Monday, 30 September 2013

The illogical pricing of property

In my latest post at Pieria I discuss the way in which treating houses as investments creates unsustainable rises in house prices, and outline two possible futures:

"The dream of property ownership has been fostered by Government in the UK for a very long time. Perhaps not as long as in the US, where FDR's New Deal in the 1930s promoted the goal of every American owning their own home: but certainly for over 50 years. Owning a house has become the principal icon of membership of the middle class. 
"Yet owning a house is becoming ever more difficult as house price rises outstrip wages. In the US, this tendency was interrupted by the 2007/8 crash, though house prices are now rising again. But in the UK, house prices have risen to the point where in much of the country only the very well-paid can afford property on a single income, and in parts of London and the South East even well-paid couples struggle to afford a family home...."

Read more here.

Saturday, 28 September 2013

The FLS early warning system

The Bank of England has produced usage data for the Funding for Lending Scheme (FLS). And very interesting it is too. Here is the full list of lenders that have signed up for the scheme, the amounts they have taken and their net lending position:

FLS usage and lending data1  
Click on the table to open the FLS usage and lending data spreadsheet

The Excel spreadsheet behind this gives information on exactly when the FLS funding was drawn - which is important, given the fact that funding costs generally have reduced considerably since FLS was introduced:

(chart taken from Bank of England's Inflation Report May 2013, p.12)

There is much less incentive now for banks to take FLS funding than there was in 2012 when market funding costs were very high.

I was therefore particularly interested to note those lenders that are both contracting net lending and tapping the FLS for cheap funding. Here they are:

Bank of Ireland
Co-Operative Bank
Santander UK
West Bromwich Building Society

Also of interest are the Manchester Building Society and Clydesdale Bank, which are not currently taking FLS funding but have signed up for the scheme, and whose net lending has been contracting for the whole period of the scheme: and Lloyds Banking Group, which is now expanding its lending but whose cumulative net lending for the duration of the scheme is negative, and which took FLS funding early on in the scheme when it was still reducing its net lending.

In short, it is the usual suspects, plus a couple of building societies and - mysteriously - Santander.

Taking FLS funding while net lending is reducing is expensive. Lenders are charged a penalty for failing to expand lending while in receipt of FLS funding. However, as I have noted before, in 2012 funding costs for some banks were sufficiently high for it to be worth their while taking FLS funding and accepting the penalty. That is probably why Lloyds Banking Group took FLS funding in Q3 and Q4 2012 despite its net lending reducing at that time. The penalty was insufficient to offset the benefit from reduced funding costs. The same probably applies to RBS and Santander, both of which accepted FLS funding early in the scheme despite reducing net lending. Indeed, Santander has subsequently repaid £900m of its £1bn FLS funding.

However, the Co-Op Bank, Bank of Ireland UK and West Bromwich Building Society have chosen to tap the FLS funding scheme more recently, when the interest advantage from taking FLS funding seems much less likely to offset the penalty. Why would they do this?

The clue lies in the balance sheets of all three institutions. We are looking at two badly damaged banks and a badly damaged building society. Let's look at each one in turn.

The Co-Op Bank
The taking of FLS funding coincided with the disclosure of a capital shortfall which at the time was thought to be about the same size as the FLS funding (it is now considerably larger, partly because the PRA moved the goalposts). It looks very much as if the Co-Op took the FLS funding to shore up its balance sheet: pledging part of its asset base to the Bank of England in return for safer government debt in effect transfers some of its balance sheet risk to the Bank of England. Although this would not be reflected in the capital position, since the new securities were borrowed rather than owned, the fact that the Bank of England would now face losses if the Co-Op Bank was forced into resolution possibly gave the Co-Op's management a stronger bargaining position with the PRA, as Robert Peston suggested in his blog. It is no surprise that, following the Co-Op receiving FLS funding, its management attempted (unsuccessfully) to persuade the PRA to back down on the capital requirement.

Although the FLS transaction itself is off balance sheet, being structured as a collateralised stock lending transaction (no money changes hands - see Appendix A here), it can under certain circumstances be backdoor recapitalisation. FLS enables banks to obtain funding more cheaply. It is intended to enable banks to cut interest rates on loans - and some lenders, such as Lloyds and RBS, have done exactly that. But if the bank chooses to maintain or increase interest rates on lending, the wider spread between funding costs and income from lending should improve profitability and therefore, over time, improve the bank's capital ratio. So did the Co-Op cut loan rates? No. It raised its mortgage rates in April 2012, and has not cut them since despite taking up Funding for Lending. Nor has it cut effective rates to SMEs. And it has closed its doors completely to new business customers. Quite apart from its use of FLS to shore up its balance sheet, therefore, it may also be expecting reduced funding costs to improve its capitalisation over time. However, using FLS funding as part of a profits improvement strategy seems far more significant in the other two cases.

Bank of Ireland
The Bank of Ireland got into very deep trouble in the financial crisis and was partially bailed out by the Irish government with liquidity assistance from the ECB. It remains 15% state-owned. Like other damaged lenders, it has a portfolio of toxic loans that it is gradually unwinding, and it has made losses every year since the financial crisis, although the losses are gradually reducing.

