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Monday, 11 May 2009

Edinburgh economist predicts toxic debt boon

From Sunday Times business section, 10 May, 2009, page 1
"Robert McDowell says UK Treasury will finance recapitalisations and pay off many budget deficits through troubled banks" by Ian Fraser
The UK government should comfortably claw back at least half of forecast budget deficits in 2010-12 because of higher-than-expected returns from its ownership of shares in troubled banks and profits from bank bailouts, according to an Edinburgh-based economist.
Robert McDowell, a banking economist and risk-management consultant, said: “The UK and US Treasuries are charging substantial fees and exerting 25-30% haircuts, leaving themselves with more than adequate headroom to generate substantial medium-term profit which, I calculate, will finance both their bank recapitalisations and pay off half of medium-term government budget deficits, thus relieving taxpayers of the risk of sharply higher future tax rates.”
The British and American Treasuries have been criticised for their programmes to purchase billions of pounds of “toxic” and“legacy assets” from the banks, including impaired mortgage-backed securities, collateralised debt obligations, credit card bonds and student loans.
However, McDowell, who advises governments as well as banks, said such criticism is unjustified. He believes that, while asset-backed securities were arguably the cause of the credit crunch, they are also going to play a part in bringing it to an end.
McDowell said the UK government’s support for the banking sector, including the special liquidity scheme and the asset protection scheme, will generate a net profit of about £185 billion, and possibly more than £200 billion, “which is a substantial three-year gain from off-budget financing worth about £900 billion currently”. He said £200 billion would eradicate 45% of future budget deficits.

