Debt Rattle, June 30 2008: Red flags and black holes

Dorothea Lange Feeling low in Toppenish August 1939
"Sick migrant child. Washington, Yakima Valley, Toppenish."
The daughter of migrant laborers harvesting hops in Washington State

Update 3.20 PM EDT
Ilargi: I see the Dow is up, about 0.5%, but I think it’s a false comfort. The reason why is the numbers for the large financial corporations. They are getting absolutely "anvilled" again today, after most of them have already lost 50% or more of their value. I wonder how much stretch is left; it has to stop somewhere. What got me thinking about that this morning, even before the markets opened was that the 2nd article below says:

Profitability in financial services is falling at its fastest rate in at least 19 years as the credit crisis continues to hurt, a new study indicates. A balance of 44pc of firms have reported a fall in profits in the quarterly financial services survey released today by the CBI and PricewaterhouseCoopers. It is the worst result since the survey began in 1989.

source: Yahoo finance June 30, 3.15 PM EDT

Fannie and Freddie announced today they will both sell billions of dollars in bills in Dutch auctions (where successful bidders pay the price of the lowest accepted bid, not the actual price). Not a very strong call, to put it mildly. Moody’s put Morgan Stanley on downgrade watch, so that goes down. As for Lehman, see the first article: (I’m not a big fan of the idea that Lehman will be the next to go, because of their prominent place in the Fed ownership hierarchy).

Lehman Decline Gathers Steam

Shares of Lehman Brothers Holdings Inc., which were hovering around $21.50 through most of the trading session, have dropped sharply in the last hour, lately down nearly 9% in yet another examples of credit-related concerns manifesting in individual names.

Lehman has been one for the brave and nervous for months now, ever since Bear Stearns Cos. imploded in March. The company got through that month, but as credit concerns have come to the fore again, it’s been a popular target for short-sellers. Options activity leans to the side of put-buying as the stock sinks.

Quarter-end issues could be coming into play, as some dump shares of a stock they don’t want listed among their holdings. The company’s credit-default swaps, which measure the risk of default, cost more than on Friday. To protect $10 million in bonds for five years, it costs a bondholder $285,000, compared with $275,000 on Friday.

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Ilargi: Over the weekend, we’ve seen multiple sources list the growing number of reports that warn of crashes and collapses to come. These reports, from RBS, Barclay’s, Fortis and others, are nothing new for those of you who follow The Automatic Earth on a daily basis. We have posted these and many other warnings for a long time.

Today, yet another grim picture is painted by the Bank for International Settlements, the central banks’ bankers. And more such warnings will be forthcoming. As we have always said, the economic downfall that is now starting to shape up for real, is inevitable. You can not "invent", out of the blue, trillion after trillion dollars of credit, and expect all of it to be accepted as any kind of "real" capital or money forever into the future.

It is not going to happen; it has to come down. The game is over. We already know the outcome. It’s just a matter of seeing HOW we will get to where we must go. What we’ve seen so far amounts to nothing more than a fart in a hurricane, if you will excuse my French. This entire economy of ours is faith-based, it's a religion whose priests dress assets in leveraged emperor's clothes.

The amount of deluded credit, still perceived by most people as having true value, that will soon vanish into the black hole of nothingness, from which not a penny will ever be seen again, is stunning in sheer quantity. The $3 trillion lost so far in the US housing market is but a tiny percentage of what will be going going gone.

The recent reports, and the increasing attention they are generating in the main media, are waking up increasing numbers of people these days. I’m afraid for most it will be too late to do much about their situations. The warnings now come from the players themselves, those who stand to lose their own shirts and shorts and socks and sweaters. That in itself is an extra warning, a giant blood red flag; it indicates that we are indeed fast approaching the edge of the cliff.

Note: I find it interesting to see people starting to understand that we are entering the mother of all deflations, and all the talk of inflation is not worth the paper it’s printed on. As US home prices plunge, homes become more expensive to buy. Think about that one.


