³ÉÈË¿ìÊÖ

The past 18 months was a story about the collapse of lending to banks and by banks - and about how we as taxpayers came to the rescue by providing £600bn of loans, guarantees and capital to the banks, to keep them afloat.

The story of the next year will be about the implications of this continued shrinkage in the availability of credit and about the implications of this massive, unprecedented support given to banks by taxpayers.

As a nation, our fortunes in 2009 will be conspicuously tied to the fortunes of our banks as never before.

First, an economic recovery rests on the ability of banks to support viable businesses during what increasingly looks like a severe recession.

Second, and as important, the balance sheet of the British public sector can be seen as the aggregated balance sheet of some substantial banks - because the state now controls three banks, Northern Rock, Bradford & Bingley and Royal Bank of Scotland, and will have a huge stake in a soon-to-be created fourth, LloydsTSB/HBOS.

It means that if the perceived credit-worthiness of our banks - with their trillions of pounds of assets and liabilities - were to deteriorate further, that would have an impact on the perceived credit-worthiness of the state.

As never before, it matters to all of us that the banks run themselves in a prudent way. In an extreme and highly unlikely case, if the markets viewed our banks as recklessly managed basket-cases, that would have an impact on the value of sterling and on the ability of the government itself to borrow.

So our prospects and welfare depend to a huge extent on an a few weeks ago by the to manage its investments in the banks, (UKFI).

It's probably no exaggeration to say that - for the coming year or two at least - UKFI will be as important to all of us as the Treasury, or the or the City watchdog, the .

UKFI's primary aim is to "protect and create value for the taxpayer as shareholder" - while also making sure that the banks we own provide "competitively priced" loans to small businesses and homeowners "at 2007 levels".

Those objectives are not quite irreconcilable - in that the banks over which it has sway should be capable of providing substantial credit to the housing and small-company markets without chucking good money after bad, even though this is a dire period of economic contraction and proliferating bankruptcies.

But, for the avoidance of doubt, UKFI has no ability to increase the supply of credit in the economy as a whole.

Remember that the ability of banks to lend is anyway being undermined by losses on the stupid loans they made in the boom years and also by the collapse in the price of houses, property and shares, which slashes the value of vital collateral that backs loans.

So many banks are lending less to big companies, they are lending less for commercial property transactions, they are lending less to City institutions, they are lending less in the form of unsecured personal loans.

Lots of overseas institutions are cutting back significantly on the bounteous credit they provided directly to the real economy in the UK during the preceding few years.

Also many bigger companies that borrow directly on wholesale markets by selling bonds and other securities are finding it much harder and more expensive to raise money.

And credit provided between companies that buy and sell to each other is being massively restricted, by a collapse in the availability of insurance for such credit.

All of which can be summed up as "ouch" for businesses and households - and is the primary reason why some companies are going bust, and why those that will survive are reducing investment and cutting jobs.

So even with £600bn and rising of support for banks from taxpayers, our banks simply don't have the resources to keep afloat real companies - manufacturers, exporters - that are vital to the future of the British economy.

Which is why early in the new year, the Treasury will announce details of yet more taxpayer lending, this time to ensure that credit is provided to viable and strategically important companies - such as the more efficient carmakers.

The line between private sector and public sector, which became blurred in 2008, may become almost impossible to see in 2009.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The main story of is quite how close we came to the collapse of two banks - Royal Bank of Scotland and HBOS - in the second week of October. RBS in particular was alarmingly close to meltdown.

For Royal Bank of Scotland, the owner of NatWest, it was all hands to the pump from Tuesday 7 October until the end of that week.

This giant British bank, which has just under £2000bn of loans and other assets, was having enormous trouble hanging on to vital deposits and loans made by money managers and other financial institutions.

Without these deposits, it would have been insolvent.

The head of RBS's corporate bank, Johnny Cameron - who has now left RBS - was summoned to the Bank of England for crisis talks.

The Bank of England itself contacted Royal Bank's creditors in New York and Tokyo to persuade them to keep faith with the group.

By Friday, RBS was a weekend away from disaster. And the troubles at RBS were being replicated at HBOS, which by 10 October was perceived by the Bank of England and the Financial Services Authority, the City watchdog, to be almost as vulnerable as RBS.

So on Saturday 11 October and Sunday 12 October, crisis talks were held at the Treasury - led by the Chancellor of the Exchequer, Alistair Darling - that forced all our big banks to raise additional capital to strengthen their balance sheets.

And in return for this additional capital, the Treasury and the Bank of England provided banks with £350bn of loans and guarantees from taxpayers.

A trio of banks received a direct investment of capital from taxpayers. Royal Bank of Scotland has received £20bn from the state and is now 58% owned by taxpayers.

There is £17bn of our money that is expected to go into HBOS and Lloyds TSB, with most of it going into HBOS. Lloyds TSB is buying HBOS and taxpayers are likely to emerge with a stake of more than 40% in the newly formed retail superbank.

This rescue package has prevented RBS and HBOS from collapsing and has stabilised the banking system.

This extraordinary story is told on Panorama in interviews with a quartet of the leading actors in this drama: the Chancellor of the Exchequer, ; the deputy governor of the Bank of England, ; the chief executive of the Financial Services Authority, and the chief executive of Barclays, [all pdf links].

Here are some of my questions to these four, with their answers from a verbatim transcript. First, Sir John Gieve.

Peston: I was talking to a big bank yesterday actually and they were saying to me it was extraordinary - their department, their treasury department, which you know exists basically to get them the funds they need on a daily basis - I mean every night the sums of money they had to raise just to keep going for the next day got bigger and bigger. The chap I was talking to just said that they'd never experienced anything, anything like it. How many banks do you think in the UK were in this position? Were they broadly all in this position of just seeing the availability of long-term funds just drain away?

Gieve: Well, I mean each bank is, is different and some of the banks were benefiting from this. They were attracting, they were seen as the safe havens and they were getting an inflow of deposits and their problem was: "what do we do with this money we don't need?" And they started looking to deposit it with central banks, in fact. But several of our large banks, and I mean I don't want to go into names, were, were in real difficulty and you know, were having hour-by-hour minute-by-minute to balance the books at the end of the day, and obviously we were talking very closely, but it wasn't just happening here. It was happening in the States, it was happening in Europe...

Peston: I mean, I suppose what I found profoundly shocking at the time was the difficulty that an enormous bank, Royal Bank of Scotland, was having in rolling over its short-term funding. I mean that seemed to me at the time to be momentous.

Gieve: Well absolutely, and you know it, it always rolls a large amount of funding but normally this is routine. You know you've got it arranged pretty much by the middle of the day. There's no panic about it but as I say, it became a nail-biting business right up until the end of the day and obviously we were talking to them on, on a daily basis. So that was one factor, but it wasn't just RBS. I mean, remember what was happening in the States, what was happening in, in Europe as well. You could see that the banks were falling over.

Peston: No, totally - and of course, HBOS was in a very similar position before the merger with - the takeover proposal was announced by Lloyds TSB. Now, you came together with the banks over the weekend to, in a sense, allocate the capital and to negotiate who would get what. Give me a flavour of what those negotiations were like with the treasury, with the FSA, with the banks.

Gieve: Well, we made the announcement of the plan - the availability of capital and so on - on the Wednesday. What became very clear on the Thursday and Friday was that we needed to get on with it. You know, we'd offered the cash. We needed to actually get it out there and RBS quite honestly was the leading candidate but we were also clear that if you just dealt with one, you'd leave the others in a rather exposed position, you know, the caravan would move on and the searchlight would pick out Lloyds and HBOS and even Barclays. And so, really, Friday and Saturday we began to get, and the treasury in the lead on this, but again I think it was a joint effort with the FSA and the Bank, we began to sort of line people up in different rooms on different floors for a series of meetings, and it was an extraordinary, it was an extraordinary weekend. There wasn't that much negotiation because someone described it as more a drive-by shooting.

Peston: Yes - Fred Godwin, the famous phrase, the negotiation was a drive-by shooting.

Gieve: And that, you know it had to be like that. There was very little time. The government was announcing the terms on which it was prepared to come in and the banks had to think about it, but they broadly had to accept it.

Peston: As I understand it, Fred Goodwyn, his famous phrase about the drive-by shooting, what he meant was banks were told [by the FSA] "we've done the sums, this is the capital you need". Is that broadly, you know, how it happened? I mean, that's certainly what he's been saying.

Gieve: Yes, that's right. We had done some sums and between us we'd, we'd come up with what we thought was necessary and really there was only one provider [the taxpayer]. Now, for Barclays they were, they chose a different route. They thought that they were given the number and they, they said "no, we can raise this ourselves on the market," so they took a different route to the other three.

Now, Alistair Darling.

Peston: Now, my recollection of the day and night where you put together the shape of the rescue plan prior to the announcement the following morning, I think you were in, in Brussels I think, in the morning, weren't you? I think there was, I think there was an Ecofin that morning and then I think you then came back and then there was a great sort of working through the night to get, to get a package together. Did you know when you were in, in Ecofin, in Brussels for this European meeting, that you were likely to come back and have to put this thing together very fast?