However, it is, of course, the UK subsidiary of the Bank of Ireland that has accepted FLS funding. This subsidiary incorporates the Bristol & West building society and Post Office savings accounts.

The Bank of Ireland cut interest rates on Post Office savings accounts in the UK in January 2013, following this up with two tranches of FLS borrowing. It then hit its tracker mortgage borrowers with a margin increase, taking some mortgages from 0.85% over base (total 1.35%) to 2.99%. A further 1% margin rise is planned for this October. This does not look like the action of a lender that intends to increase lending. It looks like the behaviour of a lender that is desperately trying to stop the bleeding by widening its credit spreads. So what is going wrong?

From the Bank of Ireland Group's interim results for June 2013 (p.40), it is clear that all is not well with Retail UK. Operating profit of £65m was wiped out by £177m of impairment charges on loans and advances - 10% higher than in 2012 - mostly on corporate lending and construction loans. This resulted in a pre-tax loss of £97m. Admittedly, this loss is tiny compared to the losses still being incurred by its parent. But of course the parent is not in a position to shore up its subsidiary. The Bank of Ireland UK is on its own. It must do something urgently to improve its profitability. Hence the rate hikes to borrowers, the rate cuts to depositors - and the use of FLS funding.

West Bromwich Building Society
This little building society nearly failed in the financial crisis. It still has a large legacy loan portfolio which it is gradually unwinding; it has made losses every year since 2009, although the losses are reducing, and like other financial insitutions with commercial property, its impairments are rising. Although its net lending was still reducing at 30/6/12, it looked as if West Brom took FLS funding in anticipation of a rise in mortgage lending, as it is a major player in the booming Buy-To-Let marketplace (60%  of its prime residential mortgages are Buy-To-Let). Until last week, that is....when it hiked the rates charged to its prime residential SVR borrowers, a large proportion of whom are Buy-To-Let investors, by 2%. This is not the action of a lender intending to increase net lending. No, it is the action of a lender in trouble. Clearly, the reduced cost of funds due to FLS was not enough to restore its profitability, especially in the light of rising impairments. So it has widened the spread by hitting borrowers.

A quick look at West Brom's report and accounts shows what the main problem is. Its cost base is shockingly high - 91% of its income. It is normal for smaller banks and building societies to have higher cost/income ratios than larger ones, but that is exceptionally high. And it is not because its costs have increased. It is because its income has halved since 2009. It desperately needs to improve its income as well as cutting costs if it is to survive: a cost/income ratio of that size is not remotely sustainable. 

So those were the three financial institutions that have taken FLS funding RECENTLY while reducing net lending. The indications are that all three are in trouble. Could it be that take-up of FLS by an institution that is not acting in accordance with the FLS rules and expectations (namely, that net lending should increase and interest rates on loans reduce) is a warning sign? 

Let's look at two institutions that have signed up for the scheme while reducing net lending but are not yet tapping it - the Manchester Building Society and the Clydesdale Bank. 

Manchester Building Society
The Manchester is in something of a mess. This is from the Chairman's statement in the 2012 accounts (my emphasis):
The financial statements for 2012 have seen a material write-down in the Society’s opening reserves resulting from a change in the accounting treatment for certain financial instruments. Whilst the underlying business and profitability of the Society has remained unaltered, the accounting treatment was revised in order for the Society to comply with the requirements of International Financial Reporting Standards (“IFRS”). 
The accounting principles involved are complex. Included within the Society’s range of mortgage products are a number where the borrower pays a fixed rate of interest. By offering fixed rate products, the Society is exposed to the risk that future movements in interest rates will see its interest margin eroded or otherwise adversely affected. The Society has entered into interest rate swap arrangements which, where terms match, lock in an interest rate, thereby gaining economic certainty as to the margin that it will earn on these products.
At each year end, the Society has calculated the “fair value” of both the swaps and the mortgages and historically reported the fair value of both in its balance sheet under the hedge accounting provisions of IFRS. The Society has now identified that this accounting treatment does not comply with IFRS hedge accounting requirements and the mortgages should be reported at their amortised cost. The resulting accounting adjustments have been back-dated across a number of years in line with accounting conventions and the Society’s opening reserves have been adjusted to take account of the pre-2012 effect of these adjustments. Prior to these adjustments, a pre-tax profit of £1.86 million was achieved in 2012; after adjustment this figure becomes a post-tax loss of £2.72 million. Remedial action has already been taken, in consultation with the Society’s regulators, to rebuild the Society’s capital by issuing, in April 2013, £18 million of new equity in the form of Profit Participating Deferred Shares.
In line with the Board’s risk appetite, the size of the balance sheet was reduced during 2012. £4.8million of mortgages were sold at a small premium to book value. In addition, three key initiatives were taken during 2012: an application to participate in the Bank of England’s Funding for Lending Scheme, a diversification of the Society’s retail deposit base (via our North West Air Ambulance Affinity Account and a range of competitive SME Business Deposit Accounts) and the development of Introducer deposit accounts.
Ouch. I hope they sacked their Chief Financial Officer and their auditors. More importantly, though, the restatement left the Manchester terribly short of capital. That is a huge reserve hit for a financial institution of that size.  Like all mutuals, the Manchester relies mainly on organic growth (retaining profits) and/or divestment to increase equity capital. It has raised some new Tier 1 capital*. And it has divested some assets. If its income were stable or improving, that might be enough to restore its fortunes. But that's not the case. Stripping out the restated derivatives loss in the income statement reveals a drop in interest income of £3.3m - about 20% of its 2011 net interest income. Admittedly this is probably at least partly due to asset divestment, but.....ouch again. So the Manchester not only needs to repair the capital hole that has suddenly opened up due to a gross error in its use of accounting standards, it also desperately needs to improve its profitability. No wonder it is looking at cheaper forms of funding.