Global economy faces deep slowdown and deflation threat, BIS warns

The global economy may be heading for a far deeper crisis than is expected and a bout of deflation in the world's biggest economies is now a possibility, according to one of the world's most highly regarded economic institutions.

The Bank for International Settlements has warned that many in the City and elsewhere may have underestimated the scale of the coming economic downturn in one of its most sombre portraits yet of the international financial system. The Swiss institution - known as the central bankers' bank - issued the alert in its annual report, released today.

It warned that the sub-prime crisis in financial markets was merely a reflection of growing debt burdens in the developed world, which could soon contribute to a deep slowdown. "The difficulties in the sub-prime market were a trigger for, rather than a cause of, all the disruptive events that have followed," it said. "Moreover... the magnitude of the problems yet to be faced could be much greater than many now perceive."

The warning will cause particular concern among participants in the financial sector, as the BIS was among the earliest major institutions to warn that the world could face a credit crisis and financial slump. The report draws stark comparisons between the current crisis and a variety of others including the Great Depression.

It said: "Historians would recall the long recession beginning in 1873, the global downturn that began in the late 1920s, and the Japanese and Asian crises of the early and late 1990s respectively. " In each episode, a long period of strong credit growth coincided with an increasingly euphoric upturn in both the real economy and financial markets, followed by an unexpected crisis and extended downturn.

"In virtually every instance, some form of new economic discovery or new financial development provided a further 'new era' justification for rapid credit expansion, and predictably became a focus for blame in the downturn." Most sobering is the report's warning that developed economies including the US and Britain could face deflation.

It said: "The eventual global slowdown could prove to be much greater and longer lasting than would be required to keep inflation under control. This could potentially even lead to deflation, which would evidently be less welcome."

•Profitability in financial services is falling at its fastest rate in at least 19 years as the credit crisis continues to hurt, a new study indicates. A balance of 44pc of firms have reported a fall in profits in the quarterly financial services survey released today by the CBI and PricewaterhouseCoopers. It is the worst result since the survey began in 1989.

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BIS renews slump fears as global economy pays the price

A year ago, the Bank for International Settlements startled the financial world by warning that we might soon face challenges last seen during the onset of the Great Depression. This has proved frighteningly accurate.

The venerable body, the ultimate bank of central bankers, said years of loose monetary policy had fuelled a dangerous credit bubble that would entail "much higher costs than is commonly supposed". In a pointed attack on the US Federal Reserve, it said central banks would not find it easy to "clean up" once property bubbles have burst.

If only we had all listened to the BIS a long time ago. Ensconced in its Swiss lair, it has fired off anathemas for years, struggling to uphold orthodoxy against the follies of modern central banking. Bill White, the departing chief economist, has now penned his swansong, the BIS's 78th Annual Report, released today. It is a disconcerting read for those who want to hope the global crisis is over.

"The current market turmoil is without precedent in the postwar period. With a significant risk of recession in the US, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point," it said.

"These fears are not groundless. The magnitude of the problems yet to be faced could be much greater than many now perceive," it said. "It is not impossible that the unwinding of the credit bubble could, after a temporary period of higher inflation, culminate in a deflation that might be hard to manage, all the more so given the high debt levels."

Given the constraints under which the BIS must operate, this amounts to a warning that monetary overkill by the Fed, the Bank of England, and above all the European Central Bank could prove dangerous at this juncture. European banks have suffered worse losses on US property than American banks. Their net dollar liabilities are $900bn, mostly short-term loans that have to be rolled over, a costly business with spreads still near panic levels. Mortgage and consumer credit has "demonstrably worsened".

The BIS cautions the ECB to handle its lending data with great care. "The statistics may understate the contraction in the supply of credit," it said. The death of securitisation has forced banks to bring portfolios back on to their balance sheets, while firms in need are drawing down pre-arranged credit lines. This is a far cry from a lending recovery.

Warning signs are flashing across Eastern Europe (ex-Russia) where short-term foreign debt is 120pc of reserves, mostly in euros and Swiss francs. Current account deficits are 14.6pc of GDP. "They could find it difficult to secure foreign funding if global financing conditions were to tighten more severely," it said. Swedish, Austrian and Italian banks have drawn on wholesale markets to lend heavily to subsidiaries across the region. This could "dry up".

