Credit deflation and the reflation cycle to come (part 2)

[Loki]

I don't understand why everyone is so worried about physical security with gold.  You can hide £5000 worth of Brits behind a wall socket.  Untold amounts under a floorboard.

I should probably come up with a better solution than the shoebox I currently use though.

[AWW]

Just now, Loki said:

I don't understand why everyone is so worried about physical security with gold.  You can hide £5000 worth of Brits behind a wall socket.  Untold amounts under a floorboard.

The most important thing is to keep your mouth shut about it. If super-paranoid, buy with cash from dealer premises rather than ordering online. A stash of gold coins isn't on the radar of the common or garden burglar. The only way it will be is if the burglar has intelligence gathered from people you've told.

[sancho panza]

20 hours ago, AWW said:

Exactly this.

A copper friend of mine reckons you need three layers to make it very unlikely that a burglar will find something. For example, in the freezer, in one of the drawers, inside a fish finger box (or whatever). In the garage, in a cupboard, inside an old paint tin etc etc.

A friend of mine has getting on for £100k worth of gold jewellery (he's Indian). They actually have a safe with a few small trinkets in it. The bulk of it is hidden in various mundane places around the house and in the garden. If they get robbed, the thieves will take the safe (and of course they'll be happy to open it, should they be unfortunate enough to find themselves being told to do so).

The onion layers of security.Was he ex green slime?

15 hours ago, SillyBilly said:

I think the market is drunk on a v-shaped recovery that ain't happening. Ultimately we can see money printing inflates stock prices (so I buy into this thread fully) but I see at least 1 more round of panic and fear. As I don't think we've seen the "dislocation" aspect of this economic event hit as yet - even Joe Bloggs is currently supported by schemes like furlough. Retail, travel and hospitality is about to dip back in and inspect the damage. To get from here to there (whatever "there" may be) it will clearly be very painful to the wider public, most of this pain has been deferred so far as I see it. Doesn't matter how much gov print it won't create 3 million jobs in 6 months once furlough stops so awful headlines are coming. And so I see sentiment taking the markets down heavily and below March to reflect the disaster of Q2 and also the probability that Jan 20 economic levels are 24 months+ away. Money printing bringing them back up to crazy levels once more but into 2021. Fundamentals don't matter anymore and current prices aren't a "bargain" based on current earnings stocks are firmly back in the hyper bubble, 10% off highs or not.

I was saying in march that that wasn't the Big Kahuna.No way.Baltanatly stealing @Cattle Prod defintion we'll know the big kahuna has run thourgh when the FANG stocks are on the floor.No more no less.

As you psoti,the real economic damage is unknown.Speaking to someone yeartday in retail,they're reopening but thw orkers don't want to come in as they like furlough till Oct/have decided to go away . Head office mandating they'll need staff on doors to limit numbers in shiop.Shopping centrer owners are going to limit numbers in shopping centers.It's going to be an epic mess and I suspect will be the end of the likes of Intu etc

Then we move on to factories.Mrs P went in yesterday for first time in months and they've limited it to 20% of staff,one person on stairs,one in toilets etc.Another epic mess brewing for manufacturing.(let's remember there's Singapoe/South Korea(who've had the best covids are doing nothing like this)

Govt guidance is abysmal/not based on reality either clinical or economic.

Moving onto big office space LL's...............more will work from home forever.

Every which way you look,lot of bank loans are going to sour.That'seconomic dislocation as you pooint out.

Jobless total going to stay high for a long time.

14 hours ago, Barnsey said:

Knight Frank seem to be doing most of the firefighting at the moment.

The house I was interested in was a no go, owner would only take £3k off instead of the £30k I was after, definitely for the best, it’s still on for sale of course.

Have made enquires about a couple others stating our strong position but apprehension of economic downturn, both replies from the estate agents have said that the market is buzzing and no price drops yet.

What I am seeing now is a flood of properties to the market, many of which went sold STC late last year or early this year. I’m following the market closely but taking a step back now until after the end of the furlough scheme and further 3 month mortgage holiday extension, so end of October.

I made the msitake of telling Mrs P we might consdier buying.Bless her,she was striaght on RM.................had to let her down gently when I pointed out that our oilies/PM trades are doing nicely and I'm not letting any go to buy something that'll halve in value and cost us money over ten years.

