#58. Storm Front – part 3

WHY RESPONSES TO THE LAST CRISIS WON’T WORK NEXT TIME

In the first part of this series, I explained why I regard China as a financial disaster waiting to happen. In the second, I looked at what the broader consequences might be. Here, I turn to what should be done when the next financial crisis explodes.

That a new financial crisis will explode increasingly seems probable. The world’s solution to a massive debt problem has been to borrow even more, and the numbers make it painfully clear that this isn’t going to work. Looking around the world, the “storm cones” seem to be being hoisted in an increasing number of places.

The key conclusion here is that repeating the policy responses of 2008 will not be possible and, more to the point, would not be desirable anyway.

Interest rates that are already at zero cannot be cut further and, in any case, ultra-low rates, engineered using QE, have helped to make a new crisis virtually unavoidable.

Governments are now far more indebted than they were in 2008, so bailing out the banking system, even if it is possible at all, will have to be done very differently. It will not be feasible this time to duck costs that were evaded in 2008. Any further tinkering with the fiat monetary system would run a high risk of destroying it altogether.

What, in my opinion, has to happen this time is an acceptance of the challenge rather than a strategy of “extend and pretend”. Where bank support are concerned, it will not be possible for governments to take over banks as if they were going concerns, preserving their structures and compensating shareholders at something approximating to market value. This time, governments will need to preserve the ‘utility’ elements of banks and backstop depositors.

If, as seems likely, property prices are one of the bubbles that burst, a possible counter to negative equity may be to offer voluntary conversion from (negative value) ownership to rental status. The banks would avoid massive write-offs, homeowners would be freed from negative equity, nobody need be rendered homeless, and the market would not be deluged by forced sales. Big write-offs could thus be limited to mortgages on buy-to-let and second homes.

Above all, we are in clear need of responses planned in advance, which was not the case seven years ago. This time, when there is even less excuse for a lack of preparedness, policymakers and central banks need to find something better than “extend and pretend”.

The charts below provide a snapshot explanation of why a new crisis looks very likely. In the period between 2000 and 2007, global debt increased by $55 trillion, or $38 trillion if we consider “real economy” debt, rather than inter-bank borrowing. Since 2007, debt has grown by $57 trillion, of which real economy borrowing accounts for $49 trillion.

Having taken on $2.18 of real economy debt for each dollar of growth in the earlier period, we have since increased this to almost $3.

This is insane.

And even this metric understates the real scale of the problem, because most of the “growth” is actually nothing more than the spending of borrowed money, and will, therefore, reverse, if we are ever forced to stop borrowing.

In a nutshell, then, a financial system that found itself in a hole has carried on digging.

What went wrong last time

Seven years having elapsed since the banking crisis, we are now have a perspective from which to summarise how the world responded.

Two things are clear.

First, the responses to the 2008 crisis haven’t worked.

Second, we could not now repeat those responses, even if we were foolish enough to try.

The basic problem in 2008 was one of too much debt. More specifically, it was too much of the wrong type of debt.

Not all borrowing is bad. Essentially, “good” debt is self-liquidating. If the owner of a successful restaurant borrows to add extra tables, the increased income will pay off the debt. Borrowing to increase your skills should boost your future earnings, enabling you to pay off the debt. Mortgage debt, prudently managed, has made home ownership possible for millions.

Unfortunately, in the years before 2008, the financial system proved increasingly ingenious at pushing the wrong kind of debt. There are many bad forms of debt. A bad debt may be one that the borrower simply cannot afford to repay or, worse still, cannot even afford to service. Borrowing for consumption rather than for investment is generally a bad idea. Borrowing for speculation isn’t a great idea either. Separating risk from return tends to be disastrous, as does borrowing to inflate asset values.

All and more of these forms of bad lending proliferated in the run-up to the crisis. Thanks to the disastrous repeal of the Glass-Steagall Act at the end of 1999, and of its equivalents elsewhere, banks were now allowed to own securities operations which, increasingly, became debt-pushers as banks created “profits” by destroying their own balance sheets.
Sub-prime mortgages, bad enough in themselves, became worse when primed to self-destruct (as Adjustable Rate Mortgages or ARMs), and worse still when packaged into securities which, ludicrously, were accorded investment-grade ratings. These securities were a disaster, first because investors didn’t really know what they were buying, and second because they enabled the separation of risk and return.

More generally, property markets were inflated by the influx of easily-available lending, much of it made possible because previous rules on loan-to-value (LTV) and loan-to-earnings ratios were relaxed.

