Friday, September 14, 2007

Rock Shock

I'd been working late and was on the way home when this story broke.

Northern Rock has struggled to raise money to finance its lending ever since money markets seized up over the summer, in the wake of the US sub-prime loans crisis.

The decision for the Bank of England to become the "lender of last resort" is extremely rare - and also comes after consultation with the Financial Services Authority.

According to our business editor, the chancellor, Bank and FSA will make clear that the emergency facility enjoyed by Northern Rock will be made available to any other bank that runs into similar liquidity problems - as against more fundamental solvence issues.

I'm not sure I understand this. I gather there's no issue with solvency, but they can't continue to lend money unless they borrow it, because they haven't got a big enough base of depositors. The Bank of England are lending at "a punitive rate of 6.75%". But the 3-month inter-bank lending rate (LIBOR) is only 0.13% higher at 6.88% - why can't they borrow there ?

Ah - LIBOR reflects short-term loans - up to a year. Presumably NR want long-term money to match the long-term mortgages - or do they live hand to mouth, so to speak, on a succession of short term loans ? Seems like a risky strategy to me. How is the money that've already borrowed (and lent out) financed - short or long term loans (short - see update 2) ?

You have to presume that it's not the interest rates so much as that the other banks are refusing to lend to NR.

If that's true, what do the other banks know that the Bank of England is prepared to ignore ?

If they can't borrow the money at a rate which will enable them to offer attractive mortgages, why don't they just stop new lending ? Presumably the answer is that they'd be basically shutting up shop to new business, with no future profits to look forward to and a huge share price fall. But why should the BoE be concerned with that ?

If LIBOR is at nearly 7% I'd have thought that implies 8% mortgage rates before too long.

I'm sure Tim Worstall and Chris Dillow will explain all.

UPDATE - Willem Buiter is not sure that they ARE necessarily safe from insolvency risks, and is distinctly sceptical about the bailout.

Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let’s hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.

UPDATE2 - it appears they are indeed lending over long periods, but getting the money to lend via a series of short term loans.

Northern Rock said in a statement on Friday that the Bank of England had agreed to provide it with as much funding “as may be necessary” as it warned that it would otherwise be incapable of refinancing maturing liabilities and flagged that full-year profits would be 20 per cent below consensus forecasts.

Those maturing liabilities being the previous short term loan which is now due for repayment.

Analysts at Cazenove said in a note: “We assume Northern Rock will cease writing new business. The lack of new business flow and a penalty cost of funding will have a detrimental impact upon Northern Rock’s earnings ... Northern Rock is unlikely to remain independent but the value of the company to an acquirer may be significantly below the current share price.”

So they will stop new business, but because they still need to refinance the existing loans, that isn't the end of their woes. Hence the BoE bailout.

Meanwhile the rush for the exits continues. If investor sentiment is driven by greed or fear I think we know which is uppermost today.

Declaration of interest - I have a mortgage with Northern Rock, who took over the Legal and General portfolio when that company got out of the mortgage market. I wonder if they'd like me to pay it off ?

UPDATE3 - an anonymous commenter at Willem Buiter :

Laban - this basically comes down to NRK being unable to roll their commercial paper. By that I mean, they have borrowed using commercial paper which is now coming due. They are seeking to issue new commercial paper in order to borrow and thus repay the creditors of the old commercial paper. That probably came due on Monday, and it takes 2 days to settle so they had to sell it yesterday (Thursday). They failed to sell it and have to go to the BoE instead.

Interestingly, this is exactly the same thing that caused Enron to finally succumb to failure (they were unable to roll their CP too). The only difference is they didn't get a bail-out.

OK - now you want to know about commercial paper. I'd not heard of it either. It's all here.

In essence, the commercial paper market is used by companies in need of short-term loans. They issue commercial paper, which is like a bond, as an IOU. Banks are big users of commercial paper. The banks package up billions of dollars of loans made to consumers or companies, through products such as mortgages and credit cards, into special financing vehicles called “conduits”. The banks then sell on the loans held within the conduits to investors, such as money market funds, insurance companies or other banks. They do this by issuing the commercial paper. The life of the commercial paper is typically very short, about 55 days. When the time is up, the bank managing the conduit will go back to the investors and roll over the commercial paper into another short-term agreement with similar interest rates.

In the United States, there is about $2.2 trillion (£1,100 billion) of commercial paper. About half of this is unsecured, like a personal loan taken out by a consumer, but $1.2 trillion of it is so-called asset-backed. This means that the loans are secured against assets such as the bank’s book of mortgage business.