I had a quick look and around us,you wouldn't beleive how many £500k places are up for sale.A little bit of research by yours truly here.Interesting in terms of market liquidty

Houses for sale over £500k LE7=64 

https://www.rightmove.co.uk/house-prices/LE7.html?propertyType=DETACHED&page=1

Houses that have sold over £500k since June 1st 2019=34

https://www.rightmove.co.uk/house-prices/LE7.html?propertyType=DETACHED&page=1

So roughly two years supply in houses>£500k

 

 

Using all hosuetypes/prices tehre are 355 hosues for sale.

https://www.rightmove.co.uk/house-prices/LE7.html?propertyType=DETACHED&page=1

going back to 1st June 2019 there were roughly 700 sales

https://www.rightmove.co.uk/house-prices/LE7.html?page=28

So roughly,we have 6 months supply in allhouses/prices

 

 

A lot of people will think I'm stating the obvious here but one end of this market is going to get absolutely mullered more than the ohter.

 

 

 

 

 

[Loki]

^ Great post all round @sancho panza 

[Loki]

The original posts from 1997 onwards by 'Another' and 'Friend of Another'

https://www.usagold.com/goldtrail/archives/another1.html

Quote

The Central Banks have known for quite some time the true value of gold in today's paper world. In a very real sense they are on our side. Let's take their side if you will. They are not dumb or stupid, in fact many of them are the best of the best! You see, the world grew up and ran away from them, totally out of control. It has left in it's wake a money system of colossal debt and political mismanagement. They know it is over.

We are all at a giant poker table and the CBs act as the dealer. One day soon the game will end and the players will try to cash in the chips. In that day the dealer will act in our own best interest. They will not pay out gold for the chips. The money system will start over, from scratch.

Also:
It is easy to know that gold could not have been traded for all oil sold. This was never the intent. They only wanted to pull a small amount out of circulation on a regular basis. Using a small amount of oil as a partial trading vehicle gold could be purchased in an all paper deal to hide it's price. As I said before, if they walked up to the plate and started buying outright it would run the price. It is working. They only need 200 million ozs. When the system breaks that gold would be worth all the oil in Arabia and then some.

Quote

Do you think that value has been lost by holding physical gold all these years?

If the answer is yes, you are wrong! I tell you now, it's all in your perception of what is value and what is real. Gold has been increasing in value since the early 90s and doing it at a rate much higher than any other investment. Cannot see this? Hear me now, what the wealthy and powerful know: "real value does not have to always be stated or converted thruout time. It need only be priced once during the experience of life, that will be much more than enough!" Worldwide the oil business is still conducted in dollars. But, an interesting side show is now taking place that will change the way we think about gold and oil! If you wanted to devalue the US$ against other currencies what would be the best way to do it without LOWERING interest rates in the USA? Perhaps you want to cool off an over active stock market without raising rates ? Could a smart CB Chairman kill two birds with one stone ?

The US$ could be effectively lowered against most of the leading currencies by slowly taking it off the oil standard! This could be done by introducing a new concept to the world: "create a mechanism whereby a form of CB paper gold could be traded for oil as a side premium. So, instead of them taking physical gold off the market at it's now MAINTAINED commodity price, let them take "gray paper CB gold" priced at it's true value in US$ for oil." You see, this could solve the "problem of supply" that is also the problem for LBMA! We now have a "parallel market" with gold trading at it's commodity value on the physical market while being held for it's oil value by major players.

You don't think this is true? Think now, as the answer becomes clear:

Who is on the other side of the long gold deals that contango the metal far above it's current commodity price while freezing out most small private buyers? Why is gold being slowly transformed into a new kind of hybrid asset, off traded an for oil value of many thousands of dollars per oz.?

 

[Fully Detached]

16 hours ago, Barnsey said:

Knight Frank seem to be doing most of the firefighting at the moment.

The house I was interested in was a no go, owner would only take £3k off instead of the £30k I was after, definitely for the best, it’s still on for sale of course.

Have made enquires about a couple others stating our strong position but apprehension of economic downturn, both replies from the estate agents have said that the market is buzzing and no price drops yet.

What I am seeing now is a flood of properties to the market, many of which went sold STC late last year or early this year. I’m following the market closely but taking a step back now until after the end of the furlough scheme and further 3 month mortgage holiday extension, so end of October.

We have 3 viewings lined up over the next week, mainly because our landlord is selling and I want to have some options in case they get a bite. Agents that I have spoken to have done a 180 degree turn from accepting that this market is not going to be like it was 2 years ago, to the usual guff about how they've sold 30 houses since breakfast and they're being "snapped up" faster than they can market them. I suspect they very quickly got an idea of the sort of discounts buyers were expecting and decided to go into full denial mode. I shut one up yesterday by saying I didn't doubt people were walking in and offering the asking price, but my interest was how that would work out for them in a couple of months time when the bank decide they aren't going to lend to someone who hasn't worked for 3 months.

During the viewings, my stance will be quite simple - the BOE are forecasting a 16% drop. Putting aside the fact that they will deliberately understate their expectation, that means that the mortgage banks will be working on a 16-20% drop, and basing their lending on that. What buyers are willing to pay is irrelevant unless they're all in cash.

