Tuesday, June 12, 2012

Fiat currency and banks - when it all goes wrong

Okay, so there are our banks, running away nicely. Depositors are happy, although they'd like a little more interest. Lendees (?) are happy, although they'd like a little less interest. Record profits are being announced, record dividends are being paid, and CiF is full of articles about how many nurses could be paid for out of "Bank of Evil & Sons" bonus pool. Hunky-dory. 18 months later, it's a world of shit and pain. What could have gone wrong?

Well, go back to the simplified model we had with the two classes of assets - our 10%-ish of low risk, high liquidity, low profit and the rest in higher risk, uncertain liquidity, higher profit. There are clearly a bunch of things that could go wrong here.

  • We could be pushing the edge of that 10% - it's not set to punish the banks but to ensure that a bank run can be managed. 
  • We could have categorised assets incorrectly. Something we thought was low risk (or high liquidity) could turn out not to be either, or to be neither.
  • The regulatory model could be wrong - some things we are told were in the top asset class could turn out to be worthless.
  • Our profit model could be wrong for the higher risk assets - we could not be making enough on the good loans to cover the expected %age of defaults.
  • We could have a liquidity crash. Remember - we've got to cover the fact that you have between £2000 and £0 in the bank each month - and we've got to have the cash to pay you, even though we've lent out £1000 of your money (£100 to the govt and £900 to real people.)
Or, it could all happen. And, of course, you have the usual things going on - business executives taking strange decisions (RBSG and ABN AMRO, for example) that go badly, horribly wrong.

  • There was a lot of pressure, from the market analysts, for banks to generate every increasing profits. You can't do this with low-risk investments.
  • Many banks don't have the time to research, in detail, the risk models of the increasingly outre investments on offer. Hence the ratings agencies. They get paid to do the specialist analysis stuff. They get it wrong, especially for a category of assets and you've got stuff you think is near-cash that turns out not even to be "investment grade".
  • Government bonds. Greek and Spanish, especially. And other things.
  • Yes, err, mortgages. Housing market never falls? Non-recourse loans in the USA (certain states, YMMV)? Powered by Government regulation - the Home Mortgage Disclosure and Equal Credit Opportunity Acts in the USA, the Thatcher started (and New Labour continued) war against local councils via the Council House sales (with silly discounts.)
  • Ah, yes. And here is the rub. These mortgage-backed securities - the Collateralised Debt Obligations of much infame. What was the problem here? Well, some of them, particularly the junior tranches of US mortgages, became worthless (non-recourse loans in a falling market). For the rest, people couldn't work out what they were worth. So very few people wanted to buy them, except at fire-sale prices. The market became illiquid and you had a price spiral of doom.
You see, although the UK house market is over-priced (relative to average earnings and the value of land - it's a planning permission issue), UK mortgage "asset-backed securities" were probably still worth a significant %age of their nominal value. We have had a rise in unemployment, yes, so mortgage defaults will be up. We have had a drop in the housing market*, so the collateral isn't worth quite what it was. But, still, with a bit of ingenuity, you'd have probably been able to recover over 80% of the value. Taking a long term view, you may even have made a profit over nominal.

But, with daily settlement required, a long term view is hard. With "mark-to-market accounting", ingenuity has to take a second seat to panic. And there we are.

What was the only thing that could have made this worse? Delay followed by selective government bailouts. What did we get? Ah, yes, Bruin to busy saving the world to work out what he should be doing at home, UK Financial Investments Ltd and 82% HMG ownership of RBS. Oh, well ...

And, please note - there is nothing in any of this that being on the gold standard would have prevented. Gold values fluctuate all the time - and the only banks that were ever required to be backed up in bullion were the central banks. Because it isn't the value of the £ or the $ that crashed (although they've not exactly done well). It is the value of the bank assets denominated in £ or $ ...

* But, if you look around, this is actually, in the UK, largely a liquidity crash, not really a value one. Values have gone down, indeed. But not to crash levels. The average house price is down to about £160k from a peak of about £185k. Painful but not catastrophic.

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