China is not immune, although the BIS has dropped last year's comment that growth is "unstable, unbalanced, unco-ordinated and unsustainable". The US accounts for 20pc of China's exports, but that does not capture the inter-links across Asia that ultimately depend on US shopping malls. "There is a risk that China's imports overall could slow down sharply should the US economy weaken further," it said.

Global banks - with loans of $37 trillion in 2007, or 70pc of world GDP - are still in the eye of the storm. "Inter-bank money markets have failed to recover. Of greatest concern at the moment is that still tighter credit conditions will be imposed on non-financial borrowers. "In a number of countries, commercial property prices are beginning to soften, traditionally bad news for lenders. These real-financial interactions are potentially both complex and dangerous," it said.

Do not count on a fiscal rescue. "Explicit and implicit debts of governments are already so high as to raise doubts about whether all non-contractual commitments will be fully honoured." Dr White says the US sub-prime crisis was the "trigger", not the cause of the disaster. This is not to exonerate the debt-brokers. "It cannot be denied that the originate-to-distribute model (CDOs, CLOs, etc) has had calamitous side-effects.

Loans of increasingly poor quality have been made and then sold to the gullible and the greedy," he said. Nor does it exonerate the watchdogs. "How could such a huge shadow banking system emerge without provoking clear statements of official concern?" But there have always been excesses in booms. What has made this so bad is that governments set the price of money too low, enticing the banks into self-destruction.

"The fundamental cause of today's emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in the advanced industrial countries have been unusually low," he said.The Fed and fellow central banks instinctively cut rates lower with each cycle to avoid facing the pain. The effect has been to put off the day of reckoning.

They could get away with this as long as cheap goods from Asia kept a cap on inflation. It seduced them into letting asset booms get out of hand. This is where the central banks made their colossal blunder. "Policymakers interpreted the quiescence in inflation to mean that there was no good reason to raise rates when growth accelerated, and no impediment to lowering them when growth faltered," said the report.

After almost two decades of this experiment - more or less the Greenspan years - the game is over. Debt has reached extreme levels, and now inflation has come back to life. The easy trade-off has metamorphosed into a vicious trade-off. This was utterly predictable, and was indeed forecast by the BIS, which plaintively suggested in this report that central banks might like to think of an "exit strategy" next time they try such ploys.

In effect, this is an indictment of rigid inflation targets (such as Britain's), which prevent central banks from launching a pre-emptive strike against asset bubbles. In the 1990s, they should have torn up the rule-book and let inflation turn negative in light of the Asia effect. The BIS suggests that a mix of "systemic indicators" should be used.

The crucial objective is to slow credit growth and make sure that the punchbowl is taken away before the drunks run riot. "We need policy measures to lean against credit-drive excess," it said. If there are going to be more bail-outs on both sides of the Atlantic - as there will be - the "socialised risks" should be taken on by political systems, and not dumped on the books of central banks.

"Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off. "To deny this through the use of gimmicks and palliatives will only make things worse in the end," he said. Let us all cheer Dr White off the stage.

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See How U.S. Home Prices Have Changed

The S&P/Case Shiller Home Price Indices have been measuring the average change in single-family home prices since 1987. These indices are thought to be the best indicators of home price trends in the United States.

Ten of the cities that have been tracked since 1987 include: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington D.C. The indices have reported a lot of ups and downs in these cities. Home prices soared especially high between 2002 and 2005. The average median home price increase in the 10 cities was nearly 75 percent during this three year period.


Of course, prices have been falling since 2006. Between April 2006 and April 2008, the average median home price fell nearly 42 percent in the 10 cities mentioned above. Prices are expected to decline further in most cities.

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Bears close in as US shares slide

Wall Street's outlook for the second half of the year has soured as US stocks stare into the jaws of a bear market. All eyes will turn to the opening of London's FTSE today, as it responds to Friday's fall in New York's benchmark Dow Jones index. Barring a miracle, today will see the end of Dow Jones' worst June since the Great Depression.