[JMD]

5 hours ago, MrXxxx said:

But would the second generation show the same enthusiasm for personal advancement?...

..seems to be a pattern seen that the first generation migrants work hard for a better life, and their offspring having had it easy (er) lack the same motivation.

On another note, it would be an idea selling opportunity for all of those inner London mega apartment developments that were/are about to become unsold.

I hope my original post didn't read like a cliched moan about immigration? Far from it and that definitely wasn't the intention (I don't think you thought this MrXxx btw). I just think up to 3M HK Chinese coming here is a really big issue; might this for example, prevent most other immigration happening for next 10 years, if we were to super-size our immigration in this way? I think it raises many macro type questions.

The HK Chinese, as others have alluded to, are pretty much a unique group of people (historically/culturally) and I genuinely believe that they would be an asset to this country - a combination of: high skills (business/technical/professional), culture (British friendly), wealth (if they can get it out). So I was really asking in a macro sense, i.e. British/Chinese future relations.etc. How it could happen logistically, I have no idea to be honest, but I think such a policy would truly reveal Boris's 'plan' for this country. 

On a sobering thought, If the Chinese couldn't 'incorporate' the HK people, and appreciate how valuable that community really is - it probably shows how alarmingly intellectually bankrupt the Chinese hierarchy is. It was a test and they failed it big time. 

MrXxx, as for those Chinese owned London apartments you mention, it would be ironic (not to mention poke in the eye) if their next tenants were newly arrived from Hong Kong!

[Fully Detached]

14 hours ago, BearyBear said:

Has anyone noticed this..?

https://www.bankofengland.co.uk/statistics/money-and-credit/2020/april-2020

Key points:

• UK households and businesses are continuing to increase their deposits in banks and building societies. Sterling money holdings of households, non-financial businesses, and financial businesses rose by £37.3 billion in April, following an increase of £67.3 billion in March.
• Households and private businesses have been repaying loans from banks, on net, but corporates have accessed significant funds through corporate bond and commercial paper issuance. Households repaid £7.4 billion of consumer credit, on net, in April, the largest net repayment since the series began.
• The cost of credit fell in April. For individuals, effective rates on overdrafts fell 15 percentage points. The interest rate on new fixed-rate mortgages was little changed, but floating-rate mortgage borrowing rates fell by 46 basis points. The interest rate paid on new borrowing by businesses fell by 10 basis points, with larger falls on rates for SMEs.

I guess a lot of people took the 3 month mortgage holiday whether they needed it or not and used it to pay down the credit card or other debts. In fact Nationwide pretty much said so last week, when they suggested that the earliest adopters of the holiday were the more financially astute, rather than those in financial difficulty.

I think what we've seen is PPI round 2, done in record short time, putting £1.5-3k directly into the pockets of the smarter cookies in the space of 3 months. Nice.

[DurhamBorn]

https://www.telegraph.co.uk/politics/2020/06/02/debt-inflation-union-power-britain-sleepwalking-back-1970s/

Can put in here and read if needed

https://outline.com/

I think this is the same guy who wrote an incredible book called "The welfare state we are in" that is the best iv ever read on the massive problems with welfare and how destructive it is.I think the article nails a lot of whats coming,even if not understanding the real macro drivers.The fact these articles are starting to drip out from people who i would consider having a long term understanding of the economy (also from a social side) is telling.

[TheCountOfNowhere]

33 minutes ago, DurhamBorn said:

https://www.telegraph.co.uk/politics/2020/06/02/debt-inflation-union-power-britain-sleepwalking-back-1970s/

Can put in here and read if needed

https://outline.com/

I think this is the same guy who wrote an incredible book called "The welfare state we are in" that is the best iv ever read on the massive problems with welfare and how destructive it is.I think the article nails a lot of whats coming,even if not understanding the real macro drivers.The fact these articles are starting to drip out from people who i would consider having a long term understanding of the economy (also from a social side) is telling.

"Inflation rose to a peak of over 27 per cent. Pensioners with savings were effectively robbed"

 

Yet very quiet on the MASSIVE house price inflation where THE YOUNG with savings/wages were effectively robbed.

 

[Popuplights]

3 hours ago, TheCountOfNowhere said:

Is anyone back in profit ?

Currently now down 4%

Still down 7 % overall. Most of that is from some RDSB I bought a long time ago at over 20.00

[TheCountOfNowhere]

4 minutes ago, Popuplights said:

Still down 7 % overall. Most of that is from some RDSB I bought a long time ago at over 20.00

The nameless share and RDSB are the same for me.  Most stuff is back up or close to breaking even.  BT is a heft loss too.

