Tuesday, 4 December 2012

Banks and their Toxic Loans

There was an interesting article by Liam Halligan in yesterday's DTel, in which he advocates banks being forced to 'fess up to all their toxic loans forthwith. 
What's needed is "full disclosure", forcing the banks to recognise such losses, taking the hit, and moving on. Some banks would fail, of course, executive egos would be bruised and reputations would suffer. Banks would be restructured, while protecting retail and commercial deposits, with the weak being taken over by the relatively strong. Then, though, banks could recapitalise, the wheels of finance could once again start turning, and capitalism's "creative destruction" would be able to take its course.
Over the years, several of our long-time commenters have also warmed to the idea of precipitating a spot of creative destruction to purge the system.  In normal times, as a fervent free-market capitalist I'd be among their ranks: but just now I beg to differ.  

Back in 2008, one of the remarkable steps taken by authorities worldwide was to require banks to stop marking their positions to market, writing off or provisioning for all bad debt etc etc. - for the probably very well-founded fear that it would start an unstoppable avalanche.  I was surprised at the rapidity with which they did this, but in retrospect I don't think it was wrong.

(By the way, some of these new strictures - or perhaps we should say 'reverse strictures' - now apply to corporates, too: it is far less easy for them to make provisions now than previously.)

In other words, we may be sure that astronomic amounts of trouble are stored up behind the newly-erected walls of opacity in the accounts.  Release this deluge at your peril.  Has to be done eventually, of course, but under careful control.

(By way of an illustration of the prudent management of a far less extreme, but nonetheless dangerous situation: after Enron melted down in 2001, the gas and power sector was plunged into financial darkness.  Many highly leveraged power stations became worth very much less than the value at which they appeared on their owners' books.  Their banks were therefore in (relatively) serious trouble - these are billion-dollar loans - and the project finance sector froze for almost 2 years.

If any one bank had decided to write down its distressed power-plant loan book, a market valuation signal would have been established, and there would have been carnage.  But - even under the stricter rules of the time - by a miracle of, *ahem*,  spontaneous identicality of views being taken, this never happened.  The entire sector was quietly and very methodically restructured - hence the 'dominos falling slowly' effect I wrote about a long while ago - and three years later you would scarcely have known how close to the brink the system had been.)

Carefully does it, guys - there is a lot at stake here.


PS [for pedants only] - technically speaking it appears Halligan knows not what he is talking about. "UK banks need to maintain capital buffers against unexpected losses. Such "provisioning" is crucial in any economy."  Nope: provisions are taken against expected losses - it is risk capital that is held against unexpected losses.


Blue Eyes said...

Plus, how do you properly mark to market? What is the market value of a mortgage where the home is worth less than the loan but the mortgagee is willing and able to keep paying the interest and repayments?

It comes back to the same old choice: massive meltdown and dislocation hopefully followed by an early recovery or slow bump along the bottom hopefully followed by a delayed recovery.

If we held anything as crass as a vote on the issue, I strongly suspect that most people would vote against losing their shirts tomorrow.

Electro-Kevin said...

Excellent comment by Blue.

I was an advocate of the short sharp shock. I can see it's not going to be managed that way and am altering things accordingly.

That's not to say that outside events might not bring it about anyway.

Blue Eyes said...

EK, totally agree. I have a feeling that this (rather false) sense of "stability" that we are "enjoying" could easily be tripped up by some event or accident. The Bank might print a couple of billion too much or there might be a tiny oil shock or some other media-driven crisis and we'll lose our shirts anyway.

I think we're in an unstable equilibrium...

Blue Eyes said...

PS on dislocation, I distinctly recall one direct consequence of Black Wednesday which was that my school had an order of Macs delayed because the contract had been denominated in sterling.

If we let the banks go to the wall we'd probably have a period where nobody could buy anything from abroad. That might be a serious problem in our open economy.

Jim said...

Is this not the Japanese solution? Allow zombie banks to stumble on with unrealised debts for decades, everything lubricated with regular bouts of QE? A 'solution' that is still playing out in Japan with no sign of an end? Is that really the long term answer?

Anonymous said...

