081105 Gardiner to Gang

There were so many typing errors in my message that I have revised it. One sentence even lacked a vital ‘not’.

Geoffrey

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081104

The recession in the building industry is already at maximum, if what has happened here on the biggest housing development in Europe is general.

Building for ordinary sales is at a halt. Only schemes which have government support are proceeding.

By coincidence I have a roof leak, caused, I believe by faulty workmanship when the house was built in 2004. The National House Builders Registration Council insure the work for ten years, but there is an excess of £500. I am told that the excess is indexed, presumably to the cost of building, and that the excess is now £808. That implies an average rate of building cost inflation of 12.75 % over four years, illustrating dramatically by how much domestic inflation is higher than the Consumer Price Index, the latter being reduced to 5% by the deflation of import prices in the same period.

But wages in the building industry have dropped 50% in the last few weeks. The index has yet to reflect this.

I have had no difficulty finding someone to do the repair. Two years ago when some tiles failed, no-one wanted to know about them. Fortunately the builders accepted responsibility.

Banks.

The full terms - nearly - of the bank capital issues are now available on the websites, though Americans will have to pretend to be British if they want to access them. This is the result of official regulation which always works when it is silly.

The Lloyds issue is at very nearly net asset value (NAV), which is fair. The support for HBOS looks nearer a fifth of NAV, and Lloyds could be on a winner if it takes HBOS over. The market is beginning to reflect this in the Lloyds price. The shareholders may take up all the Lloyds rights, leaving nothing for the government. But there is a catch. The government is also to put capital into HBOS on the same bargain basement terms, and it is a mystery how this is to take place. The government injection seems to be timed to take place after the Lloyds take-over, so one would not expect the government to want HBOS shares, but to want Lloyds. What will be the price if it does buy Lloyds shares? Will they be at a similar discount to NAV as would be the case if the government purchased HBOS shares at the price it has indicated? If so Lloyds shareholders will take a big haircut. Presumably Lloyds shareholders will have a preemption right and they should exercise it.

RBS. The share issue terms I have already described as a swindle, which the shareholders can only avoid by taking up all the £15 bn of rights in full. But at the moment the shares are selling below the price of the rights issue, making it cheaper to buy in the market than take up rights. This price implies that the shareholders do not intend to take up their rights or apply for excess shares (which will be permitted for the first time for yonks), even though the price will be only 63 per cent of the eventual NAV after the issue (RBS figures). This figure is more than my calculation as I came to a figure for the post-new-issue NAV of £1.45 at a cost of 65.5 pence a share. Both calculations exclude intangibles. I have not discovered yet the basis of the bank’s calculation but it could include losses not yet announced, though that would at the moment seem unlikely.

Barclays might have been able to get new money from the government on just as favourable terms as Lloyds but it has chosen to give away huge gobbetts of shareholder value to its friends in the Gulf. Is John Varley serious, or is he trying to make clear in a dramatic way how silly the Government move is and get it changed? As the move is the work of the new chairman of the Financial Services Authority, clearly a great macho, I think it is unlikely to succeed. Amazingly Barclays did not use its own experts to find money in the Gulf but some woman. This is typical Barclays. Numerous times when I was with them the directors would take bad advice on new issues from outside advisers, totally unaware that it had far cleverer and more experienced people on its own staff.

The terms include noting for the Barclays name, once estimated to be the most valuable brand name in the world, worth $3.7 bn.

Government folly continues unabated.

I calculate that the liquidity needs of the British financial system are at least $60 bn and ideally £80 bn. This is therefore the amount by which the Debt Management Office (DMO) should underfund. The last figure for its underfunding was £5 bn, so that the Bank of England has to lend the banks the what they need and borrow it back from them. The note issue of around £40 bn is nowadays not backed by government bonds but by reverse repos which are private sector obligations.

In August last year the Bank of England appears to have raised the liquidity target for banks from £20bn to £30 bn, yet at the same time the DMO was stripping £2.5 bn out of the banks by a gilt issue. Naturally the banks had to make arrangements with the Bank and it was the leaking to the BBC of one of these arrangements that caused the Northern Rock fiasco.

Of course the lack of ‘liquidity’, deposits at the Bank of England, would not matter if the banks lent to each other. That practice bypasses all attempts by the government to restrict the creation of new credit by banks, making possible therefore an infinite amount of credit. Why should a government want to encourage interbank lending if it cares about limiting credit creation? Should it not prefer that the central bank be the intermediary for all interbank flows? Flawed understanding of theory must be at the root of this.

Perhaps I should explain my reasoning by describing two scenarios.

1. Gresham’s Bank advances £1 bn of new credit to a company which buys services from a company which banks with Glyn Mills Bank. As a result of the payment for the services Glyn Mills has too much on its account with Central Bank. Gresham’s is overdrawn. The Central Bank which can either let it ride or it can insist on buying assets from Gresham’s. It pays no interest to Glyn Mills on its excess over the liquidity target for Glyn Mills. It can offer to sell to Glyn Mills the assets it has bought from Gresham’s. In this scenario the Central Bank has some control, but not a perfect one, over credit creation.

2. Same initial transaction but knowing where the money is going Gresham’s does a deal to borrow direct from Glyn Mills as soon as the money appears in the clearing. The balances of both banks therefore remain the same at the Central Bank. Central Bank does not have to do anything and as a result has no control over the amount of new credit creation.

In the second scenario, the only control the government can have over credit creation is by changing the capital adequacy ratios, or changing asset weightings for calculation of CAR, or both. This is why I proposed at the Sunningdale conference I attended in 1973 as the Barclays rep the use of CARs and weightings to control credit creation and thereby inflation.

Sadly I have to admit that I have never described the system quite properly in my books. I failed to see that an infinite credit creation is possible so long as banks can trust one another. But in a big credit creation spree the trust must fail, and that is what has happened in the recent crisis. The Bank of England and the DMO did not realise the huge part the DMO must play in providing liquidity when such a thing happens. The DMO is not subject to the Bank or the FSA. Its operations conflict with the open market operations of the Bank. The DMO does not have in its remit any instruction to provide liquidity to the banks. It is a very bureaucratic body which labouriously sets fundraising plans for months ahead, in total ignorance of its real purpose. Recently it issued gilts like fury under the delusion that it had to accumulate ‘money’ so that the government could pay for the shares it had promised to buy in the banks. In 30 days it sold £20bn of gilts, stripping liquidity to the bone just when it was most needed. If liquidity is stripped so thoroughly, no bank can lend to any other. This what happened at the time of the Northern Rock affair.

Geoffrey