Tuesday, 24 February 2009

Credit Contraction in Euroland and the UK

There is another piece in today's DT by AEP noting the mutiny by the NCB Club Med Governors on the ECB board against the financial rectitude the ECB inherited from the Bundesbank. Print money cries the PIGS but who will pay the piper? The Maastricht Treaty, which set up the ECB, forbids the ECB from buying up dodgy bonds with newly printed money. This is perceived as minor problem that can be ignored by Barroso but will go down very badly in Germany where already a majority of the populace want their Deutsche Mark back.

A major credit contraction was inevitable once banks were forced to raise their capital ratios. Previously a minimum of 8% of a banks lending was its own capital and the other 92% came from deposits i.e. a multiplier of 11.5 roughly. Increase capital requirements to say 12% and the multiplier comes down 7 and credit contracts by around 40% or banks need 50% more capital. It's a simple sum!

We saw the same lack of joined up thinking in the UK when Northern Rock was required to repay its Bank of England finance as quickly as possible encouraged by the idiotic chanting of the mantra " the tax payer's money must be repaid asap", lead singer the Lib Dumb Vince Cable. He should have stuck to dancing! Northern Rock obeyed and customers with expiring fixed mortgages were told to go elsewhere. Northern Rock made very large payments to the BoE and their customers paid through the nose for fresh fixes if they could get them. Credit collapsed further and the contagion was spread to other banks.

Now Northern Rock has been commanded by Gordon, the saviour of the World, to up their lending using £14 bn. of taxpayer's money! Unfortunately the Rock has a number of bonds coming up for refinancing. Simple, split the Rock into two separate legal entities and dump all the liabilities into one bit and start again with the good bit and our £14 bn. They did this when they effectively robbed the shareholders of their interest in the Rock in a compliant UK court. The bond market where these liabilities will end up is a much more powerful and international beast that has in the past destroyed US presidents. Gordon may save the world but who will save Gordon from the bond market? Who saves the saviour? (I would be grateful for a Latin translation of this question.) The bond market always wins.

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