Saturday, 4 April 2009

Cat skinning

There’s more than one way to skin a cat and as my neighbour’s keeps using my front garden as a litter tray my preference is for whichever is the most painful. Similarly there’s more than one way to recapitalise a bank. One way, the couldn’t be higher profile if it had a million flaming rockets up its jacksie way, is for government to commit to underwriting bank rights issues (the issue of additional ordinary shares), which sees an issue price being set, then government buying up however many of the new shares private investors chose not to invest in (typically because the rights issue price is higher than the shares were trading at in the immediate run up to the issue).

It’s just I’m thinking another, cheekier approach is going on right now. This other approach involves the more traditional thang of banks retaining earnings to bolster their capital bases. Here, hang on a mo for a quick digression; a bank’s capital gives it the wherewithal to afford losses made on lending and investing. So the bigger the capital base the more confidence you can have in a bank, hence the government emphasis on recapitalising banks to rebuild confidence in them. Ahhhh!

Right, digression over, so aye, recapitalistion via retained earnings. The primary way banks boost earnings is by increasing the margin between what they pay to raise funds (e.g. interest paid on deposits) and what they charge the borrowers of those same funds. This all got complicated by the credit crunch. In fact it’s still complicated. One of the markers of the extent to which confidence was lost in banks was the margin that suddenly appeared between the Base rate set by the Bank of England and LIBOR rates, LIBOR being the London Interbank Offered Rate, or what one bank charges to lend another one. Due to the crisis of confidence banks are still contending with (essentially the realisation that big banks can fail), LIBOR rates stopped closely following base rate.

Instead they shot up. The resultant spread between LIBOR and base rate provides both a yardstick for measuring confidence in banks and a guide to actual bank funding costs. One final point, the spread that emerged broke the connection between base rate and the interest rates actually paid by borrowers, undermining traditional monetary policy. Oops, again I’m digressing. Anyhow, regardless of what base rate was/is, mortgage rates jumped up, and have stayed up because LIBOR remains so relatively high.

This is surprising from a housing market perspective because the typical loan to value on mortgages has plummeted since the middle of last year, which matters big time because it means, on average, every new mortgage/remortgage is getting progressively safer and safer.

Here, a quick, simplified, example – I borrow £90 to buy a £100 house, so that’s a 90% LTV, which was what first time buyers typically got in the years before the credit crunch. Now say my house is repossessed and sold, cos that’d be in a fire sale, chances are it’ll be sold for only £80. So rather than pay the outstanding £10, I declare myself bankrupt and the bank loses £10. Now, say the same thing happened, but I’d only borrowed £79 i.e. a 79% LTV, which would be quite generous today, then the bank would owe me £1 from the fire sale of the house.

So banks have moved themselves from a position where they could lose money on new business to one where they really have to go some to do so. Yet despite this conservative step-change in credit policy and loan quality, mortgages still feel awfy, awfy expensive. Plus we don’t hear that much these days about banks being all nasty and refusing to pass on interest rate cuts (unless its to cut interest rates on savings).

Given what actually seems to be happening, I’m thinking mebbe there’s now a tacit acceptance by government that banks can be allowed to screw borrowers over, with this letting them rebuild their capital by themselves.

So if my hunch is correct, then WHOOPEE - government doesn’t have to invest anymore of our money in them, but BOO - because British banking is only part nationalised, private shareholders will profit from this as will the bank executives who will be proclaimed business heroes in due course, essentially for being allowed to rip off customers in a market that’s lost around a third of the competition. And BOO2, because banks appear to have swung from not pricing for risk and lending too much too cheaply, to potentially “over-pricing” for the far smaller risk attached to less debt, then they’re stuffing the housing market because no one can afford the equity needed for a first time buyer mortgage.

Theres more BOOs, but I figure you get the point.

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