QE For Ten Years: Saving the Banks and Smashing Society

My last blog began with a second reference to the ten years that have elapsed since the collapse of Northern Rock told the public - and the unobservant Econocracy - that there was a crisis already well developed in the world of banking. More than a year before the Northern Rock event hit the British system, the USA had had its own crisis in the collapse of several institutions which the Clinton regime had induced to accept 'sub-prime' mortgages. The term sub-prime was not in common currency in the UK, and the USA was far away, so not much notice was taken of those events even in the London money market.

Within the US financial system, it had slowly become apparent that the sub-prime mortgages had been sold on [in the manner described yesterday] as parts of securities which were just bundles of debts where the borrowers would [in the main] carry on making the payments they were contracted to make: thus the buyer of such a security was effectively buying a cash-flow of future payments. The original lender of the money would retain the duty to collect the payments and pay the interest on the security, and there would be an allowance for the proportion of the borrowers who would default on their payments. So the original price of the security was based on a supposedly objective view of what it would yield to its owner during the term for which it was valid. On that basis, the security could be sold on, for inclusion in larger or more inventive types of security. The sub-prime mortgages were a category where the borrower was very likely to default, and the continuing decline of the old industries in what were quickly becoming known as the 'rustbucket' areas meant that many families lost their main earnings and could not afford the repayments. Defaults on payments of sub-prime mortgages seemed, at first, an American problem: but during 2007 an increasing proportion of securities traders became worried about UK securities that included packages of mortgages issued by banks and building societies whose lending had become [by all historic comparison] reckless.

Among these was Northern Rock, which was borrowing credit in the wholesale market [see last two blogs in this series for details] in order to lend to new customers. The lending was reckless: more than 100% of the asking-price for the house was available to clients who were taken at their word as to how much they earned. This sort of lending [in which the Rock was only the most conspicuously adrift from traditional caution] led to clever traders realising that securities based on Northern Rock loans, and securities containing a 'repackaged' share of Northern Rock, may not perform as promised. So the wholesale market stopped buying Rock securities: and the Rock had no ready money in its tills beyond the usual daily turnover. Hence, as customers heard the rumours and queued with their documentation to demand their own money, the firm failed and [as explained previously] the government instructed to Bank of England to provide the money that the customers were demanding. After the crisis the residue of the Rock was sold off: its trading branches were taken over by Virgin Money and most of them are still trading, and the mortgage debts were sold to firms that managed the run-off so that most of the securities that the Rock had sold were successfully [and profitably] carried forward to their terminal dates.

Behind this happily makeshift resolution of the crisis caused by one smallish [albeit prominent] firm, the financial markets as a whole were beginning to panic about the multi-trillion pound market in securities that had been built up by 'innovative' firms that had been making their own paths to untold wealth by taking the fullest advantage of the market freedom created by the Thatcherites on the urging of the Econocracy in 1986. Within a year of the Northern Rock crisis, there was an emergent crisis throughout the market. Nobody could be sure which securities contained how big a proportion of debt that might become 'sub-prime' if the root provider of the cash flow failed. So the Bank of England was instructed to copy the US Federal Reserve, which had already begun an indefinitely large open-market operation which it called QE: Quantitative Easing. Though the detail is mind-bogglingly complex, the principle is simple. The banks were told to form an orderly queue, and slowly to arrange their portfolios of securities so that they could present government bonds at the Bank of England which would [in essence] 'print money' with which they bought the government securities [and just kept them in their vault, metaphorically]. Thus any bank could get cash by selling government securities to the Bank, and use that cash to fund the orderly winding-down of the 'assets' in the market. Those that were considered 'toxic' were disposed of cheaply, and holders of the rest of the mass of securities could resume trading, albeit cautiously. Nobody realised, when Britain adopted QE in 2008, that the queue would continue shuffling to the Bank asking for cash until now: but that has happened. it has saved the banks and the wholesale securities trade that lies behind the banks; but it has been ruinous to the economy in which human beings depend, and to the society that binds humans into a community. This is the subject for the next blog. 

Northern Rock: How the Crisis Happened

Northern Rock was the first bank in the UK to go bust for almost a century and a half; thus it was a great shock, which the authorities were not prepared for. I commented yesterday how Alastair Darling, the Chancellor, rose to the occasion ad accepted responsibility for finding a way of resolving the crisis and ensuring that the depositors got their money back.