Darling: During the weekend before that, there had been a lot of speculation about whether or not the banks would be recapitalised and the markets were very very febrile on the Monday morning. I wasn't surprised when I was called early on on the Tuesday that one bank in particular really was in difficulties and I decided that you know whilst there was a bit more work to be done, we needed to get our plans out and so I decided we'd do a statement in the House of Commons on the Wednesday which I did. It was obvious it would always have to be a two-stage process, because you had to announce the principles, then sit down with the banks and of course I then had to go to Washington to the IMF meetings when I took the opportunity of course to speak to my counterparts, to say "look, we're doing this, you know I hope you can do it too". And then the final deal was done on that Sunday night and announced the following Monday.

Peston: I mean that bank in difficulties was the Royal Bank of Scotland, having tremendous difficulty renewing its short term borrowings on wholesale markets. Was this irrational, was there any fundamental reason do you think why Royal Bank was having such difficulty?

Darling: There's lots of things been happening over the last few weeks and months that are you know, on one level you can say they're irrational [I think he meant "rational" here] because as it turned out, RBS needed an awful lot of capital. It's one of the biggest banks in the world and we now own 57% of it. And when people had seen, you know, giant banks in the US collapse, everything that, that's happened, you can say on one level it's irrational. On another, another, the other level you can understand why people began to lose confidence. What we had to do, though, is to say "well never mind that, let's you know really take some decisive action - let's make sure that we can maintain the banking system" - and that's what we did.

Peston: I mean, I found it profoundly shocking, I must admit, at the time. I mean, here was the owner of NatWest, this enormous bank, that one just assumes couldn't possibly fail, having these difficulties raising short-term funds. You announced the structure of the rescue, but then again on the Thursday and the Friday they've still got these difficulties. There's a fear also that it's going to infect other banks like HBOS which was beginning to have difficulties of these sorts. You then come to the Friday of that week. Was it obvious to you again on the Thursday and the Friday that what you were going to have to do was negotiate with all the banks through the weekend to put together the detail of the rescue package, or in a sense did you decide quite late on the Friday that if you're going to do Royal Bank, maybe you should do all of them?

Darling: I was very clear even before the turbulence of that week that whatever we did, we had to do it for the entire banking system. We couldn't get ourselves into a situation where you're simply fixing one problem because the problem was then moved to somebody else and, you know, we just couldn't allow that to carry on happening. We'd seen it in America where they, no sooner had they sorted one bank's problems out than the problems transferred to the next. So on the Wednesday, I announced a general overall plan - the scheme, if you like. Things did get worse during that week because confidence was just draining out of the system and in some ways, that made it easier for us to talk to the banks and say, "look, we're all in this together. No one's got any choice. Everybody's going to have to recapitalise. The only choice we'll give you is you either do it through us or you raise the money on the markets yourselves" - and you know, that's precisely what happened. But on the Monday when we'd done it, it did actually, there was a sense of calm and the fact it then became clear that it wasn't just us. The Americans were going to do something, we had, Gordon Brown had been in Europe on the Sunday before and he'd got agreement, you know, surprisingly quickly right across Europe that central banks, governments would do the same sort of thing...

Peston: Did you get any sleep that weekend [of 11-12 October, when agreement was reached to inject £37bn of taxpayers' money into RBS, HBOS and Lloyds TSB], in fact?

Darling: Yes, I did. I had to go to Washington on the Friday and Saturday and so I came back on the Saturday night overnight and you know, there's a limit to the amount of sleep you can ever get in an aeroplane. Then I had meetings all day on the Sunday and then at ten o'clock on the Sunday night, just when you know everything was agreed as far as I was concerned, inevitably when you deal with a bunch of bankers, they started trying to re-open it. So I said about one o'clock - "okay, re-open it if you want. I'm going to my bed. If you haven't agreed it by five o'clock, then you're on your own". So happily, when I woke up at five o'clock, we'd got an agreement.

Peston: Crikey, and was the agreement very different from the agreement that you'd had at, you know, or where you thought it was going to be when you went to bed?

Darling: Not fundamentally, not at all. If you - look, you're negotiating with people who are running multi-billion pound businesses and who, you know, whose world had changed and of course they had one or two legitimate points that we were ready to talk about and you know, I talked to, to them about it but you know, what I wasn't going to have is someone trying to unpick the deal, basically ask for the bits they wanted and not the bits that I wanted. It had to be an all-encompassing deal. The deal was done you know, and completed, on you know, the early morning of that Monday and it had to be, because we had to make a market announcement when the markets opened at eight o'clock on the Monday morning.

Finally, John Varley.

Varley: What was clear was that confidence in the system was, was suffering very badly [in the week of 6-10 October]. It was, the circumstances were as extreme as anything that I can remember. And if I put it in context, it seemed increasingly likely as the week went on that one or two of the British banks would not be capable of opening for business the following week, and it doesn't get much more extreme than that. And as you know, the government stepped in and took action, and came to a decision about a system-wide remediation that I think was very helpful for the regeneration of confidence. But it was a, it was a surreal week because the markets were extremely skittish, the media was very extreme in its commentary and it was a challenging week for all stakeholders of banks, and indeed the employees of banks.

Peston: I mean, the two banks in question were Royal Bank of Scotland and HBOS. Do you think that their vulnerability was irrational or, you know, were the markets behaving rationally in the way that they were finding it difficult to raise money. Were they actually fundamentally weak?

Varley: Well, I'm not going to make a comment, least of all on Panorama, about our competitors. It wouldn't be appropriate for me to do so. But what is clear is that there was a crisis in the market that week and it had to be addressed because what you couldn't have was any big bank being in a position where it wasn't capable of opening for business. That, the systemic consequences of that, would have been too awful to contemplate. And I think it was, the week was symbolic in the following way which was that up to that point - I mean, over the preceding twelve months, put it like that - a lot of what had gone on in the United Kingdom and elsewhere around the world was what I would think of as national firefighting. Individual bush fires broke out and they were doused by the authorities. What was very clear in that week in October was that something much more system-wide - much more generic - needed to be applied both in the United Kingdom and elsewhere. And market-wide solutions were put in place in that, in that week in October and since then, and I think actually, actually it's been very positive for the world, because it seems to me as though the national firefighting forces have now been overtaken by the international fire brigade. And the international fire brigade I think is doing quite a good job in managing banking systemic risk.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The point of (which will be broadcast tonight at 8.30pm) is to convey quite how close we came in October to the collapse of the banking system.

It's a suspenseful story told in interviews with a quartet of the leading actors: the chancellor, Alistair Darling; the deputy governor of the Bank of England, ; the chief executive of the Financial Services Authority, and the chief executive of Barclays, John Varley.

I hope the programme also gives a sense of the shocks generated by this near catastrophe and the tumultuous year that lies ahead.

For me, what stood out when interviewing this quartet was the revelation about how Royal Bank of Scotland and HBOS were - in October - only hours away from being unable to open for business.

Inevitably, in a 30 minute documentary, many fascinating contributions from interviewees hit the cutting-room floor (such as John Varley's remarks on how it will take between one and two years for the contraction of lending to stop - which you can read in the note I published on Saturday).

So here are some resonant and significant remarks from Sir John Gieve that didn't make it into the finished film; Sir John rarely gives interviews and is to stand down in March from his role in charge of financial stability at the Bank of England.

This is Gieve's explanation of how and why the Bank of England failed to curb the growth of the bubble in borrowing and asset prices which lies behind our current woes: "We didn't think it was going to be anything like as severe as it's turned out to be... Why didn't we see that it was so serious? I think that's because we, perhaps, we hadn't kept pace with the extent of globalisation. So the upswing here didn't involve the big increases in earnings and consumption and activity which we saw in previous booms. We saw the credit, we saw the house prices, but we did see a fairly stable pattern of earnings, prices and output."

As others at the Bank of England have told me, the Bank's Monetary Policy Committee believed mistakenly that the lending binge and asset-price surge were semi-independent from activity in the real economy, and that they would eventually moderate without wreaking devastating damage to prospects for households and businesses.

But, as Gieve says, the Bank had identified the bubble, even if it didn't fully understand quite what misery its popping could and would cause. So why didn't he and his colleagues raise interest rates to attempt to stem the growth in lending and the rise in the price of houses and other assets?

"If we'd used interest rates to try and address this asset-price credit growth, we would have been holding down the level of activity elsewhere in the economy, in manufacturing, in other services, holding down the level of employment at a time when consumer price inflation and earnings were stable and reasonably low. And people would have said, you know, 'this is a wilful reduction in the prosperity of the country'."

The mess we're in demonstrates for Gieve that the Bank of England does not possess the proper tools for dealing with incipient booms in assets and lending. The power to raise and lower interest rates isn't adequate for the task, he says: "I think that one of the main lessons from this is that we need to develop some new instruments which sit somewhere between interest rates, which affect the whole economy and activity, and individual supervision and regulation of individual banks.

"Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument - you set one interest rate for the whole economy - with something which is more financial-sector specific."

So what might this new tool or instrument be? Well, it would have to be a mechanism to prohibit or at least discourage a lending splurge during a period of sustained economic growth, such as a formulaic stipulation that banks have to hold more capital relative to their loans and assets during the good years (which is precisely the opposite of what happened in the euphoric phase before August 2007).

And what about the price that we as taxpayers will eventually pay for the bailouts in 2008 of many of our biggest banks? I asked Gieve - who was intimately involved in these rescues - whether we would end up with a profit or loss on the nationalised and semi-nationalised banks. Would we as taxpayers get our money back?

"Well, I think it'll be a mixed picture. I mean, I think there are some [lending] books - Northern Rock, Bradford & Bingley - which the taxpayer is now holding which clearly have a level of defaults in them: I'm not quite sure how that will balance out against the residual of the capital. As for the more mainstream banks: yes, I think they've got a commercial future and I'm sure that in time they will, as for example the Swedish banks have after their crisis, revive and start building and growing as commercial entities again."

In other words, he says there is quite a risk of us making a loss on the Rock and Bradford & Bingley. But he's hopeful that we'll end up in the black on our massive investments in Royal Bank of Scotland, HBOS and Lloyds TSB.

ADDENDUM: It matters that we learn how to prevent a repetition of the economic mess we're in, partly for reassurance that we can plan on the basis that stability will return.

Which is why the frank admissions of what went wrong made by Gieve are significant, especially that interest rates are an inappropriate instrument for dealing with lending and asset bubbles.

What some may therefore see as worrying is that there is no sign right now of the Bank of England, or the Treasury or the Financial Services Authority being endowed with such bubble-busting powers.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Further to my New Capitalism note last week, here are two short films I've made for the News At Ten. And if you want some bedtime reading, you can download the full 3,000-word essay (oh yes) here [37Kb PDF].

Part One [Broadcast Thursday December 18th]:

Part Two [Broadcast Friday December 19th]:

• Bookmark with:
• |
• |
• |
• |
• - What's this?

One of the main contributors to what looks like a severe recession in the UK is a contraction of lending by our banks.

Which is why it's unlikely that a recovery will start until banks grow their lending again.

How long will we have to wait for that?

Well the chief executive of Barclays, John Varley, says in an interview with me for Monday's Panorama (8.30pm on ³ÉÈË¿ìÊÖ1) that it will take between one and two years for lending to stop shrinking.

He insists that banks are open for business, that loans are available. But he says that a reduction in the overall quantity of debt in the economy is absolutely necessary - although he concedes that the process is extremely painful.

John Varley also says that the banking industry is going through what he calls a public relations crisis, that it must apologise for what went wrong - because banks will not regain the vital trust of customers unless and until they own up to the sins of the past and say sorry.

UPDATE 09:12

Here are a few relevant quotes from John Varley.

He says: "I think that we will see the process of reduced borrowing play out over at least the course of the next twelve months maybe, maybe twenty four months. I think it's important to say though that the industry is open for business..."

Mr Varley stresses that credit remains available to businesses and households but that the amount available is "shrinking, it absolutely is, and that is a painful process; it's a process through which the world absolutely has to go and if you asked me 'when will it stop?' I think it will stop when asset prices stabilise.

"As soon as asset prices stabilise, then we will see the financial economy recover. And when will that occur? That will occur some time over the course of the next 18 months."

When he talks about asset prices, he means the price of property, shares and so on.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

A well-known wealthy entrepreneur told me last night that he'd lost about 1% of his net worth on an investment in Madoff and is setting about getting his money back from every hedge fund that he's invested in.

Nor is this chap untypical. Erstwhile superstars of the hedge-fund industry - who currently have all the glamour of the Bay City Rollers in the post Shang-a-Lang years - are braced for very substantial collateral damage from Madoff's gigantic swindle.

Many of their investors want out.

And the reason is simple. Managers of funds and of funds-of-funds, who placed their clients' money in Madoff, usually claim that they spend a great deal of time and effort looking under the hood of those to whom they entrust cash.

This excerpt from the 2007 prospectus of , the investment company which announced last week that 9.5% of its net assets had been placed with Madoff, is pretty typical: "in-depth due diligence will also be conducted on the fund managers' compliance procedures, risks systems and governance structure."

Hmmm.

Whatever vetting Bramdean and others carried out at Madoff plainly wasn't enough (I should point out here that its only because Bramdean's prospectus is a public document that I've singled it out: its losses, and therefore its grounds for turning flaming pink with embarrassment, are considerably smaller than those of many other money managers).

That these professionals apparently allowed Madoff to get away with it on such a scale for so long has shattered the confidence of many investors in hedge funds and funds-of-funds.

Which is why Madoff's shocking demise has massively increased the risk premium applicable to hedge funds: they'll find it more expensive and more difficult to borrow from banks and to retain the cash of their investors.

The $1.5 trillion hedge-fund industry, which generated half the earnings of the world's biggest investment banks and defined the debt-binge years, is shrinking before our eyes.

And as I've mentioned before, that has a negative impact on all of us.

As hedge funds deleverage, de-risk and reduce their debt-financed investments, there's a substantial knock-on to the ability of all banks to lend, because of the vicious interconnection of falling asset prices - caused by funds dumping their assets - and the availability of credit (see my notes, the New Capitalism and Made off with £50m).

Hobbled hedge funds mean weakened banks - which means less credit for us.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

It's pretty clear that taxpayers are about to .

That seemed to me to be the subtext of the mildly opaque statements on this given to me today by Peter Mandelson, the business secretary, in an interview.

is a looming crunch on debt that needs to be refinanced.

It has told Mandelson that it can't secure the finance from the private sector in the normal way. So it's asked the government - or us as taxpayers - to fill the gap.

My strong sense is that Mandelson has no doubt that Jaguar Land Rover - which employs 15,000 here - should be saved.

A good chunk of its business - though not all of it - was viable before the economy started to contract fast and car sales dropped like a stone.

And Jaguar Land Rover is responsible for a disproportionate amount of precious UK-based research and development in the automotive sector.

The main outstanding question over whether it should be propped up by us is whether its owner, , really does lack the ability to obtain the finance elsewhere.

Tata is a huge group, with a dizzying mixture of interests all over the world. It is under financial pressure, but it remains a formidable business force.

It would plainly be wrong for taxpayers to lend to Jaguar Land Rover or to underwrite lending to the group if there were other sources of finance available, but these were somehow seen by Tata as too pricey.

British taxpayers must be the lenders of last resort - not a cheap source of funds in a world where the cost of capital has risen.

It's all very well for Peter Mandelson to insist that he would only save businesses that are of strategic importance to our economy and would be sound in a world where credit was flowing freely.

Jaguar Land Rover would tick those boxes.

But he also needs to be mindful - in advertising to the world that he dare not let too much of our relatively small manufacturing sector disappear in a recession that seems particularly horrible - that he doesn't become the lender of first resort to canny mutinationals.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The US and the regard the great threat right now as deflation.

If they're right, deflation would be a disaster for our economies, for the reason set out in typically elegant fashion this morning by .

As I've been boring you rigid with for months and months now, the cause of our economic woes is that we borrowed too much - or financial institutions lent us too much (to digress for a second: there's a resonant unresolved issue of accountability and responsibility in these two ways of seeing the debt binge).

The sum of consumer and corporate borrowing in the UK is equivalent to something like 240% of our annual economic output in the UK, while US household and business debt is closer to 300% of that country's GDP. In cash money, that's about $45,000bn - or one of those big numbers that induces vertigo.

Which is quite a burden, and - as far as I can tell - a record-breaking mountain of debt for us to pay off.

The alarming and important point is that if deflation were to set in, if prices were to fall, the real burden of that debt would increase - thus prolonging and exacerbating the severe recessions that appear to be taking hold in both the US and the UK.

That's why the US Federal Reserve has set its as so close to bupkes or zero as makes no difference.

But, of course, the interest rates that businesses and consumers actually pay is much higher. So the Fed has embarked on a mission to bring the interest rates that participants in the real economy pay to as close to zero as it possibly can.

The Fed is doing this by spending hundreds of billions of dollars buying up US government debt and also loans to companies and householders - which has the effect of forcing down yields or interest rates.

By the time the US central bank is finished, it will have pumped trillions of dollars into the US economy in this way.

Over here, the Bank of England is preparing to do something similar, for the moment when its Bank Rate falls to nil (which may never come - but it would be foolish of the Bank of England to assume the zero hour will not arrive).

This process has the ghastly name of "quantitative easing". And it's not dissimilar to running the money printing presses at quadruple speed, filling up choppers with cash and then showering the population with greenbacks.

It's supposed to encourage businesses and consumers to spend rather than save, so that economic activity revives.

And it exposes the shocking paradox of our age: debt got us into this mess, but paying down that debt too quickly will only make the mess worse (or so the Federal Reserve and Bank of England believe - though I should point out that a growing number of economists are beginning to express fears that what the central banks are doing will prolong and exacerbate the crisis).