[MrXxxx]

3 hours ago, sancho panza said:

FT.com article(I'm don't subscribe) paints a stark reality looming for a lot of US cities and public sector unions where pensdion monies are held in trust for the beneficiriaes.Given how bad most teachers are at maths,they're not seeing this coming.Nor are huge chunks of the parliamentary elites in eitehr the UK or teh US

This got me thinking (thanks SP) about any on here able to take a DB early, and the spectre of looming inflation/recession. Now I know others have discussed transfers into cash, but for those who want to use them as part guaranteed security within a portfolio (akin to buying an insurance policy) then some thought about advantages of taking early may be worthwhile.

Taking early usually means a lower pension but I can see a number of advantages:

1. Although in a SHTF/Pension bankruptcy you are covered by government protection scheme, until you start drawing its only 90% [100% after up to £50k pa(?)].

2. Many DBs have limited inflation linking I.e full to 5%, half from 5-10%, nothing >10%, so some of later gain by waiting may be lost.

3. Moving goalposts of tax treatment and minimum drawing age.

4. Lost investment time in market/pension recycling opportunity.

Maybe worth thinking about now a high inflation environment is just about `-baked in` for next 10-15 years?...

[TheCountOfNowhere]

3 minutes ago, MrXxxx said:

This got me thinking (thanks SP) about any on here able to take a DB early, and the spectre of looming inflation/recession. Now I know others have discussed transfers into cash, but for those who want to use them as part guaranteed security within a portfolio (akin to buying an insurance policy) then some thought about advantages of taking early may be worthwhile.

Taking early usually means a lower pension but I can see a number of advantages:

1. Although in a SHTF/Pension bankruptcy you are covered by government protection scheme, until you start drawing its only 90% [100% after up to £50k pa(?)].

2. Many DBs have limited inflation linking I.e full to 5%, half from 5-10%, nothing >10%, so some of later gain by waiting may be lost.

3. Moving goalposts of tax treatment and minimum drawing age.

4. Lost investment time in market/pension recycling opportunity.

Maybe worth thinking about now a high inflation environment is just about `-baked in` for next 10-15 years?...

I love the way people stlll think they'll get their pension.

[janch]

From the Telegraph article above:

 

"every measure restraining public behaviour should be examined for whether it really is necessary, bearing in mind that rules such as the two-metre requirement for social distancing are keeping millions of people from earning money and paying taxes. We urgently need to keep a lid on the recession we are facing. Restaurants, bars, shops, factories, tradesmen and offices are all hampered. If at all possible, they should get back to business. This matters not just for now but for the next decade."

 

The reason for all the absurd rules is because of Health & Safety and companies/organisations frightened they will be sued if anyone catches the dreaded lurgey.  The left have truely put a massive spanner in the works of the economy.

[JMD]

1 hour ago, Loki said:

The original posts from 1997 onwards by 'Another' and 'Friend of Another'

https://www.usagold.com/goldtrail/archives/another1.html

 

Loki, great find. Are the quotes you included recent ones?

I was struck by the description of the CB's, it reminded me of how DurhamBorn describes the CB's, i.e. they are not bad/evil people, instead it is our own politicians who have just blindly pandered to the people and who have created our financial mess.    

[Loki]

2 minutes ago, JMD said:

Loki, great find. Are the quotes you included recent ones?

I was struck by the description of the CB's, it reminded me of how DurhamBorn describes the CB's, i.e. they are not bad/evil people, instead it is our own politicians who have just blindly pandered to the people and who have created our financial mess.    

No, they're from page one! Apparently the posts ran from 1997 - 2001.  I thought that quote might strike a chord here.

[JMD]

1 hour ago, DurhamBorn said:

https://www.telegraph.co.uk/politics/2020/06/02/debt-inflation-union-power-britain-sleepwalking-back-1970s/

Can put in here and read if needed

https://outline.com/

I think this is the same guy who wrote an incredible book called "The welfare state we are in" that is the best iv ever read on the massive problems with welfare and how destructive it is.I think the article nails a lot of whats coming,even if not understanding the real macro drivers.The fact these articles are starting to drip out from people who i would consider having a long term understanding of the economy (also from a social side) is telling.

DB, Loki has just posted a link to the 'Another'/'Friend of Another' blog - are/were you an avid reader of that blog? 

[JMD]

7 minutes ago, Loki said:

No, they're from page one! Apparently the posts ran from 1997 - 2001.  I thought that quote might strike a chord here.

Definitely does strike a chord, but wow!!! page one you say. I'm no expert on the technicals the blog delves into. But I don't know how to interpret it if the posts are so 'old', relatively speaking of course.

Then again, true wisdom doesn't age. Its immutable like gold itself I suppose!

[Loki]

5 minutes ago, JMD said:

Definitely does strike a chord, but wow!!! page one you say. I'm no expert on the technicasl the blog delves into. But I don't know how to interpret it if the posts are so 'old', relatively speaking of course.