The commercial paper market in Europe is worth $840 billion, of which about $300 billion is asset-backed commercial paper.

For the most part, the commercial paper market carries out its day-to-day business and rarely hits the headlines. In the past few weeks, however, interest rates in the market have hit six-year highs as panicky investors have refused to roll over the paper. Instead of reinvesting in commercial paper that is coming to the end of its 55 days, investors are turning to other short-term safe havens, such as US government debt.


Bert Rustle said...

The banks are reluctant to lend to each other for any length of time, reportedly Northern Rock has not been singled out. Apparently concerns about what Collateralised Debt Obligations other banks may be holding makes lending other than overnight somewhat unattractive.

Basically, the banks as a group have hedged their bets rather less than I have the above paragraph.

Why did so many banks lend to so many with a real potential for default?

Laurence Auster’s article, dramatically entitled Racial socialism and the subprime mortgage crisis , links to an at least superficially informative article by Thomas DiLorenzo The Government-Created Subprime Mortgage Meltdown

The thousands of mortgage defaults and foreclosures in the "subprime" housing market (i.e., mortgage holders with poor credit ratings) is the direct result of ... the 1977 Community Reinvestment Act (CRA), which compels banks to make loans to low-income borrowers and ... "communities of color" that they might not otherwise make based on purely economic criteria.

... The CRA is enforced by four federal government bureaucracies ... any bank merger, branch expansion, or new branch creation can be postponed or prohibited by any of these four bureaucracies if a CRA "protest" is issued by a "community group." ... use[s] this leverage to get the banks to give them millions of dollars as well as promising to make a certain amount of bad loans in their communities.

Banks have been placed in a Catch 22 situation by the CRA: If they comply, they know they will have to suffer from more loan defaults. If they don’t comply, they face financial penalties ...

banks ... have been forced to hold ... bad loans, ... "subprime" loans. In order to compensate themselves for the added risk of extending these loans, many lenders have increased the lending fees associated with mortgage loans. ... So-called predatory lending laws therefore force the banks to "eat" the losses. This is undoubtedly a contributing factor to the bankruptcy of dozens of mortgage lenders over the past year.

Any American financiers know of the validity of this?

Anonymous said...

The banks are refusing to lend to NR (or indeed any other bank) because LIBOR loans are effectively unsecured. The loan by the BoE will be more effectively secured by Northern Rock handing over collateral on Northern Rock's prime mortgages.

Furthermore, existing LIBOR rates are meaningless because Banks are often refusing to trade their liquidity AT ANY PRICE. This is an indication of just how severe the credit crunch is right now.

Anonymous said...

"The thousands of mortgage defaults and foreclosures in the "subprime" housing market (i.e., mortgage holders with poor credit ratings) is the direct result of ... the 1977 Community Reinvestment Act (CRA)"

No, this has nothing to do with it. Mortgages from that long ago would be either paid off or at least the income of the debtors would likely have increased sufficiently to ensure they could comfortably afford the housing. The sub-prime effect is recent and was caused by the change in the way mortgages work. Instead of mortgage raising money from high street deposits to fund mortgages, they now bundle up their mortgages and sell off the debt on international markets. Due to an excess of money in these international money markets the mortgage lenders have found it easy to get their hands on the necessary finance and have fallen over themselves to find somebody, anybody, that will take that mortgage finance. Since the mortgage lenders are not holding on to the mortgage debt but are selling it on to third parties, they really haven't cared about the risks of lending to dodgy clients - they have simply passed the risk on to someone else. The third parties that bought the debt thought they were OK because the riskier debts were mixed in with prime mortgages and therefore were highly rated by debt ratings agencies.

It should be noted that this sub-prime mortgage issue is really a cover for what has actually happened in the US economy. House prices are plummeting in the US due to Americans losing their jobs. This is despite the fact that the American economy is actually growing. It is growing because all the US jobs have been shipped to China. Thus despite apparent growth the globalisation process has finally started hitting the US job market and people in all sectors of the economy are losing their jobs and their homes - it isn't simply subprime that is failing. There is now a serious glut of properties on the market at all levels. The economy has hit the end-stops after years of debt fuelled growth, and the selling out of American workers. The same will happen here - but it will be much worse as the debt as a proportion of GDP is much higher.

Bert Rustle said...

Anonymous 9:24 AM wrote

... the 1977 Community Reinvestment Act (CRA)" ... has nothing to do with it. Mortgages from that long ago would be either paid off or at least the income of the debtors would likely have increased sufficiently to ensure they could comfortably afford the housing.