Clydesdale Bank
On 23rd August 2013, Moody's downgraded Clydesdale Bank's senior debt. The reasons it gave are telling:
The lowering of the BCA reflects Moody's view that Clydesdale faces longer-term structural challenges from its weakened franchise and past risk-management/control weaknesses. The rating takes into consideration the bank's efforts to address these challenges by strengthening its risk management and controls framework and improving efficiency through a cost reduction program, but Moody's believes that these measures will take some time to be effective, while at the same time the bank remains exposed to ongoing short-term pressures. These include (1) a business loan portfolio whose asset quality remains under pressure; and (2) low profitability, which reduces the bank's financial flexibility.
Clydesdale Bank is currently owned by the National Australia Bank (NAB), which has recently recapitalised it and taken on to its own balance sheet the Clydesdale's distressed commercial property portfolio. This looks like the sort of action that a parent would take if it were preparing its subsidiary for eventual divestment, and Moody's takes this into account. But the Clydesdale still has a commercial lending portfolio that is not doing too well, and its profitability is poor. Cutting funding costs, as I have explained already, is a way of improving profitability. It may be that the Clydesdale plans to use the FLS to reduce its funding costs as part of a profits improvement strategy. If so, I would expect to see FLS takeup coupled with interest rate rises on loans and cuts to deposit rates. Furthermore, FLS can be used as part of a strategy to bolster the capital position over the medium term: as it seems likely that the Clydesdale will face further impairment charges, improving its capital position is important. Once again, we have FLS (though admittedly not yet in receipt) associated with a lender that appears to be in some trouble.

I haven't looked in detail at the lenders that borrowed in the early months of FLS while contracting net lending, because - well, we all know what state RBS and Lloyds were in at that time, and Santander was undoubtedly preparing itself for a Spanish default (since its parent is Spanish). But I think the cases I have looked at above are sufficient. FLS may not be very effective as a lending boost. But it is an excellent early warning system for banks and building societies in trouble. 

Related reading:
Funding for Lending Scheme Usage & Lending Data - Bank of England
The Funding for Lending Scheme - Bank of England
The fatally flawed FLS - Coppola Comment
Has the Bank of Engalnd's loan scheme failed? - Robert Peston (BBC)
Under the Radar - Coppola Comment
Bank of Ireland Group interim results 2013
Bank of Ireland's losses are falling - BBC
West Bromwich Building Society report & accounts 2013
Manchester Building Society Report & Accounts 2012
Moody's downgrades Clydesdale Bank's senior debt - August 2013

* In 2009 the West Brom converted its subordinated debt into PPDS. The Manchester is subtly different, in that it has issued new PPDS rather than converting sub debt. But the result is the same. Arguably, neither the Manchester nor the West Brom is really a true mutual any more, since PPDS are much like non-voting equity shares. FT Alphaville, quoting the FSA extensively, attempted to explain them here.

I am indebted to Robert Bothwell for his assistance with the financial analysis behind this post. 

Saturday, 21 September 2013

The ignorance of markets

In my latest post at Pieria, I complain about trading strategists who don't do their homework:

"There is considerable debate about whether markets are efficient, and whether investors are rational. To me it is self-evident that investors at times are anything but rational and markets at times are anything but efficient, but I will leave the economists to argue about that. If anyone really wants to know more about the limitations of the efficient markets hypothesis, read this post by Euronomist. And for more on whether or not human beings really are rational utility maximisers - as is implied by the rational expectations hypothesis - read this post by John Aziz.

When it comes to monetary policy, though, all too often we are not dealing with inefficiency or irrationalilty, but simple ignorance....."

The rest of the post can be found here.

