Monetary Crisis … The Build Up

Understanding the build up


The 90's heralded the “The City” as the powerhouse of the UK economy and London became the leading Financial Centre in the world outside of New York.

The tribulations of the early 90's had all but passed by 97 when Labour came into power. Gordon Brown was given a kick start with the Auction of 3G licenses and immediately won the hearts of “The City” when he used the bulk of this windfall to reduce the Governments borrowings. He continued the Thatcher privatisation policies dressed up as “Public Private” partnerships. The fact that he was borrowing (creating money) at a rate never before seen in the history of the UK seemed to escape the City as they now had all the Public Private partnerships into which to channel the funds flowing in to the city. In the style of all entrepreneurs he provided budget after budget showing his prudence in not borrowing … simply as he had kept it “off balance sheet”. This brought about nearly 10 years of sustained housing price inflation.

Towards the end of the 80's and increasingly so during the 90's securitisation became the name of the game. By securitisation we would parcel up a whole lot of instalment receivables and sell those off on the money markets. This procedure was adopted by the smaller banks (and perhaps large ones as well) thus increasing the amount of money available to them for lending. As money in the money markets was not necessarily the local grown variety … could be from anywhere in the world … this amounted to uncontrolled “money creation” all the rules of Thatcherite measurements of money supply were thrown out of the window. This allowed Northern Rock to happen. Here was a “bank” granting mortgages not out of depositor funds but out of their ability to securitize parcels of mortgages and sell them off in the money markets.

The nature of this type of transaction is such that the Bank earns its margin on the whole 20 year term up front, as it is paid a discounted value of the total cash flow … usually a percent or so below the rate being charged to the mortgagee. If we assume a mortgage of £100000 over 20 years at 6% pa which we then discount at 5% pa. Our profit on selling that mortgage would amount to £8000. Obviously this is an oversimplification and the rates I have chosen exaggerate the effect but it should suffice to illustrate a point. If we then compare the income statements two banks … one who has lent out of depositors funds and the other out of money market funds.

Bank A. Out of depositors Funds

Net Interest earned Year 1 say £6000

Cost of Funds (say at 4%) £4000

Net Income for year £2000

Bank B discounts transaction in money market

Net Income for year £8000

Most would say that Bank B is really on the ball … his financials show him as being a lot more efficient than Bank A … even though in the long term Bank A will earn more money out of the transaction.

Thus was the Northern Rock bubble born. Once in this game the pressure becomes to increase the size of the individual transaction … so instead of lending 75 or 80% of the value they lend 100 or 125%. Obviously there are a lot more tricks involved in making this model work, but generally it is a sound strategy as long as there is a continual flow of available funds into the capital markets. Norther Rock were providing "The City" an easy way albeit creative way to get rid of surplus funds!

What has actually happened is that the flow of funds dried up … as it did at the end of the 70's and again in the beginning 90's. It is very easy for politicians to say “credit crunch” and we need to regulate our financial markets more, we need a new model etc., etc. The truth is we need to look at why those funds dried up and where have they gone.

It is silly for us to think that foreigners can’t see for themselves what is happening to the USA and UK economies … The USA deficits have been growing year on year since the Bush era began … and this from a Republican Government! Clinton actually managed to bring it down during his term … mainly because he never had total control of Congress and the Senate!

The UK with all Gordon Browns clever manoeuvres has managed to become the most heavily indebted country in the world with foreign debt reaching a staggering $10.45 trillion on 30th June 2007 (Source CIA analysis 2008). Surely it is reasonable for them to start limiting their exposure to what looks like a disaster waiting to happen. Just so that we have a perspective of this number, which is almost incomprehensible … that foreign debt has grown by $2.17 trillion since 30th June 2005 (roughly 40% of our GDP).

Where have all the funds gone then?

Continue to part 3 ?

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