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September 1, 2007

The Lessons of Northern Wreck

By Spear's

In our Spring 2007 edition, we asked a simple question: ‘Have the central bankers lost control?’ On August 9th, we got the answer and, yes, you read it here first. The money supply was growing at an unsustainable 13 per cent in the UK and the Bank of England’s brief from Gordon Brown did not include monitoring M4, now no longer considered relevant.

Ever since Brown ‘freed’ the Bank of England on his first day as Chancellor, he has trumpeted his own brilliant economic master-stroke, but there are problems: he stripped the Bank of England of its traditional role of sole supervision of the banking system and handed it to the FSA, who had no expertise in the sector, and he put the Bank in charge of inflation, but hobbled it to a questionable yardstick called the RPI, which was soon superseded by the CPI. The CPI, however, was an even worse yardstick invented in the EU, which excludes the cost of housing and just about anything else going up in price. So no one was watching the banking system or the money supply, while UK inflation was calculated at 2.1 per cent, whereas everyone knew it was around 8 per cent.

This ticking time-bomb of cheap money, suppressed inflation data and asset-price bubbles exploded when the so-called CDO market in America seized up when ‘sub-prime’ mortgages started backfiring: ‘sub-prime’ is a new euphemism for lending money to people, or debt-ridden companies, who cannot repay the debt or keep up the interest payments on the debts they have taken on.

Don’t ask why the banks lent them the money in the first place, why should they care, as the underlying asset was rocketing in value, wasn’t it? Well, yes and no: yes it was, until it wasn’t, and then the values did a ‘Duke of York’ and headed back down again; or it wasn’t, because the values had often been overstated in the first place, often fraudulently. It’s cheaper now in Detroit to buy a house than a car, and Motown’s not selling many cars either. The logic of the late Milton Friedman, that money supply growth = inflation, and its corollary that cheap money = asset price inflation, is back on the menu, but who’s in charge?

And what did the central banks actually do when the crisis broke? They poured oil on the fire of inflation by flooding the wholesale money markets with easy credit – the Fed and the ECB each pumped in about 175,000,000,000 dollars and euros, respectively, in the first few days alone, thus putting off or prolonging the evil day of reckoning until… until after the US Presidential Elections in November 2008! The FT’s headline on October 15th informed us that ‘Banks line up $75,000,000,000 Mortgage Debt Fund’, to be called the ‘Single Master Liquidity Enhancement Conduit’ or SMLEC – they must be joking, the SCHLECKS! The only people to benefit from this nonsense will be the Chinese, as they at least get their Olympics in before the deluge.

Mervyn King at the Bank of England got blamed both for keeping his head while all around him others were losing theirs and for not entering his no-go ‘moral hazard’ territory of pumping money into banks in trouble, as with Barings, but also for not monitoring the banks, which were no longer his prime responsibility anyway. Even the directors of Northern Rock, now dubbed Northern Wreck, blamed the poor old Governor for their own incompetence, saying he didn’t act quickly enough to man the pumps. And who’s watching real inflation, as oil hits $90 per barrel and the price of wheat doubles? Just watch commodity and food prices soar, and the dollar sink lower: the favoured US strategy in a crisis is usually to let inflation lift the younger generation’s debts off the rocks at the expense of savings and pensioners, for the ‘good’ political reason that dead people don’t turn up at the polls, as John Maynard Keynes once observed. And this policy of letting the Dollar slide has its own euphemism, called ‘benign neglect’.

The extraordinary thing about the credit crunch of the summer of 2007 was that a problem which began on Main Street soon cropped up all over the place: an East German state bank went bust, BNP Paribas had two hedge funds that lost €1.5 billion, HSBC lost $2 billion dollars, Goldman Sachs Global Alpha Fund lost over half its capital and so on, until Merrill Lynch announced a whopping $8-billion write-down on a CDO book of $22 billion, with no undertaking as to its adequacy.

Then Citigroup announced that its initial estimate of losses of $6 billion should have been $16 billion or more, as though someone had left the ‘1’ off the front by mistake. It soon emerged that many banks had created SIVs and Conduits – Sieves and Plug-holes would be better technical terms – in order to earn just 0.25 per cent on others’ money: the thinking was that if a bank created a Special Investment Vehicle and put in just 5 per cent capital and a bit of debt, then others would do the same, and they did, but when the music stopped these others wanted their money back and the host bank, which thought it had no liability, suddenly realised that in the real world it did, and then it had no option but to keep its progeny out of gaol: the ‘Dad! I’ve bought some experience that I’m unable to pay for’ syndrome came all the way home to roost. Now all these SIVs were never meant to turn up on the balance sheet, but suddenly they did and all at the same time too. It will be interesting to see what the auditors do with these ‘now-you-don’t-see-it, now-you-do’ liabilities come 31st December.

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Even a casual reader would think this editorial is a tad cynical, and they would be right, because the message to our readers is to be ultra-cautious in the months ahead. In fact, getting cynical is now the best way to wealth preservation, and we don’t expect to sound the all-clear in this decade.

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