There is something that we – unlike, it seems, bankers and politicians – need to understand about mortgage lending. Say that Mr X can afford mortgage payments of $5,000 per year. On an interest-only basis (to keep it simple), this means that he can afford to borrow $100,000 if the interest rate is 5%. Lower the rate to 2%, however, and he can now borrow $250,000.

Unfortunately, just as Mr X can now afford to borrow much more, so can everyone else. So, instead of buying a better house, he can really only buy the same house for more money. So property prices at any given time are a function, not of supply and demand, but of the amount, cost and ease-of-access of mortgage funds.

This mountain of debt, dangerous in character as well as in sheer size, began to wobble in 2007 – when bankers began to find it difficult to know which other banks they could trust – and fell over completely in 2008. As the wholesale debt markets seized up, bad debts were crystallised and the banking system teetered on the brink of a black hole.

What we did wrong

If circumstances change for the worse, borrowers can easily become engulfed by too much debt. The fact that they cannot repay it is the second problem, not the first. The really pressing issue is keeping up the payments. Having more debt than you can repay is insolvency, but being unable to meet interest payments is illiquidity, and that can be far worse.

This presented policymakers and central bankers with three immediate problems.

First, a vast swathe of banks were insolvent and, far worse, faced becoming illiquid.

Second, borrowers were unable to keep up interest payments, something which, if it happens on a big enough scale, creates bad debt write-offs that can easily destroy banks’ entire loss-absorbing capital (which was, and remains, far too small anyway).

Third, economies pumped up by activities such as real estate and finance could suffer severe setbacks, making the debt-servicing problem even worse.

Governments and central banks acted, first, to prevent panic, partly by guaranteeing deposits but principally by intervening, either taking banks into public ownership or foisting them off onto solvent but gullible competitors. In Britain, for example, the state had no real choice but to take over Northern Rock and the Royal Bank of Scotland, both of which had followed very risky business models. Shareholders were compensated at something approximating to the share price, and structures were kept intact, meaning that most senior executives, though chastened, kept both their jobs and their assets.

Simultaneously, central banks cut their policy interest rates virtually to zero. There was some Keynesian calculation here – lower rates act as a stimulus – but the main aim was to prevent borrowers from going bust. Fiscal policy loosened dramatically, less as a deliberate act of strategy than as a simple consequence of tax income crashing and welfare costs rising.

Central bankers soon realised, however, that cutting policy rates wasn’t going to be enough, because interest rates are really determined by bond markets. If these fall, rates (which are the yields on bonds) rise. Conversely, if bond markets can be pushed higher, market interest rates will fall. For this reason, central banks resorted to QE (quantitative easing) on a huge scale, inflating bond markets (and thus manipulating yields downwards) by buying bonds using money newly created for the purpose.

Unfortunately, none of these measures was a permanent fix. Government debt ratios increased dramatically, as did fiscal deficits. The banks – and the bankers – were bailed out with cheap funds, which for the most part they were encouraged to lend. In most countries, really severe falls in property prices were prevented. Mortgage payments fell sharply, bailing out the reckless at the expense of savers.

It should be no surprise at all that of this restored, not just a semblance of “business as usual”, but ‘recklessness-as-usual’ too. Bond markets soared – an intentional policy outcome – and ultra-low costs prompted a renewed surge in borrowing.

Seven years on, very little has changed. Property and other asset markets are even more inflated than they were in 2008. Government debt ratios have soared, and getting annual borrowing back down has proved a long slog. Economic recovery has been lacklustre, and even such growth as has been achieved is mostly phoney, amounting to nothing more than the spending of borrowed money.

Western economies remain on a treadmill of borrowing to grow – in Britain, for example, official projections indicate that the economy will grow by a nominal £500bn over the coming five years, but only if households go on a £330bn credit binge as well as borrowing a further £500bn in order to inflate house prices by another 35%.

Just as the Western economies have reverted to type, the hope that emerging economies might become the new drivers of the global economy have proved false. Three of the four much-vaunted “BRICs” – China, Brazil and Russia – are crumbling as we watch. India aside, these countries are vindicating the minority who, all along, suspected that the fashionable enthusiasm for the BRICs might not stack up.

What could we have done instead?

Alternative history can be an absorbing read. There are very interesting books which postulate, for example, a successful German invasion of Britain in 1940 (Kenneth Macksey’s Invasion: The Alternate History of the German Invasion of England, July 1940) or the failure of D-Day (Disaster at D-Day by Peter Tsouras).