Thursday, 19 September 2013

Stand By Your Bank

In my post on the "ethical" Co-Op, I argued that the Co-Op Group management is treating subordinated debt holders in the Co-Op Bank shabbily. Various people questioned this on the grounds that as the Co-Op Bank is a public limited company, the Co-Op Group's investment in its bank is limited to its stake and it is not obliged to provide additional capital: it could simply "walk away" and allow the bank to fail. This comment challenged me to explain why this is not the case:
The thing I still don't understand is why you think the Group can't walk away from the bank if it is a subsidiary Ltd company, as seems the case. Is there some legal entanglement beyond the usual corporate pyramidal structure? What is the mechanism through which you think the banks' liabilities can "move up" the limited liability barrier? This is not a question of ethics here, just basic corporate law. 
Let's imagine the group withdraws the current offer and stops contributing any new group cash into the Bank, and the regulator pulls the plug (stop allowing the insolvent bank to operate below regulatory limits). What happens? The bank obviously goes into administration under the new bank resolution regime. I would expect the group to be able to continue operating their remaining businesses as (almost) usual. They may face some extra losses from any inter-group claims (e.g. that discussion on whether the IT loss onto the Bank or onto the Group's IT subsidiary) but as such that might not be enough to make the group insolvent.
Is it that you think there's enough inter-group claims to take down the group, or something else? It may be worth a full post, I doubt I'm the only one mystified by the idea limited liability doesn't work as expected.
Indeed the Co-Op Group management themselves seem to think they could allow the bank to fail and still continue as a going concern. From the 2013 Co-Op Group Interim Results, p.15 (my emphasis):
The directors of the Society believe that it is likely that the recapitalisation plan will proceed, but have prepared sensitised forecasts for a period in excess of 12 months from the date of approval of this interim report which indicate that, should the recapitalisation plan not succeed, the Society and the Group (excluding the Bank) could still continue to operate within the terms of existing bank facilities. The Society’s directors do not believe, therefore, that the risks identified by the Bank’s Directors in relation to the ability of the Bank to continue as a going concern represent a material uncertainty to the ability of the Group (excluding the Bank) and Society to continue as a going concern.
So does the Co-Op Group have to stand by its bank?

When a bank is part of a financial conglomerate, the Prudential Regulatory Authority (PRA) has the power to direct its parent to recapitalise it. This power is intended for use in cases where a bank is owned by a holding company that is itself a financial services company and/or has other substantial interests in financial services. The Co-Op Group management is in effect assuming that because it is a retail group, the PRA's power of direction does not apply. Is this the case?

The definition of a "financial conglomerate" is set by the EU, which maintains a list of European financial institutions it considers to be financial conglomerates. The latest list can be found here. Listed at no. 57 is the Co-Operative Banking Group:

Now this is more than slightly confusing. The Co-Operative Banking Group Ltd and the Co-Op Group are not the same entity. Here's what the Co-Operative Banking Group Ltd has to say about itself: 
We are the financial services arm of The Co-operative Group and our businesses include The Co-operative Insurance, The Co-operative Bank, Britannia and the internet bank smile.
So the "financial conglomerate" as defined by the EU is not the Co-Op Group (a mutual) but a financial services holding company with limited liability which is 100% owned by the Co-Op Group. Does this mean that the PRA's  power of direction only applies to the holding company, not to the mutual that owns it? 

 From the PRA's statement of policy regarding power of direction, it seems that this may indeed be the case (my emphasis):
6. The definition of ‘qualifying parent undertaking’ includes
any UK-incorporated parent undertaking (or parent
undertaking with a place of business in the United Kingdom) in
an ownership chain which meets the definitions contained in
the Order, even if the undertaking is not itself the ultimate
parent undertaking. In general, the PRA would consider action
to be most effective when taken in relation to the ultimate
parent undertaking at the head of the ownership chain, as that
is usually where most of the power to direct and control the
group resides.
7. However, where the ultimate parent undertaking is not a
‘qualifying parent undertaking’
(for example if the group is
headed by a non-UK entity or a non-financial entity) then the
PRA will not have the power to direct that ultimate parent
undertaking. In such circumstances, the PRA may consider
that use of the power of direction over another qualifying
parent undertaking in the ownership chain is appropriate.
So the PRA would ideally like to direct the Co-Op Group to recapitalise the Co-Op Bank, but is unable to do so because the Co-Op Group is not defined by the EU as a financial conglomerate and is not a financial entity. The PRA can only direct the Co-Op Banking Group Ltd. But the Co-Op Banking Group Ltd is already divesting its insurance businesses: once these have been sold, not much will remain of it apart from the three brands that together make up the Co-Op Bank (they are separated out in the Banking Group's statement but are in fact one banking entity). If the Bank is allowed to fail, therefore, then the Co-Op Banking Group will fail with it. That is 92%  of the Co-Op Group's asset base, but currently contributes less than 10% of its income. It is therefore in theory possible for the Co-Op Group to cut its losses, allow the Co-Op Banking Group to go belly-up and continue in business as a pure retail group. And that is indeed what the Group is warning the bondholders that it may do. In response to Robert Peston's questioning of the proposed bondholder bail-in, the Group pointed out that the only alternative would involve much larger losses for bondholders:
And Co-op Group makes one further point. If the preference shareholders and bondholders don't like it, there is an alternative.
It is called resolution, in which the bank would be seized and rescued by the Bank of England, and the pref holders and bondholders would see the value of their investments reduced to a big fat zero.
In other words Co-op Group says the choice for bondholders and pref holders is between big losses and total losses.
Clearly, therefore, there is a huge hole in the definition of a "qualifying parent". I suppose, when the PRA was granted power of direction over parent entities, it was never envisaged that a supposedly ethical mutual would mismanage its bank so comprehensively that it entered regulatory insolvency, nor that the supposedly ethical mutual might then try to cut its losses and walk away from its bank, leaving little old ladies to lose their savings and the Government to pick up the pieces. The PRA's powers of direction were intended for large financial conglomerates like Lloyds, not for retail groups with a bit of banking attached. No-one has considered what the PRA's powers should be when a failing bank is owned by a retailer, and the legislation does not cover that situation. It desperately needs amending. Are we really going to allow the likes of Tesco, Sainsbury and (since the Northern Rock sale) Virgin to walk away from the banks they own, leaving bondholders and/or taxpayers to bear the costs of failure?