What is profoundly unsettling to central banks and governments is that growing numbers of businesses and consumers are opting to save rather than spend even as interest rates fall to these record lows.

Which is why those central banks and governments are taking ever more desperate steps to stimulate growth through increases in public spending and to make money as cheap as possible.

And that of course raises the question about whether the worst threat we currently face is deflation or inflation.

At the moment our economies turn, there's a genuine risk that central banks won't be able to drain all this cheap money from the system quickly enough to avert quite a surge in the inflation rate.

Against that background, I conducted an unscientific poll of leaders of some of our biggest multinational businesses at a lunch a few days ago.

I asked them to think about 2010, and whether they were planning for that to be a year of deflation or inflation.

To a man (this isn't me being sexist, it's that world: they were all men), they said they expected a sharp rise in the inflation rate.

They said this in a resigned way, as though it was the bill for a party that had been far too expensive and had gone on far too long.

UPDATE, 09:44 AM:

The Bank of England's monthly agents' survey of business conditions contains disturbing evidence of businesses turning down profitable orders because they're unable to obtain either loans from banks to finance the increase in working capital or insurance from specialist insurers to cover the risk of non payment.

There's also an alarming trend of businesses conserving cash and deferring or cancelling capital expenditure.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The Treasury quietly conceded yesterday that the crisis undermining banks' ability to borrow from each other and from financial institutions could last for five years.

In fact, it's likely that banks' ability to borrow on wholesale markets will never recover to the boom conditions that characterised the few years before the summer of 2007.

Either way, the Treasury is trying to help banks adjust to a prolonged funding drought by amending the terms of the it announced in October - which allows banks to purchase a guarantee from taxpayers to cover the risk of default on what they borrow from banks and money managers.

The Treasury has announced that this scheme will now run for five years, up from three years.

Which, as I say, rather implies an abandonment of the Micawberish notion that something would turn up and that banks would one day wake up to find that they weren't being shunned any longer by institutions with big deposits to place.

Also, following pressure from the banks and the Tories, the Treasury has also significantly reduced the fee payable to it for having taxpayers in effect lend money to the banks.

It has done this by excluding from the calculation of the risk premium payable to taxpayers the great surge in the perceived riskiness of banks that took place in September and October.

In effect, the Treasury has converted the Credit Guarantee Scheme from an insurance policy, which was designed to provide comfort to markets that banks wouldn't collapse for want of access to funding, into a , to replace the funds that have disappeared with the de facto closure of wholesale markets.

Or to put it another way, the scheme has been redesigned in the hope that it will now help banks to raise money for lending to all of us.

That represents a fairly substantial policy shift. And it's slightly odd that the Treasury has announced this in a whisper, through a parliamentary written answer made by Ian Pearson, a junior minister.

So far, banks have raised just £20bn from the scheme in its previous more expensive form. If the repricing means they now borrow the full £250bn on offer, as well they now might, taxpayers would be underpinning a good deal of banks' mainstream lending.

We, as taxpayers, would in effect have replaced the shrunken wholesale markets.

In respect of how the financial economy works, that's about as big a change as it's possible to imagine: so it's a shame, perhaps, to keep that quiet.

UPDATE, 09:16 AM: Bankers are, predictably, whining that the fee for raising money under the Credit Guarantee Scheme hasn't been cut enough.

And they are right that it won't allow them to raise money cheaply enough for them to be able to lend to us at the much reduced interest rates the government would like.

So there is still something of a contradiction between ministers' rhetoric about the need for banks to cut the interest rates on mortgages and loans to small business and their actions.

Even so, the CGS reforms represent a significant policy shift - and it won't be the last initiative by the Treasury to underwrite lending to financial and to non-financial companies.

Taxpayers are the new wholesale financial market.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The transformation of the years of easy credit into a financial nightmare for many big companies is illustrated by the Bank of England in its , which was published overnight.

This transition from credit feast to credit famine is depicted in a chart of the maturity profile of outstanding European corporate debt (stay awake, this matters to you).

What it shows is that next year, 2009, there will be a massive bulge in the value of bonds issued by European companies that have to be repaid.

Or, to put it another way, about $1000bn of "old world" companies' borrowings in the form of tradable debt has to be paid back during the next 12 months - with something like $800bn of this owed by financial companies and $200bn by non-financial companies.

That would be a colossal sum to pay off at the best of times, and is equal to about five times what's been repaid in 2008.

It is a disturbingly huge amount, at a time when even the bluest-of-blue-chip companies are finding it difficult and expensive to raise money by selling new corporate bonds.

More or less every chief executive and finance director I know is agonising about how to obtain debt finance - and is having very unsatisfactory conversations with banks.

Here's the Bank of England's characteristically euphemistic account of the implications: "a large volume of corporate debt matures towards the end of 2008 and over 2009, which presents significant refinancing risks for firms".

What's likely to happen is that Europe's biggest and strongest companies will vacuum up whatever meagre credit is available from malfunctioning wholesale markets and banks.

And that, in turn, means that weaker businesses, those most desperate for credit, are going to find that conventional sources of credit are simply not available to them.

Their desperate plight - their almost complete inability to raise vital finance - is shown by another Bank of England chart. It plots the market price of European leveraged loans - banker-speak for the debt of companies with big borrowings - which has collapsed to 65 cents in the dollar on average.

To translate: companies with large debts are only expected to pay back two thirds of what they owe, which doesn't make them a sound banking proposition in our harsh new world of tighter-than-tight credit.

So lots and lots of companies won't be able to raise the finance that would keep the bailiffs away, unless taxpayers step in as the lender of last resort.

Taxpayers have already done that to the tune of £600bn and rising for British banks (see my note "How much will taxpayers finance economy?"). And, as I've been pointing out for some time, we are being asked to provide life support to a swathe of the real economy, from steel makers to car manufacturers.

The Government will succumb and will lend taxpayers' money to non-financial companies.

In a way, there's no choice, because we'll be hobbled for years as an economy if our few remaining manufacturers and exporters are wiped out.

But many will urge that companies which borrowed recklessly in the good years - often to generate unsustainable growth in profits that triggered bonus payments or to finance excessive special dividends - should not be bailed out.

Though in punishing imprudence we would be foolish to punish ourselves.

The trick for government, therefore, would be to rescue fundamentally viable businesses, while somehow leaving feckless management to swing in the wind.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

I am told that "Madoff" is pronounced "made off" - as in "he made off with the money".

That's the end of the jokes.

The supposed $50bn swindle by at his hedge-fund and securities trading business is serious stuff.

It's possible that Mr Madoff's $50bn estimate of how much he's evaporated is an overstatement. But there will be losses for investors in his funds, such as clients of Nicola Horlick's .

Perhaps more troubling are the implications for the multi-trillion dollar hedge fund industry in general.

This industry is rapidly contracting, as the likes of Morgan Stanley and Goldman Sachs reduce the credit they provide to funds.

And the collapse of Madoff is likely to to accelerate the disappearance of funds - in that it may persuade many investors to demand their money back from even high qualiity funds and funds of funds.

Investors will note that regulators have taken long, hard looks at Madoff over many years, and failed to detect fraud.

Which will make investors fear - however irrationally - that no hedge fund can be deemed wholly safe.

If investors demand their money back, there would be wholesale dumping of assets by hedge funds.

And that would compound losses for them, as the price of assets would fall - and it would prompt demands by creditors for hedge funds to put up more collateral (margin calls), which would lead to further asset sales.

All of which would mean that the moment when share prices, property prices or any other asset prices find that elusive floor would be deferred yet again. Which matters to anyone saving for a pension and for banks' ability to turn on the credit tap again.

Which is why, as I said, it would be unwise to chuckle at Madoff's mad mess.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

There's a great deal of grim news around this morning.

I'm hearing very bleak reports about prospects for , the wholesaler of music, electronic games, DVDs and books, that's owned by troubled Woolies.

A significant slimming down of Entertainment UK now looks likely, I am told - which would be bleak indeed for its employees, who number well over 1000.

Also, HBOS - owner of the Halifax - has reported a significant increase in the charges it takes for bad debts.

If you add together HBOS's investment losses and securities losses with an incremental impairment charges on mortgages, personal loans and corporate loans, there has been a £3bn rise over just the last two months in all these categories of loss.

So that's £3bn of additional loss incurred by HBOS, owner of the Halifax, since 30 September.

Not nice.

The most horrible trend is in lending to big companies. For the first 11 months of the year, the impairment charge on corporate loans is £3.3bn, an increase of 560% since 30 June.

That says a great deal about how the economy has deteriorated since the summer. But it also implies that HBOS's corporate lending department was taking excessive risks.

For the year as a whole, HBOS is also going to suffer a loss on unsecured lending to consumers in excess of £1bn.

As for the impairment charge on mortgages, that's £700m for the first 11 months of 2008 - but rising very fast indeed.

Finally, there's the .

That's causing massive anxiety in the British car industry - and is particularly alarming for Vauxhall, the British subsidiary of General Motors.

Vauxhall employs 5,000 directly and countless others indirectly at suppliers and distributors.