Thomas DiLorenzo wrote
"... the direct result of thirty years of government policy that has forced banks to make bad loans to un-creditworthy borrowers. The policy in question is the 1977 Community Reinvestment Act (CRA), which compels banks ..." 1977+30=2007, so he implies this is going on now. Do you have evidence to the contrary?

Anonymous 9:24 AM wrote The sub-prime effect is recent and was caused by ... sell[ing to] ... third parties that bought the debt thought they were OK because the riskier debts were mixed in with prime mortgages and therefore were highly rated by debt ratings agencies. My suspicion is that you write of an additional as opposed to an alternative process to that described by Thomas DiLorenzo. Also a CDO is not mixed in the sense that it’s distinct risk-varying tranches can be bought by different investors. I would hazard a guess that the most risky (and hence highest yield) CDO fractions are held by hedge funds, not commercial banks and that these high risk fractions constitute a considerable buffer to commercial banks incurring losses.

Anonymous 9:24 AM wrote ... House prices are plummeting ... Americans losing their jobs ... despite the ... economy ... growing. Is it?
via it states ... Recently an economist, Susan Houseman, discovered that the reliability of some US economics statistics has been impaired by offshoring. Houseman found that cost reductions achieved by US firms shifting production offshore are being miscounted as GDP growth in the US and that productivity gains achieved by US firms when they move design, research, and development offshore are showing up as increases in US productivity. Obviously, production and productivity that occur abroad are not part of the US domestic economy.

Houseman’s discovery rated a Business Week cover story last June 18, [ The Real Cost Of Offshoring, by Michael Mandel]
The whole VDare article by Paul Craig Roberts appears quantitative and plausible; is it?

DJ said...

Securitisation - the process by which banks sell off bunches of loans to outside investors - doesn't make banks careless of their lending criteria. On the contrary, in so far as they need to produce loans that will stand up to 'due diligence' checks, underwriting tends to be tighter than normal.

Anonymous said...

bert russell: I'm not really saying that there aren't situations in the US which push banks to offer loans to poorer people (whether black or not). I'm just saying that in no way is that a big enough chunk of the market to cause the kind of chaos we are seeing now. This subprime issue is a cover. The real situation is much worse but the Fed, the US Govt and the financial institutions are happy to go on letting people believe otherwise. They don't want to start a run on the banks like back in 1929.

As far as the outsourcing issue is concerned, you are absolutely right. Chinese GDP and US GDP is being double-counted. However, I suspect that the US really is making the bulk of the GDP since the good are not really sold that cheap - thus big profits are being made by US companies selling Chinese made goods to the rest of the world. The problem is that this money is in the hands of the corporations, not the ordinary US worker. The Chinese are not making great money out of it either - they are basically being used as slave labour and what money is being made is ending up in US treasury bonds to pay for future Chinese pensions which are going to be more difficult to afford in the years ahead due to demographic changes. Anyway, as far as the US is concerned there probably has been real GDP growth, but how much of it is real and how much ends up in the hands of the US worker? I would argue that the US Govt has effectively sold out the US worker in favour of cheaper Chinese alternatives. (One could say that the current UK government is doing the same here, but using cheaper Polish alterntives that are actually imported). So much for democracy allowing us to elect a government with the interests of the electroate at heart. Meanwhile the US consumer has now run out of money to pay for all these cheap Chinese goods - you can only withdraw so much mortgage equity.

Bert Rustle said...

anonymous 1:05 PM wrote ... As far as the outsourcing issue is concerned ... Chinese GDP and US GDP is being double-counted. ... big profits are being made by US companies ... not the ordinary US worker. ... I would argue that the US Govt has effectively sold out the US worker in favour of cheaper Chinese alternatives.

According to Edwin S. Rubenstein George Bush is dissolving the American workforce and electing a new one.

... More than a quarter of a million Hispanics found jobs in August, the largest monthly increase since March 2004, and the third highest since the start of the Bush Administration in 2001. Meanwhile, the nearly 600,000 reduction in non-Hispanic employment was the biggest hit this group took since April 2005.

Bottom line: Worker displacement catapulted to a record high in August.

Anonymous said...

The show "MTV Cribs" can shed light on the US subprime market.

A typical episode will include a rapper - lets call him Lil'Sub - who shows a film crew around his palatial McMansion. This house will be very new, very big, very ugly and furnished in luxurious bad taste.