At present, the Co-Op Group is accepting some responsibility for recapitalising the Co-Op Bank, but wants to share that responsibility with the Co-Op Bank's subordinated debt holders. Viewed in the light of the Co-Op Group's apparent lack of liability, this looks generous. And it is also dangerous. Raising the funds required to make the Co-Op Group's contribution will increase its balance sheet leverage and therefore its business risk, especially as its non-financial asset base is so small. Not surprisingly, the Co-Op Group's own bondholders are not happy. According to Mark Kleinman at Sky
Lenders to the Co-Operative Group are demanding that its new management team slashes capital expenditure and provides greater protection for their loans in return for them supporting a sweeping financial restructuring.
So it seems the Co-Op Group's lenders are setting conditions for their support of the recapitalisation plan. Although they might be yet another group of the Bank's lenders, or the Banking Group's. The complexity - and opacity - of the Co-Op Group's organisational structure could confuse even an experienced journalist like Kleinman. And the approach taken by the Group to financial reporting doesn't in any way help to clarify matters. 

But the unhappiness of this group of bondholders is as nothing compared to the misery of the Co-Op Bank's subordinated debt holders, who stand to be stiffed, frankly. And they are angry. So angry that they have formed themselves into THREE groups, each taking a different approach to fighting against being bailed in:

  • Group 1, representing small investors, is running an orchestrated campaign to persuade anybody and everybody to excuse small investors from taking part in the bail-in ("Woodman, spare that tree!")
  • Group 2, made up of institutional investors, questions the entire rationale for the bail-in and accuses the Co-Op of rigging the figures to ensure the bondholders take more of the pain than they deserve;
  • Group 3, made up of hedge funds (which quite possibly only bought their subordinated debt holding when prices crashed after Moody's downgrade), wants to take over the Co-Op Bank. 

Predictably, the Co-Op Group is refusing even to talk to any of them until the share sale prospectus is issued in October. And the PRA, which probably realises it has very little leverage because the legislation does not give it the power to direct the Co-Op Group, is keeping its head well down. Though to its credit, in my view, it is still refusing to budge on the capital requirement, despite the attempts by both the Co-Op Group itself and Group 1 of the bondholders to persuade it to water it down.  

The Group 1 bondholders' attempt to persuade the PRA to use its power of direction to force the Co-Op Group to recapitalise its bank fully is I think doomed to failure for the reasons I have given above. And whether Group 2's accusations stick remains to be seen: there is certainly to my mind a serious question over £148m of sunk IT costs apparently written off but in fact allocated to the balance sheet of CFS Management Services Ltd., a sister company in the Co-Op Banking Group. But it would be far more difficult to prove that the vast provisions allocated against (mostly) ex-Britannia assets are unjustified. 

By far the most serious threat is actually from Group 3. Even if the 100% bail-in they propose is insufficient to plug the capital hole and/or some of the other subordinated debt holders refuse to take part, this group says it will top-up any shortfall itself - and it unquestionably has the means to do so. Group 3 is well-informed, well-organised and well-funded, and it means business. The Co-Op Group should take its threat seriously. 

If the Co-Op means to stand by its bank, it will have to engage with the bondholders - not only with the Bank's bondholders, but also with its own. Upsetting bondholders is not wise: investors can have long memories, and a company that comprehensively shafts not only its subsidiary's bondholders but its own is likely to be very unpopular in the marketplace for quite some time.  

Of course, if it becomes too painful to Stand By Your Bank, there is always D.I.V.O.R.C.E - as Robert Peston suggested when the Co-Op's difficulties first became apparent. Perhaps an independent Co-Op Bank in private ownership, and a Co-Op Group freed of the banking albatross round its neck, is the best solution to this unholy mess. 

Related links:

The "ethical" Co-Op - Coppola Comment
Under the radar - Coppola Comment
Co-Op Group Interim Results 2013
Policy statement: the power of direction over qualifying parent undertakings - Prudential Regulatory Authority
The Co-Op Bank: Dial B for Bondholder - FT Alphaville
Co-Op bondholders step up pressure for "plan B" on debt restructure - FT (paywall)
Co-Op Group lenders "close to new deal" - Mark Kleinman (Sky News)
Does Co-Op Group deserve to keep control of Co-Op Bank? - Robert Peston (BBC)
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston (BBC)
The plausible executive and the ruined bank - Frances Coppola (Pieria)

Monday, 16 September 2013

Psychological games and financial crises

At Pieria, the financial crisis remembered.....