My understanding is that the Business Department views Vauxhall as "viable" - which is its test for whether it should receive state support, if the worst were to come to the worst and General Motors itself were to collapse.

So the moment when we as taxpayers start providing financial help to individual motor manufacturers, to keep them alive through the acute phase of our economic contraction, is fast approaching.

UPDATE 1300 GMT:: The administrators to Entertainment UK have announced that they are "scaling down" efforts to find a buyer for the wholesaler and are making 750 employees redundant. It looks very unlikely that this supplier to the big supermarkets will survive.

There will be pain for book publishers, electronic games creators, DVD publishers and music businesses. And there will also be disruption to retailers, notably Zavvi, the chain of music stores.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Corus tells me that the employee pay-cut proposal is one of only a series of measures being discussed by Corus's management and workforce.

Those discussions seem to be constructive. A strong survival instinct seems to be dominating the approach taken by management and unions.

But it seems unlikely that such a pay cut would eliminate the need for redundancies, such is the scale of the collapse in demand for steel that has taken place.

So , Corus's chief executive, has lobbed the ball over to government, by asking for temporary financial help.

What Corus would like to see in the UK is a version of a scheme recently introduced in the Netherlands, by which the Dutch government pays up to 70% of the salaries of struggling Dutch companies for up to 24 weeks.

The point of the Dutch scheme is to keep employees on the books of stretched companies during the most acute phase of the economic contraction - in the hope that the relevant companies can afford to pay wages once more, when the recovery begins.

There's certainly a logic to the Dutch safety net, in that it should mean that important companies don't permanently lose access to a trained, skilled workforce.

But, if introduced in the UK, it would involve ministers making a nightmarish judgement about which companies and employees deserve such a subsidy and which should be left to stand or fail on their own.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

When workers at and to preserve jobs, it's legitimate to ask whether a rise in inflation was ever the kind of serious threat it was perceived to be earlier this year by the .

The MPC delayed cuts in interest rates, because it feared that rises in energy and food prices could feed through into higher endemic inflation through pressure from employees for compensatory pay rises.

There were plenty of voices outside the Bank of England questioning whether this was a well-grounded fear, given that the Thatcherite and post-Thatcherite reforms of the labour market have decisively tilted the balance of power in the workplace away from collectively organised employees towards employers.

However, on the MPC itself, Danny Blanchflower was a lone voice arguing that the inflationary risks were much smaller than the deflationary pressures of an economy slowing down fast.

Blanchflower has won the argument by knockout - though he may regret it, in that there's plenty of evidence that our economy is even weaker than he may have feared.

The pressures of frequently being the minority of one on the MPC were not easy for him. And he's decided that he's had enough of this particular game of soldiers, and he's therefore standing down in May.

Which some will see as something of a loss to the quality of the debate on the MPC.

As for the implications of the offer by Corus's trade unions of a 10% across-the-board pay cut for 25,000 employees, they seem to me to be significant.

The hope of the unions is that such a big reduction in the wage bill of Corus - albeit a cut that would last for just six months - would avoid the need for the Llanwern plant in south Wales to be closed.

And the unions would hope that those who manage Corus would also take a 10% cut, in an act of solidarity.

Their initiative is redolent of a collective determination to avoid unnecessary hardship in the very painful recession that appears to have gripped most rich countries including the UK in a particularly severe way.

Their behaviour is consistent with the possible re-making of capitalism I described in the note I put out on Monday (see "The New Capitalism").

But the initiative will be derided by the red-in-tooth-and-claw managers of the 1980s and 1990s, who would see it as a Micawberish fudge to delay a necessary permanent reduction in the overheads of a business that needs to adjust to harsh new economic realities.

So it may not be a life or death moment for the "sauve-qui-peut" dogma that has ruled in boardrooms and also conditioned governments' industrial policies for almost 30 years. But it's certainly a significant moment.

UPDATE, 10:13 AM:

Michael Leahy, general secretary of the Community union, said this to Radio Wales:

"Any proposals which have come forward have done so as consequence of proposals that have been put by the company. We've commented on those and put forward a number of alternatives and we haven't reached a conclusion.

"They've put a number of proposals including a general pay cut. They've not even suggested this is an alternative to reductions in the workforce or closures, but we know however if the order book stays as it is for a long period of time, then we know structural changes may need to take place in Corus."

He said members would be informed a range of options were on the table but they and Corus were committed to avoiding closures and job losses, if at all possible.

"We realise that there's been a global downturn in production of steel and people wanting steel - in fact we realise there's been over 40% reduction in the order books for steel in Corus UK and Europe-wide.

"We've been discussing a range of possible arrangements to ensure we have a sustainable industry going forward and to protect the interests of our members - they have mortgages and commitments. We didn't want a dramatic impact on their jobs or ability to earn as a consequence of this crisis."

• Bookmark with:
• |
• |
• |
• |
• - What's this?

There's shocking evidence this morning of the magnitude of the global economic slowdown from Rio Tinto's swingeing expenditure cuts. But there are also signs of evasive action by the Treasury to prevent the continuing squeeze on bank lending from magnifying what looks like a very sharp recession in the UK.

Remarks yesterday by the Chancellor (see ) suggest that the Treasury is making progress on initiatives to facilitate increased bank lending to the real economy.

For detail on what the Treasury is considering, see my note of Friday (How much will taxpayers finance the real economy?).

Putting the mechanics to one side, the government is edging towards a scheme that would have the following important characteristics:

• taxpayers would underwrite bank lending to the real economy, or the provision of loans to business and to the housing market;
• the cost of that taxpayer support for banks would be cheaper than the main existing scheme, the £250bn credit guarantee scheme, and access to the support would be easier and quicker for banks;
• the help from taxpayers would be in place for perhaps as long as five years, or longer than the three years of the credit guarantee scheme and of the £200bn special liquidity scheme (which allows banks to swap mortgages for easy-to-sell Treasury bills);
• the overall design of the new arrangements would mean that the state would in effect be borrowing to provide funds to banks, thus in part filling a massive hole for them caused by the virtual closure of wholesale markets.

To put it another way, taxpayers would become lenders to the real economy to the tune of several hundred billion pounds, on top of the £600bn of support we as taxpayers have already provided to the banking system in the form of loans, guarantees and the injection of capital.

That may sound scary. And it would certainly be foolish to assume that money managers, who are supposed to buy all the debt issued or guaranteed by HMT, won't at some point get a seriously bad case of the heebie-jeebies about the rising burden of our public-sector liabilities.

But even the Tories say that extending and easing taxpayer guarantees for bank lending would be a good thing, presumably because, like many, they view the alternative - bank lending continuing to shrink and thus exacerbating the deep problems already being experienced by businesses and households - as much scarier.

There's no ignoring the powerful recessionary forces that threaten us. For example, the - which is never knowingly sensationalist - that it believes that the economy shrank by a worse-than-expected 1% in the three months to the end of November.

Also, a shocking announcement of is a microcosm (albeit a very big microcosm) of savage recessionary trends highlighted yesterday by the World Bank.

Hailing the end of a "historic commodity price boom", the World Bank forecasts that world trade will shrink by 2.1% in 2009, the first contraction of world trade since 1982.

Part of that is a manifestation of the amazingly shrunken appetite for raw materials of the world's great manufacturer, China. And Rio doesn't expect a recovery in Chinese demand until the second half of next year.

The World Bank says that "the possibility of a serious global recession cannot be ruled out". And you only have to look at what Rio Tinto is doing to see why a cut in the world's economic output is far from impossible.

The giant mining conglomerate is reducing its "controllable operating costs" by a colossal $2.5bn a year. Its capital spending is being reduced by $5bn next year to $4bn - and it gives no guarantees there'll be a revival in 2010.

Those attempts by Rio to generate cash and thus reduce its massive borrowings of $39bn will cause disappointment and indeed hardship in many communities all over the world.

In developing countries, for example, belt-tightening by companies like Rio will have a profound effect. According to the World Bank, net flows of lending and investment to developing countries are projected to shrink from $1000bn in 2007 to $530bn next year - a reduction of almost half.

The official forecasts of the World Bank are that in 2009 the world's "high income" economies will shrink by 0.1% and the global economy will expand .

To put that into context, in recent years global growth has been nearer 4%. So although the global economic mess was largely generated by the financial excesses of the richest countries, notably the US and (in a supporting role) the UK, no country will be wholly insulated or protected.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

The contraction of the world's developed economies that we're witnessing represents the end of an era. Taxpayers have been forced to support the banking system and the real economy on a scale we've never seen before.

For many years to come, what's happening will affect the relationship between business and government, between taxpayers and the private sector, between employers and employees, between investors and companies.

A new capitalism will emerge from the rubble.

Please click here [pdf] for my thoughts on how we got into this mess and what the re-made economy will look like.

UPDATE 06:41AM, 9 Dec: As edwddprice noted, the £9bn on page 6 was a typo. It should have read £9trn or £9000bn. It has now been fixed in the pdf.

