ₤39 billion are loans. Most of the loans are to buy-to-let customers. In terms of liabilities, the bank have some ₤20 billion in retail deposits. The Treasury should find this nationalisation less traumatic.

The real difficulty with B&B is the lending book. While the B&B had its own "organic" loans, which it generated through its own branch network, it also had a large amount of acquired lending; loans it bought from other institutions. The arrears numbers on these acquired loans are horrible. The bank also dipped deeper than most into the self-certification loan market. The arrears rate on these loans is high and rising. It is a lending book that will deteriorate further as the economy slows and borrowers run into payments difficulties.

According to media reports; the B&B's loan book is likely to stay on the government books for long time. The Treasury appears to have the good sense to understand that fire sale of bad loans would not be in the best financial interest of taxpayers. As for the retail deposits, the government will auction them off to the highest bidder.

I am curious how this latter transaction will work. Deposits, are of course, liabilities to banks. Presumably, these liabilities will be backed up by some form of government paper. It is just a guess here, but if this is how the Treasury will arrange this sale, then the B&B will add around ₤20 billion to government debt.

A second issue will be the remainder of the B&B's liabilities. Will the creditors receive a government bailout, or will they have to wait until the B&B is liquidated?

The demise of the B&B is a serious blow to the buy-to-let business. In future, investors will need to receive a significant risk premium if they are to be persuaded to invest in specialist BTL investors.

The end of the B&B also rules out any serious possiblity of banks recapitalizing via rights issues. Anyone who invested in the B&B earlier this summer would have literally thrown their money away. Investors won't make the same mistake again.

Like the NRK failure, the end of the B&B marks a major turning point on the road towards deflating the UK's housing bubble. Just as the NRK collapse signaled the end of the high LTV retail mortgage; the B&B signals the end of BTL loans to highly leveraged small time speculators.

We need a UK bailout strategy.

I've been surprised by the UK banks. In contrast to their American cousins, banks here have been noticeably quiet about the need for a generous tax payer financed bail out.

I wonder why? Perhaps, our banks have already quiet received assurances from the government that when the time comes, the taxpayer will be there for them. Both the government and the banking sector have good reason to keep quiet. A bailout will be extremely contentious and won't be an easy sell.

However, silence is the last thing we need right now. Instead, we need a serious debate about the appropriate circumstances when the government should intervene in a failing financial institution. If the Americans have taught us one thing this year, it is that an ad hoc, "take it as it comes" strategy simply doesn't work. The uncertainty about who gets bailed out only makes matters worse.

Nor is it tenable to say "we'll have no bailouts here". The consequences of a full scale bank run is just to horrible to contemplate. Besides, whether we like it or not, governments always come to the rescue of failing banks. The key question is how they bail out the banks.

Since a UK bailout is all but inevitable, here is my simple guidelines for the upcoming financial rescue of our largely insolvent financial system. The overriding idea is that the government should provide financial assistance generously, but brutally punish any bank who dares ask for it.

Principle one - All deposit taking institutions get bailed out. Everything else goes down in flames. So, hedge funds, SIVs, and the rest of the shadow banking system should understand that there are no government guarantees. They are on their own.

Principle two - Any deposit taking institution that asks for emergency liquidity should provide high quality collateral and pay an above market interest rate for any cash. If, in the opinion of the Bank of England, the bank would have difficulty paying the penal rate, the government should immediately nationalize the troubled institution.

Principle three - The shareholders of all nationalized financial institutions get wiped out. The value of shareholder equity goes to zero.

Principle four - The board of directors, the CEO and the CFO of any nationalized firm are fired immediately without compensation.

Principle five - The assets of all nationalized firms are sold only where the maximum value to the taxpayer can be reasonably assured. In some cases, this might mean holding onto assets for a very long time.

Principle six - Banks are nationalized before their net worth is zero. Every bank must keep a minimum capital adequacy ratio of 2 percent. Any bank falling below this threshold is immediately nationalized.

Principle seven - The head of the FSA is automatically fired if any bank fails with assets greater than 0.5 percent of total UK bank assets.

I hate speculating about the future of particular institutions. Bank failure is a nasty business. Judging by press reports this weekend, the UK government might need to think about a coherent bank resolution strategy very quickly.

The failures could start coming thick and fast.