Then again, true wisdom doesn't age. Its immutable like gold itself I suppose!

In the timescales of what we talk about, it was only last week 

(1982 for disinflation, 1997> for these posts)

Quote

After a proof read by one from the west this is a start and should help you understand.

For a number of years many persons have tried to invest in gold using the tools of past gold encounters. Even thought the last several upswings in bullion always took the gold stocks along for a ride, this time it will be different!

Ever ask someone if they owned gold. They might say " yes, but only 5% of my capitol is in it for insurance" Was it bullion? "No, my broker is to smart for that, he put me into a good gold mutual fund." "He says, if it really looks like it's going to go up I'll also have you in some comex futures or options "

During the first bull market of the seventies we saw few mining stocks outside South Africa worth owning .

Because they were relativity new to the game most people stayed with bullion. There certainly were no mass gold options and there were even fewer gold coins around. Most just brought whatever bullion bars they could find and as their past European counterparts did, they just waited it out.

Today, the public went "whole hog" for paper gold and has paid a great price. Wall street invented this game from the previous war as a way of keeping customer "gold money " in house! The shame of it is that these tools not only would not work in this new market, but they also gave the street a way to short gold even more effectively. In many cases the public brought little more than "long paper" from the street, with no gold at all on the other side! No one will ever have the truth on this as the falling price made most people close out without ever calling for the goods! A good deal of the numerous mining paper capitol was used to enrich the sellers while the buyers actually had no chance of seeing a profit. That's because the commodity these securities were based on was all but guaranteed to go down as forward sellers were given a green light to sell paper gold to the limit of their financial resources.

To make a long story short, many people who would have purchased bullion years ago have now squandered much of their "safe insurance money" on wall street. It is no wonder that many WESTERN gold investors have now turned bitter on gold. If they knew the truth about this new market they would have turned their bitterness on wall street instead.

Written 4 years before the dot-com crash.  I think by Wall Street he means trading in hot shares rather than investing like we are here.

[sancho panza]

hattip @Errol for posting raoul pal's views on the Italian/Spanish banks and also the people discussing buying HSBC.Made me have a dig around.

 

Often discussed on here,different aspects of a debt deflation as prescribed by Irving Fisher . 

Debt-deflation[edit]

Further information: Debt deflation

Following the stock market crash of 1929, and in light of the ensuing Great Depression, Fisher developed a theory of economic crises called debt-deflation, which attributed the crises to the bursting of a credit bubble. Initially, during the upswing over-confident economic agents are lured by the prospect of high profits to increase their debt in order to leverage their gains. According to Fisher, once the credit bubble bursts, this unleashes a series of effects that have serious negative impact on the real economy:

1. Debt liquidation and distress selling.
2. Contraction of the money supply as bank loans are paid off.
3. A fall in the level of asset prices.
4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
5. A fall in profits.
6. A reduction in output, in trade and in employment.
7. Pessimism and loss of confidence.
8. Hoarding of money.
9. A fall in nominal interest rates and a rise in deflation-adjusted interest rates.

 

Crucially, as debtors try to liquidate or pay off their nominal debt, the fall of prices caused by this defeats the very attempt to reduce the real burden of debt. Thus, while repayment reduces the amount of money owed, this does not happen fast enough since the real value of the dollar now rises ('swelling of the dollar').^[26]'

 

 

There are demand and supply side aspects to Debt Deflations as outlined by Fisher where in simple terms Fishers Paradox occurs whereby the more people pay down debt the more their ability to earn money to pay off debt gets reduced.An obvious part of the problem here is that as consumers save,GDP takes a hit and banks are faced with a hard choice of expanding credit into a shrinking economy or increasing reserves to deal with increasing defaults.

The following paper discusses issues at UK banks but I think it's safe to say the problems UK banks face are actually not as bad as those faced by the banks in places like Italy/Spain.Highlights are mine.I'll be doing it section by section.The aim is for me to reread this just using the highlights.

 

A paper by  a former PRA valuation specialist and  a professor Econ at Durham Uni.Data current as of May 29th 2020

http://eumaeus.org/wordp/wp-content/uploads/2020/05/Can UK banks pass the COVID-19 stress test 6 May 2020.pdf

Can UK Banks Pass the COVID-19 Stress Test?

By Dean Buckner and Kevin Dowd* This version: May 29th 2020 Results currently based on data up to May 29th 2020.

 

                                                                                                                             Abstract

 

As the UK economy enters the COVID-19 downturn, the Bank of England (BoE) continues to maintain that the UK banks are strongly capitalised. Yet there is considerable evidence that they are anything but.

