The £50bn Bank of England Bailout

Rob Mackrill - Mon 21 Apr, 2008

Banks "cock-a-hoop" at new lending facility from the "Old Lady"

The ERM did for the Tories. Back in 1992, we crashed out of the Exchange Rate Mechanism and George Soros cashed in to the tune of $1bn by betting against the pound.

It may have been the making of Soros, but it destroyed the government. The debacle cost the country billions and the Tories were made to pay by the electorate. They got crushed in the 1997 election and have been in opposition since, regularly rotating leaders.

So the penalty for confidence foregone in the stewardship of the economy is not to be underestimated. For politicians on the wrong side it condemns them to possibly years, decades even, paddling the political backwaters. Sitting on their hands rather than flexing them on the levers of power. A role reduced to jousting with those who do in that elegant and boisterous debating room called parliament. Life as a spectator, not a player.

New Labour have been in power 11 years with a NICE (Non-Inflationary Continuous Expansion) economy playing soothing music in the background, helping them ramp up expenditure and get away with stealthy tax increases. Not anymore. The credit crunch presents a mortal threat. The UK electorate, when it eventually gets the chance to vote on its preferred Prime Minister, might just take out its frustrations at falling house prices and higher food and fuel costs on Brown and co.

So the incentive to prop up house prices is, by proxy, one to prop up an aging government regime. This is where the Bank of England comes in. There’s moral hazard and then there’s economic meltdown. Take your pick? Okay, moral hazard’s out and we’ll attend the meltdown bit. All hands to the pump, time for a bailout from the only one who can...call in the lender of last resort.

The Bank is making £50bn available and will swap unsalable mortgage-backed assets held by the banks for nine-month treasuries at commercial rates (as opposed to penal) who will then be able to borrow against them. The facility is being made available for three years.

Okay so let’s not get too gummed up in the technicalities, but what do the banks think of it? They’re "cock-a-hoop", says the BBC’s Robert Peston. So much so that it’s shown up in the rates bank lend to one another. Three-month Libor has fallen three basis points to 5.89%. So this effort at sticking a plunger down the financial drains looks like it is working. Will the taxpayer be on the hook? Only if a bank goes down, and there are enough safeguards to make sure taxpayers aren’t too badly exposed says breakingviews.com. With 20:20 hindsight such a facility, if available earlier, might have saved Northern Rock. It is the "world’s most ambitious and generous plan to pump money into the banking system," says the BBC’s Robert Peston.

If the likes of Tony Tan, deputy chairman of GIC, a Singaporean sovereign wealth fund is right and the world is looking at the "worst recession since 70s," then drastic times call for drastic measures. Something the Ernst & Young ITEM Club call for in their new report on the Economic Outlook for Business. The UK economy faces a sluggish two years unless "the Government takes decisive action to mitigate the credit crunch." The Times reports:

"The economic forecasting group describes the outlook for the housing market and the high street as bleak and is set to get ‘a whole lot worse’ as the mortgage drought dampens consumer spending. It warns that growth could slow from 3.1 per cent last year to just 1.8 per cent this year and 1.5 per cent in 2009."

It suggests the government be "bold" and increase its borrowings to fund the mortgage lenders if it has to, citing a ‘70s precedent when the building societies were bailed out to the tune of half a billion in 1974. A lot of money back then. And a hundredth of that’s now on the table via the Bank of England.

Interestingly, although the mortgage famine and food/energy costs will hit consumers hard, encouragingly they believe employment levels, currently at record levels, remaining high. House prices are anticipated to fall but by a relatively modest - at least alongside some more radical forecasts - 10% over two years. What will fall dramatically is the volume of transactions. They forecast the numbers moving home falling by 40% over the next two years. This adds to your editor’s conviction that through the house price crash noise the bigger crash will be in total home sales and consequently, the number of estate agents going bust. This may well prove to be first and foremost a transaction crash. But what kind of headline is that for selling newspapers?

Moving on. Oil. Daily it gets more expensive. $117. Who predicted that even a year ago when it was in the mid-$60s? It’s risen 30% in the past three months alone notes Fleet Street Letter editor, Brian Durrant. Around $2 on the oil price translates into another penny per litre on to what you pay at the pump, reports The Times. That means another 1.5p to come by the summer, if analysts are right in their forecast of $120 coming soon.

What’s sending the price to the moon? Shell commented recently the market was well supplied. And OPEC, which accounts for 40% of the world’s oil, has so far refused to increase production (if indeed they can). They see slackened demand on the horizon given the US is, for all practical purposes according to Warren Buffett, in recession. And US demand accounts for 20m barrels a day of total world demand at around 85m per day.

The secretary-general of OPEC, Abdullah al-Badri, said recently that factors other than supply and demand, particularly the weakness of the US dollar, are pushing oil prices higher. Well, up to a point, perhaps, but Bloomberg reports today that emerging market oil demand (China, Russia, India and the Middle East) just overtook that of the US for the first time. A milestone probably accelerated by China stockpiling ahead of the Olympics.

"We’ve had the dot.com bubble, we’ve had the housing bubble and now it’s the turn of commodities," adds Brian Durrant. It’s a "growing bubble" says George Soros, of commodities, implying it has some way to run. One comment that struck with me came from a professional investor over the week-end. He says he has been unable to disaggregate investment interest in commodities from core physical demand. As such he is unsure how much of the price rises are attributed to higher demand and how much to speculation. Recent investment innovations such as Exchange Traded Funds have made commodity investing easier, adding to demand and accounting for supply. More on ETFs can be found in today’s essay from Nick Sudbury in The Zurich Club Communiqué.

Regards,

Rob Mackrill
The Daily Reckoning