To this I add: The 2009 Budget authorises the bank of England to engage in up to £150 billions in Quantitative Easing, which means buying in outstanding gilts (government bonds) early. No-one has questioned where the financing originates to buy back the gilts. It has to come from net balance between assets and liabilies on the Bank of England's balance sheet. last time I looked the BoE balance sheet was £500bn, considerably more than the IMF which is seeking to grow to that level and equivalent to that of the Bank of International Settlements. Not all of the nearly £600bn assets being bought in by the BoE have yet transacted and its quantitative easing programme is somewhere in the £25-50bn range so far. I view the £150bn authorisation as an indicator of the net profit medium term that the government expects roughly to generate from its investment in saving the banks including majority ownership under UKFI Ltd.
BoE said it would spend a further £50bn of newly-created money to buy bonds. Note that the ECB has so far expanded its balance sheet much less than the BoE despite being responsible for a much bigger eceonomic areas. It has pledged to buy €60bn (£53.4bn) of covered euro bonds though the size of its asset purchase scheme is still small in comparison to those operated by the Federal Reserve or BoE with HM Treasury. This is something of an indictment of the Euro Area system whereby all the money market liquidity windows of the 16 constitutent central banks are vested and centralised in the ECB. It has a board of 16 central banks' representatives plus 6 ECB'ocrats, but among the central bankers are 9 economists and this bodes well for its gathering responsiveness. ECB President Jean-Claude Trichet said the bank would buy covered bonds, typically backed by mortgages, but did not rule out other purchases, which may let the ECB buy government bonds, although this has by political convention about fairness been resisted so far. The ECB will double the maximum term of its loans to banks to 12 months and loosen the rules on the assets which can be used as collateral to lessen the financial strain throughout the eurozone. 12 months is however much shorter than the 3 years offered by the BoE and similar medium term support from the US Treasury and Federal Reserve.
Details of the Bank of England's Special Liquidity Scheme (21.4.08) and its successor Asset Protection Scheme and Asset Purchase facility (19.01.09) - both organised by BoE as 'agent for HM Treasury and the Debt Management Office) do not have to be revealed until October 2009, and at the government's discretion not even then. This is according to the 2009 Banking Act ( What we do know is the following asset swaps for treasury bills and Bank of England cheques, where the bank assets are securitised as asset banked bonds and purchased as collateral for up to three years for: SLS - £245bn assets pledged as collateral, swapped for £185bn in treasury bills, with a roughly 3% fee. The assets are securitised as bonds paying about 3% above LIBOR, averaging say 5% net after the coupon on the T-bills over 3 years = £6bn + £28bn.
The difference between the assets pledged and the T-bills they were swapped for provides backing for the £37bn of preference shares bought from Lloyds TSB, HBoS and RBS paying 9% (subject to the banks' profitability). We can assume they will pay and average of 6% over 3 years = £7bn.
The APS scheme has we know taken in £325bn and £245bn from RBS and LBG plus another £15bn in exchange for Bank of England cheques left as deposits with the Bank of England, for a £22.1bn fee paid partly in preference shares and converted into common stock, and 2% insurance, plus very importantly, the banks agree to make no tax claim for losses for "several years!" (see
It is not possible to gauge the exact value of all this, but investment in bank shares of £37bn plus £34.6bn (£71.6bn) and becoming worth more. (see p.59 of Budget Report
These shareholdings were paid for off-budget i.e. not at taxpayers' expense. This plus about £30bn a year on average over 3 years in coupons and dividends i.e. £150-200bn say over 3 years, but can become considerably more.
There is also the BoE's Asset Purchase Facility. "Following a request from the MPC, the Chancellor authorised the Bank of England to use the APF for monetary policy purposes and increased the total scale of the fund to £150 billion, up to £50 billion of which could be used for private sector asset purchases. Asset purchases since then have been financed by the issuance of central bank reserves at the Bank of England". (page 60, Budget Report)
'Central Bank Reserves' means BoE cheques as per the Asset Protection Scheme. This has the advantage that the recipients cannot sell the payment they receive and must keep this as a financial reserve. It avoid issuing treasury bills that could be sold and may be represented at unexpected times rather than simply rolled over.
Thus from these schemes the government should gain a net profit of about £185bn, and very possibly over £200bn, which is a substantial 3 year gain from off-budget financing worth about £900bn currently. If part or all of this is used in the Quantitative Easing scheme for buying in £75bn of government bonds and then up to £150bn in total, and I judge there could be another £50bn, this is about half of the government's likely Budget Deficit of £175bn deficit in 2009, then say £160bn and £125bn in 2010 and 2011 respectively.
Given that long term interbank funding that UK banks require to finance their funding gaps remains very hard to get from private sources, we can expect the Bank of England to add several £100bn more to the Asset Protection Scheme during the remainder of this year, which would mean we can be even more confident that there will be a £200bn three-year gain or more, sufficient to cover half of government budget deficits. The agreements with the banks will also ensure about £50bn in new lending into the economy by the banks.
Chancellor Darling in his Budget report 2009 highlights in red on p.25, "Reflecting the principle of transparency, the fiscal forecasts include a provisional estimate for the high end of a range for the net impact of unrealised losses on financial sector interventions, equal to 3½ per cent of GDP." The budget deficit is about 12.4% ratio to GDP for 2009/10, then 11.9% and 9.1% in the next two years. The Chancellor is therefore indicating that a substantial part the deficit is required, at least roughly half most probably,assuming a 4:1 multiplier, to compensate the economy for the banks' and possibly may not be needed if the government's financial sector interventions pay-off.
In the case of the ECB there is now tacit admission that the policy of leaving interest rates relatively high and quietly talking down the prospect of quantitative easing has been abandoned.
There remains considerable fear and uncertainty about how the chips will fall. The BoE's MPC recently stated: “The world economy remains in deep recession. Output has continued to contract and international trade has fallen precipitously. The global banking and financial system remains fragile despite further significant intervention by the authorities.”
The BoE's QE has prompted a sudden jump in the price of government bonds, or gilts. Though this may not be sufficient to close the gap so that the BoE will not still be buying the higher coupon outstanding gilts cheaply on the secondary market. It will no doubt use other banks to do the buying for it. we can see this in that despite the higher QE, the benchmark bond yield remains above the level it was before QE was announced and began.

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