The core metrics of the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis. Their market capitalisation is now £140.6 billion, down 61% since December 2006; their average price-to-book ratio is 39.2%, down from 255% at end 2006; their average capital ratio, defined as market capitalisation divided by total assets, is 2.3%, down from 11.2% at the end of 2006; their corresponding leverage levels are 43.3, up from 8.9 (end 2006). By these metrics, UK banks have much lower capital ratios and their leverage is nearly 5 times what it was going into the previous crisis.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy. The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is little more than an elaborate, and occasionally shambolic, window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the downturn in a worryingly fragile state and avoidably so. Another massive bank bailout now appears inevitable.

 

“On Monday 17 March 2008 I was at the annual conference of the Royal Economic Society listening to a lecture on financial stability by Hyun Shin … Bear Stearns had been bailed out the very day before. … it barely crossed my mind that events were in train that, but for huge government rescues, would collapse the western banking system. In fact the thought did flit across my mind, only to be dismissed, naively, as incredible.

I tell this story to illustrate that the real shock of 2008 was not the shock – of subprime, the drops in property prices, &c – but the system’s lack of resilience to the shock. Put another way, the “it” that few saw coming was not the sharp movement of asset prices, but the fragility of the system. It is a basic proposition of financial economics, and no ground for criticism of economists, that you can’t see sharp asset price movements coming. Failure to anticipate systemic fragility in the face of such shocks is an altogether different matter.

Inadequate equity capital was the basis for that fragility. Of course there were liquidity problems too, but they were often down to (justified) perceptions of capital inadequacy, as Northern Rock itself showed. And there were problems of management conduct and incentives and corporate culture too, but their consequences for the economy are far more severe when capital falls short. Banks’ capital adequacy is a cornerstone of our economic system.” Sir John Vickers (2019, our emphasis) 1

 

                                                                                                                      Section 1. The Big (Divs) Freeze

By late March, it was clear that the UK economy was going into a major COVID19 downturn. Even so, UK banks were still intending to go ahead with their plans to pay some £7.5 billion in dividends to their shareholders. The first payment, by Barclays, was due on Friday, April 3rd.

News of the banks’ intentions triggered a public outcry. Kevin Hollinrake MP, the chair of the all-party parliamentary group on fair business banking, was appalled: “They live in a different world, don’t they? Why on earth would you pay a dividend right now? It’s shocking they could even contemplate this.” Taxpayers had already rescued the banks once, he said, and it would be outrageous if they had to be supported a second time.

As late as Friday March 27th, the BoE was said to be “relatively unfazed” about the dividend payments going ahead, although in private the BoE had been telling the banks ever so gently that it was “concerned about the optics.”

Come the next Monday, March 30th, and the bankers were holding out. To quote a subsequent article in the Financial Times:

'some of the banks argued their balance sheets were strong enough to make the payouts. They pointed out that they had passed the BoE’s stress tests last year, which measured whether the lenders were able to withstand an economic shock on a similar scale to the coronavirus fallout.'

Faced with an offer they could hardly refuse, the bankers backed down. Mr. Woods had certainly raised a few eyebrows.

So why the change of heart by the central bank? The BoE’s decision to play the heavy

'hardly smacks of a considered change of direction; more a handbrake U-turn that left black rubber marks all over the road. No, it is not whether the central bank should have acted: few seriously dispute that the country’s lenders should be conserving their capital given the economic shock Britain is experiencing. Rather, it’s the opposite. Why did it take so long? (Ford, 2020)

 Mr. Ford points out that the official explanation is coronavirus and the pressures that that puts on the banks. He continues

'But the virus did not become news only last Tuesday [March 31st]. What is puzzling is the failure to gate earlier all capital distributions. It’s hard to believe the central bank trusted bank bosses to show restraint, especially when the likes of Barclays’ Jes Staley had big bonuses riding on the payouts.

More likely, the central bank believed its own story that the lenders were super well-capitalised. That has certainly been the mood music from Threadneedle Street, with the now departed governor Mark Carney boasting recently that their balance sheets were now so strengthened that, unlike 2008, the banks could be “part of the solution”.

The next day, the prices of the Big Five UK banks’ shares plunged: 12% for Barclays, 9.5% for HSBC, 11.7% for Lloyds, 5.2% for RBS and 7.3% for Standard Chartered.

There is deeper puzzle, however. If it believed that UK banks are super strong, why didn’t the BoE just let the dividend payments go ahead? The proposed payments were barely 2.1% of the Big Five banks’ book value capital, which, by hypothesis, was super adequate. Allowing the payments to go ahead would have sent the perfect signal of strength to the market, especially at a time of so much uncertainty. The BoE blocking those payments then looks like a panicky overreaction that unnecessarily spooked the markets, because it gave the impression that the BoE was having second thoughts about how strong it thought the banks really were. How else to explain the market reaction the next day?

So the question is, how strong is the UK banking system? Or, more precisely, does the UK banking system have the financial resilience it needs to withstand a major shock and still emerge in good shape?