Five years on from the collapse of Lehman, I explain the psychological game-playing that caused the 2007/8 financial crisis - and that still continues today.
"One of the interesting features of financial and economic crises is their suddenness. It's as if the world is happily strolling along a well-trodden path on which someone has built a man-trap. We don't see the crash coming and we walk straight into it. Yet when we look back on what happened, we see all too clearly that the signs were obvious - we just didn't notice them.
"Economists have made numerous attempts to explain this apparent blindness without a great deal of success. The fact is that financial crises do not come out of the blue, and some people do see them coming. The world is warned about its folly, but chooses to ignore. Those who shout "WATCH OUT - THERE IS DANGER AHEAD" and try to suggest alternative courses of action are dismissed as Cassandras and their thinking is excluded from mainstream academia and the corridors of power. This suggests that the cause is more psychological than economic - it is rooted in people's behaviour. Like a Greek tragedy, the end is inevitable because of the nature of the players."
Read more here.

Tuesday, 10 September 2013

The plausible executive and the ruined bank

My latest post at Pieria looks at the mess the Co-Op Bank has got itself into. The former CEO, Neville Richardson, says it's not his fault. But if it isn't his fault, whose fault is it? And just how bad is this mess, anyway?

"The Co-Op Bank's former CEO, Neville Richardson, gave evidence to the Treasury Select Committee on the circumstances surrounding the failure of the Verde deal. In the course of that evidence, he made the following claims about the Co-Op Bank's finances:
  • the Britannia building society, which the Co-Op took over in 2009 (and of which he was previously the CEO) was not the primary source of the toxic assets that have blown a large hole in the Co-Op Bank's capital;
  • When he left the Co-Op Bank in mid-2011 it was profitable, well-managed and there were no signs of credit problems in its asset base.
I admit I found this somewhat hard to swallow. But since he makes these claims on the basis of figures derived from the Co-Op Bank's report and accounts which he has submitted in his written evidence to the Treasury Select Commitee, I thought I would have a look myself and see if there was any basis for his claims."

You can find the results of my analysis, and the conclusions I draw, here.

Monday, 2 September 2013

Savings, investments and a dose of realism

On the Save Our Savers website today is this article by John Phelan. It explains why savings are essential to the economy and why - in his view - central bank and government policies that discourage savings are misguided. And why QE is no substitute for "proper" savings.

I've heard these arguments a lot recently and they always seem to stem from the idea that there is only one sort of "savings", namely retail deposits in banks and building societies. And indeed, the usual definition of "savings" does mean cash, in its various forms, so bank deposits are "savings" whereas pensions are not - they are "investments". I'm not sure people necessarily make such a clear distinction in everyday parlance. But Phelan's argument is an economic one. How does economics define savings?

In economics, "saving" is the residual of income left after consumption. If S = saving, Y = income and C = consumption, S = Y - C. Note that S is the dependent variable: its value depends on the values of Y and C. When these change, so does S. This is fundamental to understanding what the present policies of central banks are intended to achieve.

Keynesian economics also says that all saving should be invested productively in the economy to generate future growth. Indeed, Phelan's entire argument rests on this - after all, if savings aren't invested productively, it is hard to argue that they are essential for future economic growth. If investment is I, therefore, S = I.

Now you can see that we immediately have a problem. If savings = cash, then all investment is cash. Clearly this is wrong. It seems savings has two, quite different, definitions - the common one (savings = cash) and the economic one:

S = Y - C = I

This is really important. Back in the good old days when people were paid in cash, people's idea of saving was to put money in the bank or building society.  And many people in the UK still think like this. As someone put it in a comment on Phelan's post, "if I take my money out of the building society, where do I put it?"  To this day, in the UK, when people talk about saving, they think "bank".

But cross the Pond, and you find people thinking very differently about how to save. There, stock market investments are a way of life. Very ordinary people have stocks & shares, and bank deposits are much less important as savings vehicles. Are we going to argue that because our American cousins invest their residual income in stocks and shares rather than putting it in the bank, that they don't have "savings"? Clearly this is nonsense. The common definition of savings is simply inadequate. People's "life savings" are the sum total of all the residual income they have stashed away over the years, whatever form it is in. To call stashing away cash "saving" and everything else "investing" is economic nonsense. All of it is S.

And ideally, all of it is I, too. The heart of Phelan's argument is that savings are essential if there is to be productive investment. I completely agree. But bank deposits are not the main source of such investment. These days, even in the UK, the main sources of savings for productive investments are funds - pension funds, money funds, wealth funds. And as more people are enrolled in private and corporate pension schemes, those sources will become ever more important. Though in fact bank deposits are really only another sort of fund. The idea that they are in some way "different" from any other sort of investment is fundamentally wrong.

Money in bank deposit accounts has been lent to the bank. It is no more "your money" than any other sort of investment. When you put money in the bank, you exchange cash for a financial asset - a balance on a deposit account. That is no different from buying a bond. In fact you can view bank deposit accounts as bonds: the interest on the account is the coupon, there may or may not be a maturity date (if there isn't it is a "perpetual"), it may or may not be liquid (how easily can you sell it/take your money out). And banks treat deposits in the same way as bonds. As I've explained elsewhere, to banks deposits are simply a source of funding. You have lent your money to the bank just the same as if you have bought its bonds. The bank has no responsibility for "looking after your money" or investing it to generate a good return for you. It will invest your money, yes, but to benefit itself, not you.

