Who's afraid of the big bad banks?

| | | | | | | |

Tony Curzon Price (London, oD): The bankers who breakfasted with GB must feel that the beans on toast was a good investment. Better than many they've been making, lately.

It seems that the bankers are plotting with the Bank of England to swap their mortgages for government bonds. Let's be clear what this swap means: the banks hold loans, or derivative instruments on loans, guaranteed by properties whose value everyone now accepts were set in a massive debt-fuelled property bubble. Government bonds, on the other hand, are backed by the State's power to tax us. Over the next three years - the term expected for these rescue loans - house prices will come close to halving, so the collateral for the banks' mortgages will be bad. As in the US, people will put the key in the letter box and walk out of negative equity rather than slavishly pay for their property prices to recover. No wonder the banks want to swap these assets for ones backed by taxpayers.

Clearly we shouldn't let the banks be bailed out this way. What we might call the Rock-solid principle of rocky bail-outs points the way: if we own the risk, we own the bank. The Treasury should have a clear valuation methodology and an agreement to be the "owner of last resort" for foolish lenders. Something quicker and easier than Northern Rock, and not an insider stitch-up like Bear Sterns.

The credit markets are in trouble because banks lent on bubble assets. Huge amounts of money will get lost, and the banks are trying to make sure they're not holding the baby. There is no getting around the simple fact that mortgage lending will not get going again until house prices have fallen. The risk of household default when people see long laboring lives under negative equity is very high. That is why interest rate cuts by the central bank will not be passed on to borrowers. All that low interest rates are now doing is providing near-free money to banks - yes, more of that - and fuelling other bubbles, in food and commodities.

We must not let the banks bamboozle our leaders. The FT reports (link above) this exchange from the breakfast meeting with the PM:

Bank executives told Mr Brown on Tuesday that he needed to move quickly to prevent smaller building societies being forced from the market, leaving only a handful of large banks to offer new loans.

"The big banks said: ‘You've got to think about this'," one person present at the meeting said. "We're going to take 100 per cent of the market."

If that is the level of threat we are now scraping at, we should say: "Fine, we have competition policy to break that up."

The policy implications are clear. As Marty Feldstein (Harvard professor and probably the world's most celebrated macro-economist) writes in the Wall Street Journal, we must first stop cutting interest rates. Second, make it easy for bad banks to be bought by the State, and for their mortgage losses to be written down as rapidly as possible to allow housing trading to start again at sensible prices. There should be a low-stigma default option for people who want to leave their negative equity mortgages; the state will own the houses thus liberated and can offer a rental contract to incumbents based on commercial rates of return. Once the property market is operational once again - in some three of four years - the state can offer to sell this stock of housing, possibly to incumbents, at sensible prices.

The quicker we leave the bubble behind, the better behaviors can re-adjust. Don't expect that to be the top priority of the banks, and don't let their scare-tactics drive policy.

| | | | | | | |