This article seeks to answer these questions. Our answer is, inevitably, involved, and is laid out in the follow steps. Section Two outlines our main argument. Section Three looks at banks’ current share prices and market capitalisations, and how these have changed since the New Year and since before the Global Financial Crisis (GFC). Sections Four and Five examine banks’ price-to-book (PtB) and market value capital to asset ratios. Section Six discusses how the UK banking system is now bifurcated into two sub-systems – HSBC and the other banks – and discusses HSBC’s exposure to Hong Kong. Section Seven examines off-balance sheet (OBS) and other hidden risk and valuation problems facing the banks. Section Eight examines the uselessness of the regulatory capital framework, section Nine examines the BoE’s claims that the UK banking system is now superstrong and section Ten discusses the BoE’s track record in the GFC. Section Eleven discusses the underlying political economy of bank capital and section Twelve concludes.

[Boon]

Gold seems to be taking a hammering today.

But the indices are doing well. 

Given the newsflow in America it makes no sense at all to me. US have banned Chinese passenger jets (and vice versa). It could get messy. Like everyone else they are dependent on cheap goods from there, can't wean yourself off them overnight. A trade war would be messy.

[sancho panza]

  

 

 

                                                                                                 

                                                                                                           Section 2. Outline of Argument

 

To summarise the main argument, as the UK enters the downturn, the BoE continues to maintain that UK banks are strongly capitalised. However, reliable evidence indicates otherwise. The core metrics for the Big Five UK banks have deteriorated sharply since the New Year, and even more since the end of 2006, i.e., the eve of the Global Financial Crisis (GFC). Their market capitalisations, their price-to-book ratios and their ratios of market capitalisation to total assets have fallen sharply since the New Year and even more since before the GFC. Their corresponding leverage levels have correspondingly increased. For example, banks’ average price-to-book ratios are now 39.2%, down from 255% at the end 2006, and their average leverage, defined as total assets divided by market capitalisation, has soared to 43.3, up from 8.9 at the end of 2006. Few would disagree that banks were already over-leveraged going into the GFC and yet UK banks are more than four times more leveraged now than they were then.

These metrics indicate a sickly banking system. If the banks were in good financial shape, their PtB ratios would be well above 100% and their capital ratios well above current levels. Traditional rules of thumb also suggest that leverage levels should be no greater than 10 or 15 to be considered safe.

In addition, UK banks have hidden problems relating to their off-balance-sheet positions, their gameable ‘Fair Value’ Level 3 (or ‘mark to model’) and loan book valuations, and their problematic implementation of IFRS 9, all of which have further adverse consequences for their capital adequacy.

The BoE’s ‘Great Capital Rebuild’ narrative about a strongly recapitalised UK banking system is an elaborate window dressing exercise. The BoE focused most of its efforts on making the banking system appear strong by boosting banks’ regulatory capital ratios instead of ensuring that the banking system became strong through a sufficiently large increase in actual capital meaningfully measured. The result is that the UK banking system enters the COVID-19 downturn in a woefully fragile state and avoidably so.

Another massive bank bailout now appears inevitable.

The assurances of the central bank about the supposed strength of the banking system must also be weighed against its unimpressive track record from the GFC: the BoE completely failed to see the crisis coming, despite market signals that something was amiss; then, when the crisis did come, the BoE persistently misdiagnosed the true nature of the crisis as being a liquidity crisis (which is not a big deal) rather than the capital or solvency crisis that it was (which is a big deal), despite the fact that markets had been signalling capital problems since 2007. The scale of the losses overwhelmed the UK banking system and blew the UK’s fragile regulatory capital framework out of the water.

Fast forward to the present, markets are again signalling major problems and the Bank of England is again insisting, against the evidence, that all is well. As Deputy Governor Sam Woods reiterated to the Treasury Committee on Wednesday April 15th, “We go into this with a well capitalised banking sector.” 9

We end with some speculations about the underlying political economy of bank capital, i.e., the game that is really going on. In a laissez faire world, bankers who took excessive risk could reasonably expect to bear the consequences of those risks, so they would restrain their risk-taking out of their own selfinterest.

Enter central banks and regulators, who set up lender of last resort facilities, deposit insurance and such like, and associated expectations of bailout. The bankers respond to these incentives by increasing their leverage and taking more risks to boost their returns on equity, which are the basis of bank CEOs’ remuneration. High leverage seeks to maximize the value of the (often implicit) central bank or government guarantees by letting banks borrow at rates subsidised by society at large, thereby privatising profits on the upside and socialising losses on the downside. The bankers’ Social Contract is highly destructive, however. The regulators attempt to rein it in by capital adequacy regulation, the aim of which is to constrain leverage, but the bankers are able to defeat them each time by ‘capturing’ the regulatory system which they then manipulate to their own advantage. Thus, the regulator’s dismal performance, while shocking, is only to be expected.