So, does S really equal I? Is all saving really productively invested in the economy? Or is there saving that isn't productively invested - and where does it fit in?

No, S does not necessarily equal I. At the moment they are a very long way apart:

(Chart from Paul Krugman via Monetary Realism. Source: FRED. US data, but a similar picture of collapsed private investment and high private saving applies in the UK too - though in the UK it is more corporate saving than domestic).

What happens to saving that isn't invested productively is that it is transformed into financial assets and hoarded. This is what Monetary Realism means when it redefines S = I as S = I + (S-I). Saving is the total of productive investments AND the bit left over. We can argue for hours about what we mean by productive investment and unproductive hoarding of financial assets. The point I am making is that quite a lot of saving simply isn't productively invested in the real economy.

As the chart above shows and Aziz explains, at the present time there is a glut of savings and a shortage of productive ways of using them. The story of the last five years has been a massive failure of corporate and government investment, not because corporates haven't got any money - they have enormous cash balances - but because they can't think of anything useful to do with their money apart from buying back their own stock. And long-term, the need for investment capital seems to be declining as manufacturing becomes more efficient and services more dominant in the economy. But at the same time there has been a huge growth in saving, both domestic and corporate.

This is the real reason why interest rates are so low. Savings that aren't productively invested can't generate a genuine return for their owners. All they can do is extract rents from wage earners and taxpayers to create the illusion of a return. Unless we can find productive uses for all this saving, it simply isn't needed. And when there is a glut of anything, it makes sense to discourage producing it and encourage activities that reduce the glut - in this case, since it appears corporates aren't investing because of a shortage of demand, most obviously consumption (since S = Y - C). Despite what Phelan says, therefore, discouraging saving and encouraging consumption until the economy is growing again makes complete sense from a macroeconomic standpoint.

Unfortunately it doesn't make sense from the point of view of people's needs over their lifetimes. People need to save, particularly to support themselves in retirement and to cover unexpected expenses. This creates a considerable dilemma: from an economic perspective we don't need more saving, but from a personal perspective we do. I am not unsympathetic to this problem, but it seems to me that attempting to persuade those responsible for macroeconomic policy to favour personal needs over economic needs is doomed to fail. The central bank is not responsible for ensuring that people can save. That is the responsibility of the fiscal authorities.

There is a lot that governments could do to help people save in a low-growth, low-investment world, but first they have to get out of the straitjacket they have made for themselves. The primary purpose of government debt is not to finance government - after all, it can create all the money it needs - but to provide safe savings vehicles for citizens. Governments should produce the amount of debt instruments for which there is (domestic) demand, and stop worrying about future debt service. After all, those debt instruments are the current savings of those who will be old in the future. Either those people buy government debt, and are supported in the future from taxes levied on future generations to pay debt service, or they don't, and are supported in the future from taxes levied on future generations to pay old age pensions. Really there is no difference. We have to stop getting so hung up about public debt. Public debt is the savings of the people of the country, and they should have as much of  it as they need.

So where does QE fit in? Does it really create "fake" savings, as Phelan suggests? No. The deposits created by QE are real. They are indistinguishable from any other sort of savings.

In the real economy, deposits are created as a consequence of bank lending. The savings deposited in banks by savers, or paid into their pension funds, were ultimately created as a result of someone else's borrowing - perhaps their employer, in the form of working capital finance enabling him to pay their wages: or perhaps someone who borrowed to buy products from their employer, providing business income from which wages are paid. The loans that originated the funds deposited by our savers can be some distance removed from them, which is why it is hard for people to understand that they only have money because others have debt. But it is important to understand that loans create deposits, not the other way round. 

So normally, in our economy, saving is only possible because others have debt. This is the S = I rule looked at the other way round, of course. As Andy Harless suggests (following Keynes), S is only possible because there is I, where I is some form of debt, physical asset or equity (equity is really only a bonded form of debt, as people enslaved because of indebtedness could tell you). Substituting Monetary Realism's breakdown of I, that means that when I is falling because of lack of productive investment opportunities, either S must falls too (dis-saving or debt increase) or unproductive hoardings of financial assets must increase. It might help to look at the equation again:

S = Y-C = I + (S-I)

When it is doing QE, the Bank of England buys bonds, mainly from investors (though some from banks), in return for newly-created money. These bonds were originally bought with cash, either by individuals or by institutions (funds) on behalf of individuals. In buying the bonds, all the Bank of England does is replace an interest-bearing asset - a bond - with a non-interest-bearing one, i.e. cash. And what do investors do with this cash? They put it in a bank, or they spend it, or they invest it in some way. If the seller of the bond is a bank, it invests the money in some way, or it parks it at the central bank. QE money is real money replacing real assets that have been previously bought with real money. The only difference is that instead of the assets being bought by other savers with money that banks have created through lending, they are bought by the central bank with money created by the central bank. Other savers are therefore forced either to compete for the remaining bonds, or to invest their money in some other way (ideally by buying riskier assets, thus encouraging I to increase) or spend it (reducing S by increasing C). Phelan's suggestion that QE money is somehow disconnected from individuals' savings is simply wrong. It would not be possible to do QE unless individuals (and institutions representing individuals) already had savings in the form of government bonds and other securities that could be bought by the central bank. What QE does is influence how people invest their savings, not create "fake" savings as Phelan suggests. 