Alexander Young, a strategist at Standard & Poor's, said: "People realise they've underestimated the second-half drag to earnings from all these macro issues we are dealing with. The outlook for stocks is pretty bad." At Friday's closing bell in New York, oil prices had yet to relent, surging to new highs of more than $142 a barrel. Meanwhile, fears that the financial sector would announce further writedowns in the second half sent banking stocks tumbling.

Shares in JP Morgan slid more than 7pc to $35.05 (£17.57), the lowest price since October 2005. Bank of America's shares were down more than 9pc, and Citigroup - the biggest US bank by assets - saw its shares dive to a nine-year low of $17.25, down 11pc. David Kostin, a Goldman Sachs strategist, said that expectations for profits this year and the next are "too optimistic".

The Dow closed down 4.2pc at 11346 on Friday evening - just 0.1pc away from the 20pc fall from its high in October that would mark an official bear market. The Standard & Poor's 500 index also slipped on Friday to 1278.38, closing at a three-month low, down 3pc. Analysts in the US are expecting companies in the S&P 500 to announce an average 11pc fall in earnings for the second quarter.

In London, the FTSE 100 has shown some resilience, mainly due to the string of natural resources companies that it now boasts. Strip them out and the index is trading at just above the 4800 level, compared with its Friday closing of 5529

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Let the Banks Go Under, Sell 10 Million Houses for $1 Each

Today's target: the notion that the collapse of the insolvent U.S. banking system would be so terrible. Really? Terrible for who? Certainly not the nation at large. In fact the dissolution of the insolvent parts of the U.S. banking sector--yes, the investment banks, the money-center banks, the regional banks, and the savings and loans--would actually be an enormously positive development for the nation and indeed the world.

Let's start with the fact that a huge number of these lenders are insolvent. If all their bad loans, bad derivative bets and off-balance sheet losses were forced to be marked to market/liquidated to raise capital, then major bank after major bank would fold/enter bankruptcy.

And what exactly would be so bad about that? Businesses go under all the time. The truth is these banks will never ever recover the loans they wrote, so why try to prop them up with taxpayer funds? To bail out the ultra-wealthy owners of those banks, of course. Recall that 1% of the citizenry own the bulk of all stocks and bonds.

Look at this chart: most of the banks have already lost half or more of their value. And has civilization fallen because the poor owners have lost half or more of their investment in the banking sector? No.


Even at its peak of bubble hubris, the entire sector was less than 20% of the S&P stock index's value. Now it's under 10%, like it used to be. The world didn't collapse when the banking sector declined, and it won't fall when insolvent banks are ushered through the bankruptcy process.

Look, WAMU has already fallen from $35/share to under $5/share. So what if it goes BK? Banks are businesses, and businesses go bankrupt all the time. United Airlines went BK and the next day employees showed up and the planes flew. When banks are liquidated/go BK, then the tellers will come to work and people will go in and do their normal banking.

If a bunch of branches close, people will adapt. It will be tough on the employees let go, but how different is this than when millions of industrial and manufacturing jobs vanished over the past 20 years? It's called creative destruction, and it's like the tide: you can't stop it, and all the government-funded sand castles in the world can't stop the tide.

That's what the Japanese government tried, and look what it got them: two decades of malaise and decline. Trying to cover up losses and keep bad debt off the books doesn't solve anything; the money's already lost. All these absurd bailouts have one goal: enable insolvent homeowners to bail out insolvent lenders with new loans which will inevitably go bad, too. Only it will be the taxpayer who's stuck with the bill, not the banks who wrote the loan in the first place.

So let me repeat: not only should we as a nation let the banks go belly up, we should insist on it. Regulators should force every lender to declare all its assets and liabilities and mark them to market immediately. If the bank is insolvent, then let it enter bankruptcy. The money's already lost; let's just be honest about, repudiate the debt and move on.