UPDATE 10:18, 3 Jan: There's another typo on page 2 of the pdf. The word "current" should have been "currency" (goodness knows how I failed to spot that). So the correct phrase should be "the gross foreign currency liabilities of our banks".

• Bookmark with:
• |
• |
• |
• |
• - What's this?

During assorted meetings with hard-bitten business leaders and politicians last week, I was surprised by how star-struck they are with Barack Obama.

In these fraught economic times, the world needs a hero. And whether he likes it or not, the floundering global elite appears still to be looking west, and to the US president-elect in particular, for the white-hatted cowboy who'll save us all.

You can see these hopes and expectations in the way that stock markets soared across the world after Obama announced on US television that he plans to invest in US infrastructure on a scale not seen since the US highway-construction programme of the 1950s.

Although he gave more details of his proposals than is normal in these transition weeks - making it clear that his first priority is to stimulate economic activity and that reducing colossal US public-sector debt will have to wait - the reaction of stock markets is largely emotional.

As I write, the German and French markets are up well over 6% and the London Exchange is 4.6% higher.

Also, sterling has recovered slightly, which may be more rational in that the UK's vast and rising indebtedness looks trivial in absolute terms compared with the ballooning borrowings of the US. But sterling's resilience may not last, in that the more the US government under Obama has to borrow, the less appetite and capacity there may be among investors for the colossal sums our government has to borrow.

The big and obvious point is that an extraordinary, frightening responsibility is being placed on Obama. At a time when most would say that globalisation has undermined the power of most elected politicians, there appears to be a widespread belief that one newly elected leader will have near-magical powers.

And he looks strikingly relaxed, in spite of an economic reality that's dire.

Here in the UK, that's confirmed (yet again) by a this morning showing that the contraction of the UK's all-important service sector is accelerating.

The next big decision for politicians in the US and UK who actually have their hands on the reins of power, rather than one about to take over, is how to help the devastated motor industries.

What's being discussed in Congress looks awfully like direct state control of GM, Ford and Chrysler, as the price of any financial rescue.

Here in the UK, the Treasury and the Business Department are also assessing requests for loans from car makers.

I'm absolutely certain they - or rather we, as taxpayers - will provide succour.

What ministers and officials will wish to do is simply fill the financing gap created by the malfunction of the banking system and of financial markets, rather than propping up lame ducks.

Governments normally get these judgements horribly wrong - and doubtless you'll shout at me if I were to even suggest that this time it might be different.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

There has been an by this morning.

One of its two founders, David Ross, has resigned as deputy chairman, following his disclosure to the mobile phone and internet group that between 2006 and 2008 he pledged 136.4m of his shares in the company as collateral against personal loans.

This is significant for two reasons.

First, under Stock Exchange rules, each time directors pledge shares in this way as collateral, their companies are supposed to make an announcement.

Ross failed to inform Carphone Warehouse that he had committed his shares in this way until 7 December.

It's not clear why he failed to keep Carphone in the picture in the appropriate way. Nor is it clear what kind of action, if any, will be taken by the Financial Services Authority, the City watchdog, against this apparent breach of the rules.

As I understand it, Ross feels he was guilty of an administrative oversight. But it's a pretty embarrassing oversight.

Second, although Ross has told Carphone that "none of these loans is currently in default", there is also an implication in the company's statement that he may at some future date be forced to sell some or all of the shares.

Carphone says that Mr Ross has "given an undertaking to the board to facilitate an orderly market, where possible, for any future disposal of shares in the company."

According to Carphone, earlier use by Ross of his shares as collateral means that 177m of his shares are pledged against loans, equivalent to about a fifth of the entire company.

Investors will therefore see this morning's announcement as raising great uncertainties about the future ownership of that fifth of the company - which at a time when life is so difficult for all retailers is something of a pain for Charles Dunstone, Carphone's chief executive, and his executive team.

It's also something of a personal shock for Dunstone. He was at school with Ross, or "Rosso" as Dunstone calls him. He founded the company with him. And it would be understandable if he felt a bit let down this morning.

UPDATE, 08:47 AM:

David Ross is a pretty well-known character on the British corporate scene. In May, the Mayor of London, Boris Johnson, appointed him to look after the financial interests of Londoners in preparations for the 2012 Olympics. Ross became the Mayor's nominee on the London Organising Committee of the Olympic Games.

He's also a director of National Express and Big Yellow Group.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

You know the world has changed when Jim O'Neill, the chief global economist of - the investment bank that defined the culture of bonus-driven, globalised financial capitalism - grumps on the that our government probably needs to create a state bank that will provide the vital credit that our commercial banks cannot provide.

He's been banging on about this for months - because, as you know, it's been obvious for rather longer that the source of our economic woes is the savage contraction of lending by banks all over the world.

And the credit squeeze is particularly acute here.

So Goldman Sachs votes for socialist, state-directed lending. The symbolic power of this thought is mind-numbing, for those of us who immersed ourselves in the liberalised, winner-takes-all financial markets of the past 25 years.

Next week I'm going to write about the long-term implications of the failure of financial markets and the rise of the taxpayer as the new source of credit for the banking system and the real economy.

What kind of capitalism will emerge from the rubble?

But right now I want to look at the contradictions in government policy towards the banks - and the difficult choice it faces about how to revive lending.

The important point, which I've made many times before, is that the £600bn (and rising) of loans, guarantees and capital provided by taxpayers to rescue the banks does not encourage them to lend more, and may actually contribute to the contraction of lending.

For example, the terms of the £250bn credit guarantee scheme - which allows banks to borrow for up to three years from markets with taxpayers standing behind that debt as guarantor - are extremely expensive. So banks have no incentive to take advantage of the scheme to raise funds for lending to all of us.

The £200bn they're raising from the by swapping mortgage-backed securities for bills has to be paid back in three years - which does not feel to banks like an eternity at a time when there's a global shortage of capital and credit.

And the preference shares that three of our biggest banks have been forced to sell to taxpayers are very expensive for these banks. So they want to redeem them as soon as possible - thus giving them another powerful incentive to shrink their balance sheets, reduce lending and prove to regulators that they no longer need the preference capital.

Then there's the impact of the global rules on how much capital banks need to hold relative to certain kinds of loans. Those rules make it hideously expensive for banks to provide mortgages to first-time buyers, by stipulating that banks have to hold massively more capital for a mortgage when the deposit on a house is 15% of value compared with when its 25%.

Also, as house prices fall, Basel II obliges the banks to raise yet more capital to cover the declining value of collateral held against their £1,200bn of mortgages.

Finally, as the confirmed yesterday, the banks are being forced to hold hundreds of billions of pounds of additional government bonds.

Why?

Well, government bonds are liquid, so when banks have relatively more of them the risk is reduced that they'll fall over (a la Northern Rock) after wholesale markets shut down in the way they did in August 2007.

Which is all very well, except that the more gilts and other high quality government bonds that our banks are obliged to buy, the less capacity they have to lend to households and businesses.

So what are the policy options for government?

Well, the Treasury could, for example, revise the terms of the Credit Guarantee Scheme and perhaps expand it, so that banks start to use it on a substantial scale to raise money for lending to all of us.

And it could also provide taxpayer guarantees for other, more long-term borrowing from money-managers and other financial institutions - something along the lines of the sovereign-guaranteed, mortgage-backed securities proposed by Sir James Crosby in his recent report for the Treasury.

I get the feeling, however, that Crosby's narrow suggestion for how to revive the mortgage market has rather slipped down the Treasury's list of priorities.

What is higher up the government's agenda is an increase in explicit taxpayer support for any kind of lending to the real economy, or lending to small businesses, big businesses and households.

It could take a number of forms.

There could be taxpayer guarantees for real-economy loans packaged up into bonds, similar to what Crosby suggested for mortgage-backed bonds.

However, there is evidence from markets that even if these bonds were converted in this way into the equivalent of UK government bonds, so that they were an explicit claim on taxpayers and the state, they still wouldn't be bought by money managers.

You can see this in the failure of , a wholly nationalised bank, to increase its funding on attractive terms from wholesale markets.

Money managers apparently don't want to buy into the UK housing market, even when the risk is covered by HMG. And they may have the same qualms about buying any kind of asset-backed security, even when it's gilt-edge or underwritten by taxpayers.

So there are two alternatives. One would be O'Neill's state-owned, state-funded bank.

The other would be a longer-term, broader more ambitious version of what's already happening here and in the US. Which is that banks could package up loans to businesses and households and then exchange them for cash from the Bank of England.

In effect, we as taxpayers would be funding the bulk of the real economy.

It sounds extreme. There are big and serious issues about whether such an initiative would be perceived by international investors as seriously weakening the strength of the public-sector balance sheet, such that there would be a damaging run on the pound.

And it would probably only persuade our banks to lend more if there was a commitment from the Treasury and the Bank of England that this funding from taxpayers would be available for many years (certainly much more than three years) - which would represent a radical re-making of how capitalism operates.