In the same vein, what might an alternative response to the banking crisis have looked like? We need to know, because repeating the 2008 policy responses will not be an option when the next crisis happens.

In its early stages, the next crash is likely look a lot like the last one. It seems likeliest to start in China, where soaring debt has been invested in surplus capacity which has in turn driven profits sharply downward.

As with American sub-prime in 2007, the first impact will be the dawning realisation that many borrowers will be unable to keep on servicing their debts. This will lead to a seizing-up of credit markets, because participants cannot be sure which counter-parties are solvent and which are not. This will bankrupt institutions which have based their business model on recycling wholesale debt.

At the same time, the scale of exposure to bad debt – most notably in China – will gradually become clear. The backdrop will be a recognition that the economy is poised to turn down, making debt even harder to service.

In 2007, governments made clear their willingness to stand behind crippled banks, not just by guaranteeing deposits but also, where necessary, by taking banks into state ownership. But this will be far more difficult this time, mainly because governments are far more indebted this time around.

In 2007, the net-debt-to-GDP ratios of, for example, the United States, Britain, France and Japan were 44%, 38%, 57% and 80% respectively. Today they are 81%, 83%, 88% and 137%. Globally, the average government debt ratio is 83% today, compared with 63% in 2007.

This puts the rescue of banks into a wholly different context. In 2008, governments essentially reimbursed bank shareholders at something approximating to share prices, but the reality was that, in the absence of government support, these banks were worthless. It might have been better had governments recognised this, giving shareholders little or no compensation.

At the same time, banks were taken over as going concerns, which in most cases was exactly what they were not.

A better approach can be exemplified by looking at the British government’s rescue of RBS. Instead of taking over the existing corporate entity, the state could instead have set up a new company – say “RBS 2” – which could have shouldered the RBS assets and liabilities on a selective basis. The liabilities not taken on would have included the employment contracts and accrued pensions of senior executives, whose former employer would have ceased to exist.

The banks’ investment banking divisions could have been split out, and perhaps handed to the shareholders, being allowed to sink or swim at no further cost to the taxpayer. The longer-term aim would have been to turn the acquired banks into wholly retail operations, to be returned to private ownership when and if conditions allow.

More generally, the denial of government support would have resulted in widespread bank failures. With hindsight, allowing banks to fail – whilst protecting depositors – might have been a better response than propping up insolvent banks. Customer deposits and the branch network could have been taken into state ownership, to be returned to the private sector in due course in a far more sober form.

Monetary policy was, and remains, the really critical issue. As things stood, a failure to cut both policy and market interest rates would have resulted in extremely sharp falls in house prices, creating vast swathes of negative equity and seizing up property markets because millions of buyers, saddled with negative equity, would have been unable to sell.

Again, it might have been better to take this hit and let property prices slump, rather than distorting the entire monetary system (and penalizing savers). A bad debt – technically, a “non-performing” loan – is created when a borrower can no longer service the debt. Even if he can service it, however, a second problem exists where a property, bought using a $100,000 mortgage, becomes worth only $80,000.

Here, an alternative would be for ownership of the property – “ownership” which is purely notional, having no net value anyway – to be transferred to the lender, with mortgage interest payments converted into rent at a level that the customer can afford. The borrower is freed from negative equity, the market is not deluged with forced sales of properties, no one becomes homeless, the bank avoids write-downs (because debt is converted into equity) and property markets are reset at far lower levels.

What needs to be borne in mind here is that high property prices are bad for an economy, not good. Purely notional equity emboldens homeowners to taken on excessive credit, vast amounts of investment (which could otherwise be put to constructive use) are tied up in a useless capital sink, value is transferred between generations, and young people are put at a huge disadvantage.

What do we do now?

In short, an alternative response in 2008 would have been to let both banks and asset (including property) markets collapse. The state could have guaranteed customer deposits, and salvaged the banks’ purely utilitarian operations. The negative equity imposed on millions could have been erased by offering the option of converting from mortgage to rent.

It is hard to see how this could have cost more than what actually happened. The plus-side would have been that markets could reset without a resort to subverting the monetary system, penalizing savers and setting the scene for a renewed surge in borrowing.

When the next crash comes, governments will be forced to consider responses along these lines. Their existing debt levels will preclude taxpayer interventions on the 2008 model, and interest rates already at virtually zero cannot be cut further, whilst any further resort to QE could destroy faith in the monetary system.

It must be hoped that there is some preparedness, at least, for countering a very similar crisis in a very different way.