At some point, there will need to be radical reform to reverse the ever more destructive banksterisation of the economy and re-establish a Social Contract in which the bankers serve the public and not the other way round. To go back to the Vickers quote with which we started, “Banks’ capital adequacy is a cornerstone of our economic system.” A healthy economy – a healthy society, even – depends on banks’ capital adequacy being restored and then protected against those who would knock it down.

[sancho panza]

                                 

                                                                                

                                                                               Section 3 Bank Share Prices and Market Cap

Let’s start with some evidence. Consider the following chart, which gives the changes in the prices of the Big Five banks’ share prices since the New Year.

Between the end of 2006and the close of business on Friday,May29th2020, the banks’ share pricesfell by between 54.8% in the case of the best performer, HSBC, and 98.1% in the case of the worst performer, RBS.

The big five banks’ latest market capitalisation (‘market cap’)is £140.6billion. This number is to be compared to the banks’ total assets, £6,093.3billion,which is 43.3times their market cap. To see how much their market caphas changed, the next table shows the corresponding market cap numbers as of December 31st2006

Banks’ market cap was £360.9 billion at the end of December 2006. Banks’ current market cap has fallen by 61% since 2006.Not much sign here of the Great Capital Rebuild.

[sancho panza]

 

 

                                                                                                        Section 4 Price-to-Book Ratio

Another metric is the price-to-book (PtB) ratio, the ratio of a bank’s market cap to its reported or book capital.9

Theoretical considerations about price-to-book

A healthy bank would have a PtB ratio well in excess of 100%.

Why is that?

Imagine that webuild a factory costing £100. We finance it through some mix of debt and equity, say,£90 in debt and £10 in equity. Shareholders are assumed to operate under unlimited liability, i.e., we are back in early Victorian England. I report the book value of my equity as £10. Shareholders anticipate that ourfactory business will be profitable, so they are presuming a positive franchise value, i.e., that future profits will be positive. Therefore, they value the firm at more than book, say, £15reflecting a franchise value of £5. So the price to book ratiois £15/£10 = 150%. The law is then changed to allow shareholders the protection of limited liability, i.e., they can now walk away from any losses exceeding the share capital they have subscribed. Limited liability is valuable to shareholders, and they value the implicit limited liability put option as, say, £3. The market value of their shares therefore rises to £18 and the PtB rises to £18/£10 or 180%. The lesson is that we would expect a healthy business to have a PtB in excess of £100 because of (a) franchise value and (b) the value of the limited liability put. Substitute ‘bank’ for ‘factory’ and the same applies.

Now suppose that the skies darken and the market anticipates that future profits will be zero, so the whole of the franchise value has been wiped out. Revaluing the franchise value at £0, the market value of the firm’s equity falls from £18 to £13 and the firm’s PtB becomes £13/£10 or 130%.

But wait.

Since the market now takes a more pessimistic view of the firm’s profit prospects, the value of the put option rises from £3 to, say, £4. So the market value of the firm’s equity goes up again, from £13 to £14 and the PtB ratio becomes £14/£10 or 140%.

The question then is what would it take to get the PtB under 100%? Presumably either a perception by the market that the firm is carrying hidden losses or a perception by the market that the NPV of its future cash flows is well below zero. Either way, a PtB less than 100% is a bad sign.

The implication is a strong one: a healthy bank should have a PtB ratio comfortably over 100%. Conversely, if a bank has a PtB ratio under 100%, then there is something wrong

Price to book ratios for UK banks

How do the Big Five banks’ PtBs look? The answer is not so good.

By PtB ratios, the best performer is HSBC at 48.8%, the average is 39.2% and the lowest is Standard Chartered at 28.7%. To point out the obvious: these ratios are well below 100%. Ergo, the market must believe that there is something wrong with the banks.

We are reminded of Merton Miller’s comments about a 50% PtB: “That’s just the market’s way of saying: look at these guys; you give them a dollar and they’ll manage to turn it [or perhaps he meant, burn it] into fifty cents (p. 199).”12

It would appear that UK banks can’t even manage that.

The next table shows the corresponding PtB ratios as of end-2006 and end 2019

The average PtB ratio was 255% at the end of 2006.

By this criterion, UK banks are in considerably worse shape than they were going into the GFC.

As a cross check, according to a BoE spreadsheet, the average price to book ratio for UK banks fell from 211% at the end of 2006 to 85% by November 2015. Unfortunately, that series ends in November 2015 and appears to have since disappeared from the BoE’s website. (Good job we kept a copy. For those who wish to see it, we provide a link to it here, see sheet ‘9. Bank equity measures,’ cell B194.) The Bank’s numbers are a little different to ours, but the story is much the same.1