However, such a substantial increase in the provision of credit by taxpayers has to be a serious option, because the sunny economic uplands won't be visible again until a solution is found to the vicious, inexorable contraction of lending.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Michael Coogan, the director general of the , is grumpy with me (and said so today on the News Channel), because he thinks I implied yesterday that the big surge in repossessions that the CML expects next year will be due to our biggest banks and building societies seizing homes.

I was amazed he drew that implication from yesterday's blog (see "Repossessions 'to rise to 75,000'").

To be honest, it never crossed my mind that I was singling out any particular type of lender as being more responsible than others for the rising trend to repossessions.

I merely pointed out that the CML had briefed the government that it expects repossessions to rise to 75,000 next year, within a whisker of the record number of homes seized in the last recession, in 1991.

But Coogan's explanation of why he's grumpy is jolly interesting. It's that he sees subprime lenders and specialist lenders - those brief-lived corporate creations of the debt bubble - as the main contributors to the spike in repossessions.

Most of these higher-risk lenders are writing no new business. In 2007, there were 37 subprime lenders happy to lend to customers perceived as less than blue chip. Today there are almost none - and there's also been a collapse in the number of lenders offering self-certified mortgages.

I'm unclear whether Coogan categorises Northern Rock in this non-mainstream category - since it was funded largely in wholesale markets, as were most of the subprime and specialist lenders.

Also the Rock's Together Mortgages were anything but mainstream, in that they gave homebuyers and re-mortgagers the ability to borrow up to 125% of the value of the relevant property.

The resonant point is that Together borrowers are finding it much harder than other Northern Rock borrowers to repay (doh!).

Anyway, if Coogan is right and the repossession increment is principally caused by a rise in arrears at firms providing subprime and secondary mortgages, then it will be harder for any government policy to reduce the rise in repossessions.

How so?

Well, with the future so bleak for subprime and specialist lenders - in the sense that they were too dependent on wholesale markets that are unlikely to recover for years, if at all - those lenders are primarily interested in getting their money back as soon as possible.
And as their borrowers fall into difficulties, these lenders may have little incentive to help those borrowers over the hump - even if they receive support from Gordon Brown and taxpayers, as per yesterday's mortgage guarantee scheme (see my note, "Taxpayers Mortgage Guarantee").

The subprime and specialist lenders will have noticed (ahem) that property prices are still falling sharply, and that there could be a massive financial cost to them of waiting two years before seizing and selling a property.

Bottom line?

I wonder whether Gordon Brown's evasive action to stem repossessions next year will prompt the CML to reduce its expectations of repossessions next year by any significant extent.

We could yet see a return to the repossession levels of the early 1990s (and to repeat what I said yesterday, the 75,000 number for home seizures in 2009 is not yet the CML's formal forecast - but is its expectation based on current trends).

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Part of the reason we're in such an economic mess is that, over the past few years, we (that's individuals and businesses, in this case) borrowed considerably more than we saved.

A cause both of the initial funding/liquidity crisis of our banks and of the subsequent solvency crisis was that the loans and other assets of our banks grew at a much faster rate than deposits from customers, such that the gap reached about £700bn earlier this year.

To put it another way, consumers and businesses (big businesses, NOT small ones), borrowed considerably more than what they deposited with banks.

We saved far too little in general. But, in particular, we placed far too little cash in the banking system. Or perhaps it's the other way round, that banks foolishly lent considerably more than we had deposited with them: they became lending machines, not havens for savings.

Either way, that gap of £700bn had to come from somewhere. And it came from wholesale markets, much of it from money managers and institutions outside the UK.

Since the summer of 2007, in fits and starts, those providers of wholesale funds have been demanding their money back. But those banks had already lent all that money to us, in the form of mortgages or massive corporate loans, so the cash wasn't readily available.

Which is why weaker banks, like Northern Rock and Bradford & Bingley, have had to be wholly nationalised and Royal Bank of Scotland is now largely state-owned.

And it's why the entire banking system is being funded to the tune of £600bn and rising by taxpayers, because taxpayers have had to step in to fill the funding gap created by the closure of wholesale markets.

To state the bloomin' obvious, our previous excess of borrowing over saving has now led the banks to lend considerably less than they were (to deleverage, to use the ghastly jargon), which has been a principle cause of the economic contraction that looks increasingly like a nasty recession.

If you're in a recession, what do you do? Well, if you're the Bank of England, you cut interest rates - to stimulate economic activity.

And today , perhaps by one percentage point to 2%, a rate we haven't seen in the UK for more than half a century.

As always, there'll be a massive political and media fuss to ensure that the cut in interest rates is "passed on in full" to borrowers of mortgages and other loans.

The chancellor and the business secretary will presumably warn the banks again that they're keeping a beady eye on them, to ensure that borrowers reap the benefit of the Bank of England's reduction.

But there is a paradox here. Part of the cause of our woes is that we saved too little and borrowed too much.

Yet by cutting interest rates the Bank of England is - in a way - punishing the thrifty and rewarding the feckless.

Although it's not quite as simple as that, because even the thrifty would be in the doo-doo if we plunged into the deepest, darkest recession.

Even so, there is an absolute imperative for banks to reconstruct their balance sheets in a more sound and stable way, and that means funding more of their loans from our deposits and funding fewer on wholesale markets.

For Royal Bank of Scotland and HBOS, for example, its vital that they attract more retail deposits - or they'll suffer very serious long-term shrinkage of how much they can lend (unless, as I've pointed out ad nauseam, we as taxpayers are comfortable financing them more-or-less forever).

So if the Bank of England were to cut interest rates by 1% today, would it be rational for a bank such as Royal Bank to slash savings rates by 1%?

If it did so, wouldn't it be punishing savers whose support it dearly needs?

But Royal Bank and others would only be able to afford to reduce savings rates by less than 1%, if it were to cut lending rates by less than 1%.

It's a dilemma, isn't it?

Small businesses are at the sharpest end of this dilemma, because for all the understandable fuss about banks restricting credit to them, as a group they actually save more than they borrow.

So although most of the banks are committed to passing on the Bank Rate cut to small businesses in the form of lower rates on loans, arguably small businesses would be more out-of-pocket if the meagre amounts they earn on their deposits were to evaporate completely.

For what it's worth, where banks have discretion, I'd be amazed if they passed on the full cut to mortgage holders.

Would that be a scandal?

Perhaps not, if banks were to maintain interest rates on savings accounts at higher levels.

In the scale of alleged bank boo-boos, what's worse? Failing to pass on all the interest rate cut to hard-pressed families, or slashing the retirement income of elderly couples who live off the interest on their bank and building-society savings?

As I say, it's a proper old dilemma.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Gordon Brown has just announced a scheme which he hopes will lead to significantly fewer repossessions next year than the 75,000 currently expected by the CML.

It's an attempt to provide assistance for two years to those families which suffer a fall in income as a result of the UK's economic woes.

The scheme is probably best explained by way of an example.

Let's say Mr and Mrs Slightly-Stretched have a £400,000 mortgage, which is the biggest mortgage allowed under the government's new bailout scheme.

Both have jobs. Rory Slightly-Stretched is a manager in the building industry and Melissa works as an estate agent.

Toward the end of this year, he's made redundant and her income collapses.

So they are no longer able to keep up the payments on their mortgage.

They then talk to their bank and calculate that they can only pay £5,000 a year of the £20,000 annual interest payments they're supposed to make (I am ignoring principal repayments).

In those circumstances, their home is seriously at risk: the bank may well decide to seize their home and sell it.

What's happened today is that the prime minster has made it less of a financial strain for the bank to leave the Slightly-Stretcheds in their home, for a maximum of two years (which the government hopes will be long enough for Rory and Melissa to get back on their feet, in a financial sense).

What Mr Brown has announced is that if the £15,000 a year which the Slightly-Stretcheds can't pay is added to the principal they owe - if the bank allows the interest to be rolled up, to use the jargon - there will be no risk for the bank, because the Treasury will guarantee that £15,000.

Or, to put it another way, the taxpayer will promise to pay back the bank that £15,000 if the Slightly-Stretcheds find themselves unable to do so. So that sum of £15,000 will become a contingent liability of the public sector.

In this notional case, taxpayers would end up being liable for £30,000 (£15,000 for the two-year life of the scheme).

But, to repeat, the £30,000 would only end up being a genuine cash cost for us as taxpayers in the event that the income of the Slightly-Stretcheds were never to recover or the value of their property were never to rise above the value of the mortgage.

It's all quite complicated, but the banks plainly think that the scheme has merit, since eight of the biggest have signalled that they'll back it (or so I'm told).

However, the scheme is not completely free for the banks, in that I understand they'll have to pay a fee for the guarantee. Also, there is a cost to banks of not repossessing from the incremental capital they have to allocate to any mortgage when the earning power of the relevant borrower collapses (sorry if this is a bit technical).

On the other hand, the legal and admin costs of repossessing are always pretty big, so banks don't like to repossess if they can possibly avoid doing so.

In other words, Brown's mortgage wheeze could lead to a serious fall in the number of homes repossessed next year - though there must be a fear that a repossession bulge will simply be delayed for two years rather than eliminated altogether.