There was no mystery about how the crisis happened. A few months earlier, in a lecture to the Insurance Institute of Ireland, I warned that the banking system was heading for a catastrophe. I said specifically that insurance companies should avoid accepting any bankers' risk onto their own balance sheets: if they did, they would be brought down with the crashing banks. Only one insurance giant, AEG, took on a massive amount of bankers' debt. Hardly recognised by their US head office, a minor London market component of the massive global conglomerate accepted billions of dollarsworth of a clever new 'financial instrument' that would only be activated in the most exceptional circumstances: then they would have to pay in full on those certificates. Hence, later in the crisis period, the US Treasury had to take over AEG and meet obligations of hundreds of billions of dollars. The existence of those obligations had not been understood by the firm's central management nor by any of their regulators while these liabilities were adopted.

The much smaller-scale, but still catastrophic, crisis that affected Northern Rock in September, 2007, arose from the same cause as the crises that hit bigger institutions in subsequent months. Thus it stands as a perfect example of the consequences of the Thatcher government releasing new 'market forces' into financial services. Until the nineteen-nineties Northern Rock was a Building Society, largely serving customers in and around Newcastle Upon Tyne. But in the mood of market freedom that followed the 'big bang' of 1986, 'the Rock' was transformed into a bank and it expanded its operations nationally. It could do this because the executives had realised that they no longer needed to accumulate new 'capital' slowly. There was a new 'wholesale market' of firms anxious to build their business by giving access to large amounts of credit to building societies. Ambitious managers throughout the country were changing comfortable businesses [which took in their assets as peoples' savings, and lent them to reliable wage-earners as mortgages] into aggressive, competitive lending machines. Licensed lending firms could sell mortgages to people who promised to repay over many years; but the new twist was that the lender could then bundle these contracts up into multi-million-pound 'packages' and sell them to the new 'wholesalers'. In return for millions of pounds a year of income [to be paid by the mortgagees], the wholesalers bought these bundles. Thus the ex-building society had more millions to lend to more customers, which became mortgage debts that the seller then bundled into new packages and sold into the wholesale market. This enabled the mortgage lenders to compete more aggressively for business. Northern Rock became famous [a fame later converted to infamy] for its willingness to lend more than the asking-price of the house that a customer wanted to buy: so that, in addition to getting a 100% mortgage there was a cash sum to pay for furniture. Furthermore, customers were not asked to prove what they said was their income: 'self-certification' was the polite term: 'liar loans' was often a truer description.

The banks joined in this competition. Most retail banks had always done some mortgage business; so they, too packaged parcels of promises-to-pay by mortgage holders and sold them in the wholesale market. What they sold was the promise of a cash flow into the future, embedded in a contract known as a security. Hence, the process came to be known as securitisation and all the people who used it both from the 'retail' market of mortgages and credit card debts and from the 'wholesale' side of the business that swapped credit for securities passed on the securities to other innovative firms.

The old style building societies had obligations to their depositors, and assets in the form of the cash balances that they held plus the valuation of the mortgaged properties. Their assets exceeded their liabilities, in general; and they had the added security that the [usually inflated] price of a house whose mortgagee failed to maintain payments meant that when the house was sold, the price would usually pay off the mortgage debt and the accrued arrears of interest. In the new world of securitisation, Northern Rock had also bought some of the packaged securities as part of their capital reserve. So when the word went around that the Rock was insolvent, and queues of depositors gathered at the doors of their branches, the firm did not have ready money to pay them. This caused a widespread market panic over the solidity and security of a vast range of securities, which may include some mortgages. There had already been a panic in the USA over the similar packages including 'sub-prime' mortgages, which made the British market more insecure. In order that the Northern Rock customers could get their money, the Chancellor ordered the Bank of England to make the cash available.

Over subsequent years, as the mortgages were repaid, it became clear that Northern Rock's assets had exceeded its liabilities as of 13 September 2007; but they had not been able to turn their assets into cash at the moment the depositors demanded it. Hence the crisis has rightly been called a liquidity crisis. Over the next ten years it became apparent that most of the clever 'products' that were floating around the wholesale market were basically sound: but as the financial crisis developed over 2007-8 those securities could not be liquidated: that is to say, swapped for cash on demand. Hence Quantitative Easing, QE, was needed; and more of that anon.