Phelan makes another, all too common, mistake: he states that the purpose of QE is to provide additional funds to banks so that they can lend. But this was never the primary purpose of QE. Both the Bank of England and the Federal Reserve have explained that QE achieves its effects principally through supporting asset prices and encouraging investors (i.e. savers) to rebalance portfolios towards risky assets: the "bank lending channel" is at best weak and at worst non-existent. And QE has indeed raised bond, stock and commodity prices across the board. The downside of this is that yields on investments have fallen, along with associated interest rates including those on bank deposits. Generally speaking, savers who were looking for yield from their investments have suffered from QE: savers who were looking for asset value appreciation have benefited.

It may be that in the future, the economy will have a greater need for saving for investment - though thirty years of interest rate decline is not exactly promising:

UK 10-year gilt yield
Historical Data Chart
(source: Trading Economics)

Or maybe there will be such a decline in saving that demand for what remains forces up interest rates - though successive governments trying to encourage people to save for their futures without providing enough vehicles for them to do so doesn't help matters. If there is a criticism I would make of QE from the point of view of savers, it is the fact that it reduces the stock of safe assets for long-term savings, raising the price and reducing the returns. Savers who don't want risk aren't going to diversify into riskier assets: savers who are saving for retirement aren't going to spend the money instead. They will either pay the higher prices for safe assets or put money in the bank. Either way they will get rubbish returns, since the fact that deposit accounts and gilts are substitutes means the rates will be pretty much the same on both. In other words, they will simply substitute one low-yielding safe asset for another, while moaning about how unfair it is. This strikes me as pretty pointless. But then my regular readers know I am no fan of QE.

In summary, although I agree with Phelan that saving is necessary for investment in a healthy economy, at present we have more savings than we know what to do with. Central banks see the present problem as principally a demand shortfall, which is depressing economic activity and discouraging corporate investment (if companies can't see adequate sales opportunities for the foreseeable future, they won't invest). Their strategy is to discourage saving and encourage consumption. This brings forward demand from the future to the present, which should generate economic activity and encourage companies to start investing again.

This is what lies behind Carney's observation that the best thing for savers is a strong economy. Raising interest rates would reduce household and business consumption, increase corporate finance costs and further discourage already low corporate investment. Keeping interest rates low until the economy is stronger is painful for savers in the short-term, but in the longer-term it will benefit both them and the future generations on whom they will rely for their income.

I suppose everyone will now think I've really got it in for Save Our Savers. Actually I really haven't. But I do wish they would get things right.

Since a couple of people have pointed out that S can only exceed I if either the public sector is in deficit or the external sector is in surplus (or both), I am adding a section on sectoral balances.

The full equation is:

S = Y - C = I + (G - T) + (X - M)

where G = government spending, T = tax revenue, X = exports and M = imports.

Rearranging this equation gives us S - I = (G - T) + (X - M).

Clearly, if S > I then either G  > T (fiscal deficit) or X - M (trade surplus), or both. So S - I, which is the "bit left over" after the private sector has made all the productive investments it desires, is made up of fiscal deficit and/or trade surplus.

If C increases and Y does not, I may decrease (less private sector capital investment). This is what we fear, and if there really are few profitable investment opportunities despite increasing C, this is what we will see. However, if central banks are correct to believe that increasing demand stimulates investment, it seems unlikely that increasing C would result in falling I. The opposite - increasing I - is what we want and is the reason for encouraging C to rise. However, it is also possible that I could remain unchanged and (S-I) could change. In an economy that is over-producing, this outcome is certainly possible. However, the FRED chart shows I rising and (S-I) remaining pretty much unchanged until very recently. The UK's corporate investment picture is not so promising: gross fixed capital formation over the last few years has been dismal.

Save Our Savers' argument is that we need C to FALL, not rise, to increase S, and therefore they want higher interest rates to encourage saving and discourage (leveraged) consumption. This is based on an assumption that increasing S always feeds through into increasing I. I'm afraid the story of the last few years is that it does not.

This sectoral balance stuff is not easy. I got it wrong in the first version of this postscript! Please read JKH's link (Monetary Realism). He explains it much better than I do.

Related links:

Why suppressing savings will lead to another recession - John Phelan, Save Our Savers
Why savers should put up or shut up - Azizonomics
Investment makes saving possible - Andy Harless
JKH on S-I-S-I - Monetary Realism
Paul Krugman does S-I-S-I - Monetary Realism
Lender, beware - Frances Coppola, Pieria
Government debt isn't what you think it is - Coppola Comment
Quantitative Easing Explained - Bank of England (with pdf links for more detail)
Quantitative Easing: Lessons we've learned - St. Louis Federal Reserve
Bank of England boss warns against choking off recovery - Evening Standard (with video)
The investment problem - Coppola Comment