You'll want to know what the cost of all this for the taxpayer would be. For what it's worth, my calculation is that it'll lead to taxpayers guaranteeing somewhere between £900m and £1.4bn of rolled up interest (the Government is saying around £1bn).

Which, in the context of the £120bn or so that the government expects to borrow next year, is almost a rounding error - and some will say is cheap at the price, if it were to prevent 20,000 or so families being evicted next year (but see below).

UPDATE 19:00

I've become a bit wary of the Government's claim that the eight biggest banks have backed the mortgage-guarantee scheme, having spoken to a couple of them.

They're not prepared to attack it in public. But they're not sure it will have much of an impact, unless they are strong-armed into keeping the genuinely feckless in their homes - which the banks feel would be a bad thing.

Also, Margaret Beckett, the housing minister, has just said on ³ÉÈË¿ìÊÖ Five Live that a bank has estimated for the Government that the scheme will help perhaps 9,000 families who would otherwise have lost their homes.

That's rather smaller potatoes than the Prime Minister implied - although, as Mrs Beckett also said, the existence of the scheme may alleviate the anxiety of many more hard-pressed families.

• Bookmark with:
• del.icio.us |
• Digg |
• Newsvine |
• |
• Reddit
• - What's this?

, ministers have been told by the .

This would take repossessions very close to the peak of 75,500 reached in 1991, during the last British recession.

It compares with the Council of Mortgage Lenders' current forecast that 45,000 homes will be repossessed in the current year.

In 2007, 26,200 homes were repossessed.

The bulk of repossessed homes are owner-occupied. So far this year, just 2,700 buy-to-let properties have been repossessed.

The Council of Mortgage Lenders told me that it hasn't yet finalised its forecast for repossessions in 2009, saying it was waiting to see whether ministers would take action to reduce the surge in the number of houses where families are evicted and their properties are sold.

However, it didn't deny that it has informed the government that there will be 75,000 homes seized by banks and building societies next year on current trends.

The government has been looking at ways to protect families from the trauma of losing their homes when a breadwinner loses his or her job.

• Bookmark with:
• del.icio.us |
• Digg |
• Newsvine |
• |
• Reddit
• - What's this?

I dread this time of year - because if you're in my trade, it's an exhausting season of parties hosted by chief executives, ministers, editors, ambassadors, even prelates.

You'll doubtless ask why, as an ungrateful and ungracious bah-humbug Scrooge, do I join the festive throng. Well, they are an excellent place to test the climate of opinion of those with the economic or political power to influence most of our lives.

And right now, the climate is grim - and the forecast is worse.

It won't surprise you that those who run our biggest retailers are utterly fed up.

What does surprise me is that those I've met recently are furious with the government for cutting VAT.

Partly it's the cost and hassle of changing all their prices that irks them.

But mostly it's that they don't believe the 2.5% cut in the VAT rate will increase their sales. I lost count of the number of times I was told that the £12.4bn cost to the of the change was "money down the drain".

All they see is an unstoppable trend of consumers spending less - and the big shopkeepers tell me they would have cut their prices, with or without the tax reduction.

They believe that a reduction in income tax or an increase in tax credits for those on lower pay would have been a more effective stimulus.

We'll see.

In my experience, retailers are always grumpy about something. But they are at the frontline of consumer spending, so it would be foolish to ignore them.

Only one group is more miserable than the retailers: the bankers and investment bankers.

The investment banks are as challenged and threatened as the coal mines in the 1980s. Those running them tell me they're planning to make further significant job cuts between now and the end of January. "We've cut so much, we've become anaesthetized to the process" said one.

Another told me that the latest round of redundancies would be pretty indiscriminate: "it's about simply getting the numbers down now" he said.

There is one common theme to the shrinkage at these leading investment banks. They are massively cutting back the businesses that provide services and funds to hedge funds - which has the knock on effect of wreaking havoc on the hedge fund industry.

"We're going to see the closure of well over half of all hedge funds" a banker told me.

Which brings me to the professional investors, who are the most dazed and confused of all those on the party circuit.

"Where oh where do we put our money?" said one.

That's not what you want to hear from someone who manages the pensions and retirement savings of many thousands of us.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

December 1 2008 is a historic day for British banking - because it's the day when the chancellor by his deeds (if not his words) made clear that he's providing 100% protection for all retail savings and deposits in British banks.

How so?

Well in normal times, savers in a small bank such as London Scottish would have been protected only up to the limit of the , which is £50,000 per saver.

London Scottish defines the notion of a marginal bank. It is a genuine tiddler, with deposits of just £273m, and is not by any stretch of the imagination a vital cog in the financial system.

In normal times, its collapse - which was - would not pose a serious threat to the banking system. And therefore the rule of caveat emptor would apply to those who chose to deposit their cash with it.

But these are not normal times.

The chancellor fears that if any saver were to lose out from the demise of London Scottish, that could prompt significant and damaging withdrawals of funds from other small banks and building societies.

To use the regulators' lingo, there would be contagion, possible runs at all but the very biggest financial institutions.

There are for example about 40 building societies with deposits of less than £1bn each.

So Alistair Darling has taken the extraordinary step of promising that no retail depositor in London Scottish will lose a bean, that all depositors will get all their money back, even if they've deposited more than £50,000 at the bank.

If savings in a bank as small as London Scottish are fully underwritten by the Treasury and the taxpayer, then in practice there is 100% taxpayer protection for all retail savings in British authorised banks.

Which begs the question why the chancellor doesn't simply acknowledge the reality and formalise this 100% guarantee.

That he hasn't made explicit that he's adopted a policy of total deposit insurance won't make life any easier for him, as and when some kind of normality and calm returns to the banking system.

The chancellor will, at some point, have to stand up and say that the £50,000 limit is a real limit. As and when that happens, there may well be a drain of funds out of small banks.

So surely it would be better to explain now why he's guaranteeing all banks' retail liabilities so that there's some coherence to any subsequent decision to withdraw the guarantee.

And if he were to guarantee the deposits in an explicit way, he might also be able to negotiate some kind of fee or reward for taxpayers from the bank beneficiaries.

• Bookmark with:
• |
• |
• |
• |
• - What's this?

Stephen Hester, the new chief executive of Royal Bank of Scotland, is perhaps showing unusual common sense for a banker.

On taking one of the hottest seats in corporate UK, he decided that his priority had to be to prevent his industry becoming public enemy number one - which is a genuine risk, since the excesses of his industry made quite a contribution to the economic mess we find ourselves in.

So it was his initiative - rather than an instruction by ministers - that Royal Bank will delay the start of proceedings to repossess the homes of those .

The owner of NatWest, which has about 7% of the housing market, announced late last night that it would postpone the beginning of the process to seize a residential property till the overstretched borrower is six months in arrears, twice the industry's "best-practice" trigger of three months.

And it informed ministers at 10pm, around the same time as it was briefing the media.

Which is not to say there's been no political pressure on Hester to do precisely this kind of thing. As of Friday, Royal Bank became 58% owned by the state - and the Treasury is desperate to prove that taxpayers are getting some kind of social return for the £20bn we've injected into this battered bank.

The point is that Hester saw the writing on the wall and didn't pretend that he couldn't read it - which would not be true of all his banking peers.

Here's the positive side of what Royal Bank has done: it gives those who lose their jobs in the looming wave of redundancies a better chance of getting a new source of income in time to prevent the bank seizing the family property.

But there is a cost, which will fall on estate agents and - possibly - anyone interested in seeing an end to the savage deflation of house prices.

How so?

Well, the disposal of repossessed property has become a vital source of income for many estate agents, at a time when property sales have collapsed by well over half and many agents are on the verge of collapse.

You may not weep for them, though you only have to look at your own high street to recognise quite how many thousands are employed by them (there are 10,000 members of the National Association of Estate Agents, so numbers on their payroll is a multiple of that).

Also there is a reason why delaying a great surge of repossessions may not be a good thing for anyone hoping for a recovery in the housing market.

The assorted surveys by banks and the Land Registry, together with anecdotal evidence, suggest that house prices are between 10 and 20% down from their peak - which, according to most forecasters, suggests that prices have another 15% to 20% to fall.

House prices are taking weeks and months to find a floor, that low-point from which recovery can begin, because many potential sellers are biding their time, hoping that something will turn up - while buyers are waiting for a crash that delivers bargains.

So the brutal truth is that a great downward whoosh in prices, the moment of catharsis, is most likely to come as and when there's a great surge in forced selling, which would be the consequence of a widely anticipated rise in repossessions.

But if all banks follow the lead of Royal Bank and add another three months to the schedule of seizing a home, well that's another three months to wait for the laws of supply and demand to exert their inevitable downward pressure on prices.

Which also means that there's another three months to wait for the crippling housing deflation to end - which also postpones a wider economic recovery, since the housing market is not hermetically sealed from the rest of the economy.

Doubtless the government will exert massive pressure on other banks to follow the example of Royal Bank, but they shouldn't kid themselves that interfering in the market brings no costs.

• Bookmark with:
• |
• |
• |
• |
• - What's this?