Sorry, but I can't agree. I lived in Japan for ten years, the Japanese gently does it approach is wrong. It enables the incompetent and the crooked to prosper, whilst punishing the energetic and creative.
The other point about Japan is that they were able to delay the final crash because of their large trade surplus, in Britain we don't have that.
I think that is why Haldene from the BoE was talking about the hidden losses at British banks so publicly, because they aren't going to be able to hide those losses for much longer.

Anonymous said...

"in which he advocates banks being forced to 'fess up to all their toxic loans forthwith."

Aye, and forthwith smoldering black holes in Edinburgh and spots in and around Canary Warf.

BE: "Plus, how do you properly mark to market? "

Easy, put it on the market. But this is exactly what the banks don't want to do, because if like Northern Rock, they loaned 120% of the value of a property at the peak of the market, those loans are now they are in deep merde.

Blue Eyes said...

The point about Japan is that yes they are up to their eyes in public debt but their economy and standard of living is excellent. The BBC goes on about Japan's never-ending depression and deflation but they have very low unemployment and a standard of living which is higher than ours in Britain. How awful!

To those advocating the Icelandic solution I totally understand the arguments, but that sort of collapse happens by accident not design. Nobody would wish for the complete collapse and certainly nobody would vote for it.

As I said above, that doesn't mean we won't get it anyway.

DtP said...

I was working in Halifax when the fan got covered and it seemed much easier to ditch any vestage of principle than it was to watch the town go belly up. We sometimes get clouded in the casual reports of bankers being paid mega bucks when a lot aren't and are just doing your bog standard testing, data processing, assurance stuff. But then, as mentioned, it's only forestalling the inevitable.

Nick Drew said...

we are all pragmatists now

(well almost all - pace, Jim)

James Higham said...

In other words, we may be sure that astronomic amounts of trouble are stored up behind the newly-erected walls of opacity in the accounts. Release this deluge at your peril. Has to be done eventually, of course, but under careful control.

Whose control?

CityUnslicker said...

Well I don't agree. Damning the whole thing up is where we got top with Labour party and public spending.

however, Halligan is wrong, the banks have done a lot to wrtie down bad debts. RBS has gone from a non core book of £385 billion to less than £50 billion. There is more to go but a lot is done.

Now what is misfiring is the transmission mechanism - indeed zombie companies survive.

I don't want a big crash either, but a steady move back towards normal conditions by stopping QE and slowly raising interet rates will help the economy find its path to growth again. Not a short sharp shock, but not a shut your eyes and crosss your fingers strategy either.

Anonymous said...

@CU "Damning the whole thing up" : )

phil5 said...

I don't agree either. At some point interest rates must be allowed to rise, to purge the zombie companies. This is an interim period where people can frantically pay down their debts (if they are able) and banks can fess up to their sins (as RBS has done as CU notes). When rates rise those who cannot keep their head above water must be allowed to drown.

phil5 said...

Of course (to continue the metaphor) if Brown and Balls had only had the gumption to hold RBOS, Bradford and Bingley and Northern Rock's collective head under water until they stopped kicking, we wouldn't be in half this mess today.

Anonymous said...

phil5: "to hold RBOS, Bradford and Bingley and Northern Rock's collective head under water until they stopped kicking, we wouldn't be in half this mess today."

Yep. Or at the least starting to emerge from the mess. And, Yes, there would be smoldering black holes in Edinburgh where once RBS stood, and Canary Warf would be a different place too.

But if Brown and Balls hadn't f****d Lloyds with the shot gun marrage to HBOS there would still be a few vultures to pick up the carrion.

To each of you saying 'after due consideration, it's better this way..", I say, you don't know, nor can you guarentee we're gonna get that period of stability needed. Spain is going down the tubes, Greece hasn't found the bottom of the drain yet and Italy ain't far behind.

So all you pragmatists, don't pat yourselves on the back just yet!

DtP said...

@Anon - 11.21. Definately no back patting from here. It's, if anything, a maudlin side step into post traumatic rage and fury tempered with a sense of hopeless desperation; ain't no bubbly. As the mot de jour coined in the infancy of this colluded clusterfuck heralded at the time and since, 'we're all socialists now'. Le Fin.