Now this house will have been:
- built by Mexicans
- furnished from Italy
- fitted out with high end appliances and electronics from Germany and Japan
- have a fleet of suv's, people carriers, trucks, 4x4's and sports cars from German and Japan
- supplied with everything else from China

Some Americans and Brits are watching and aspiring to this lifestyle. Despite not having Lil'Subs (temporary) income.

So the main output of the US seems to be rappers, financial services mirages and consumption. The rest of the world provides tangibles. Not sustainable.

Tim Worstall said...

You've pretty much got it now Laban. One further point. N Rock might have, in total, some £80 billion in debt out there. £20 billion is deposits with htem (which are being taken out by the crowds) and the other 60 billion is money market funds of varying maturities. I'm sure that some of that is long term and so not at risk of not being rolled over (because it doesn't need to be rolled over). But the BoE has agree to lend "as much as they need". At a high interest rate, they'll lose money by calling on it, but N Rock might be one of the safer places at present. They're the only epople the BoE is pledgewd to lend to.

Susan said...

If the financial system is going to fail, then let it fail now. Then there would be no excuse for the massive population replacement affecting all of the West. There will be NO false "labor shortages" or any of that. There will be NO money to finance Western welfare wealth transfers to millions of Third Worlders with incompatible cultures -- and therefore they will stop coming. I don't care if I lose everything in the crash --- at least our countries will be saved.

Bring it on.

Mr Curious said...


Some very interesting posts.

Thank you.

I came across this earlier which backs up one of your points:
"the share of (US) national income going to corporate profits (compared to labor) is hovering around a 50 year high."

If you are still around, could you point me in the direction of something that can expand on this Point:

"This subprime issue is a cover. The real situation is much worse but the Fed, the US Govt and the financial institutions are happy to go on letting people believe otherwise."?

Should I be stocking up on beans and rice and building a stockade?

Bert Rustle said...

Mr Curious wrote ... "the share of (US) national income going to corporate profits (compared to labor) is hovering around a 50 year high."

In addition the highest earners have dramatically increased their income relative to median earners. Edwin S. Rubenstein reports (with links) results of ... Economists Ian Dew-Becker and Robert Gordon have compared wage and salary growth within the richest ten percent of American earners with that of the median wage earner. ...

Here are their results, adjusted for inflation, for the years 1966 to 2001:
bullet Median wage and salary: +11 percent
bullet 90th percentile: +58 percent
bullet 99th percentile: +121 percent
bullet 99.9th percentile: +236 percent

This is pretax wage and salary income, not investment income. Since the mid 1970s, and especially since the mid-1990s, the dramatic rise in the fraction of national income earned by the super rich is due to their labor income, not their investments.

The extreme skewness is historically unprecedented—especially in a period of strong labor productivity growth. Traditionally those gains are either passed on to consumers in the form of lower prices—thereby raising real incomes of a broad swath of workers—or distributed to shareholders as capital gains and dividends, or used to raise the wages of most employees.

What happened? In answering this, Dew-Becker and Gordon take a long view of U.S. economic history:

"To be convincing, a theory must fit the facts, and the basic facts to be explained about income equality are not one but two, that is, not only why inequality rose after the mid-1970s but why it declined from 1929 to the mid-1970s....

"Partly as a result of restrictive legislation in the 1920s, and also the Great Depression and World War II, the share of immigration per year in the total population declined from 1.3 percent in 1914 to 0.02 percent in 1933, remained very low until a gradual recovery began in the late 1960s, reaching 0.48 percent (legal and illegal) in 2002. Competition for unskilled labor not only arrives in the form of immigration but also in the form of imports, and the decline of the import share from the 1920s to the 1950s and its subsequent recovery is a basic fact of the national accounts."

Of particular interest to us, however, is the anemic 11 percent growth in median wage and salary income. Harvard economist George Borjas finds that immigrants arriving from 1980 to 2000 have depressed wages of unskilled native workers by about 8 percent. ... Juxtaposing Borjas’s figure with Dew-Becker’s, we can (conservatively?) surmise that, absent immigration, the median worker’s wage would have risen 19 percent instead of 11 percent during the nearly four decades following 1966.

Implication: median wage income would have grown twice as fast, and the gap between median and upper income wages levels would be significantly less, had an immigration moratorium been imposed in 1965.

Notice how moderate we are, unlike the immigration enthusiasts. We’re not saying that immigration is the only reason for increases income inequality. But we are saying it is a reason. It's not natural, it's at least in part the result of misguided public policy—America’s post-1965

AgainsTTheWall said...

Amen Susan.