Yes, some pension funds and 401K accounts have suffered losses due to banking sector ownership. But those losses have already be chalked; there's not much downside left, so the big losers will be the fat cats, not the pensioners whose retirement fund owns a shriveling piece of WAMU or Citicorp.

Now let's move to the other big topic: how housing costs have essentially impoverished average Americans. The number one cause of poverty in the U.S. is housing prices and rents which have risen three times faster than income since the 1960s.
As David Fischer noted in The Great Wave: Price Revolutions and the Rhythm of History (page 219):

"The cost of rent and real estate in the United States multipled sixfold from 1960 to 1992, while the consumer price index increased threefold. Prime real estate went up tenfold or more."

Take a look:


If you go the BLS CPI page and fire up the CPI inflation calculator, you'll find that $100 in 1965 works out to be $600 in 2005. Meanwhile, housing prices rose 20-fold or more in that timeframe even as real wages dropped:


Hmm--productivity (and profits) soar, but wages actually decline, even as house prices skyrocket.

Put this all together and there is only one conclusion: to restore housing and rents to their rightful, historic levels, all 10 million distressed/foreclosed houses should be auctioned off for a $1 each. Let's give the current tenant or former homeowner first dibs, with the caveats (written into the deed) that they must maintain the property and that they have no other real estate property or assets.

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Homes Less Affordable as Prices Fall, Rates Rise

Rising mortgage rates are driving up the cost of buying a house even as prices fall, making property more expensive across the U.S., according to a new study by Zillow.com, an online provider of home valuations.

Monthly payments on 30-year fixed mortgages are 6 percent to 10 percent higher in 41 of the top U.S. housing markets than they were two months ago. First-quarter prices have declined from a year earlier in 88 percent of those areas, Zillow said. "We're going to need about a 30 percent decline in house prices if you are going to keep payments stable," said Morris Davis, a former senior economist with the Federal Reserve and now a real estate professor at the University of Wisconsin-Madison's School of Business.

Seven Federal Reserve benchmark cuts since September have failed to lower mortgage rates as banks have curtailed lending after taking writedowns or credit losses of more than $400 billion from investments in mortgages. Rates for 30-year fixed-rate home loans were about 6.3 percent when the Fed first reduced its target federal funds rate nine months ago. They're now just under 6.45 percent, data from Bankrate.com show.

Zillow based its calculations on almost 25,000 mortgage offers to potential homebuyers with credit ratings of at least 680 out of a possible 850. The would-be buyers sought bids through Zillow's Mortgage Marketplace, a new service that helps consumers shop for home loans. Zillow's main business provides U.S. home valuation estimates based partly on sales data.

The average monthly mortgage payment rose $131, or $1,572 a year, since the beginning of April in the 41 areas surveyed, Zillow said. The figure is controlled for population. "The story here is not so much how much more it will cost you over the life of the loan, but how much less house you can buy," said Greg Rand, managing partner of Prudential Rand Realty in Westchester County, New York. "It's an unfortunate pickle that we're in."

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Engineering the Housing Bubble Through Monthly Payments

I wanted to actually ’see’ the effects that exotic loan programs had on home price appreciation and I believe this chart, together with my written ‘bubble-years event log’ below, tells quite a story.

This simple visual clearly demonstrates how ‘low monthly payment’ engineering through the creation of exotic loan programs was almost exclusively responsible for the major housing bubble in CA. If you substitute the CA data with data from your state, I am sure it will look similar. Recently, Greenspan said exotic loan programs were not responsible for the bubble prices. I think he is mistaken.


*household income is not inflation-adjusted. Monthly payments based upon typical interest rates for that period

Chart Findings and Facts:
-Until 2002, before the age of exotic loan programs, housing prices were driven by tradition economic factors such as supply and demand, the broader economy and interest rates. The rate of appreciation was in-line with previous Real Estate market expansions. Loan programs were mostly traditional.

-In 2002, payments for the median home reached the upper end of affordability at the time.  All of a sudden in mid-2002 the intermediate-term 3/1, 5/1, 7/1 and 10/1 fully amortized and interest only loan programs were introduced. These programs carried a much lower rate than a traditional 30-year fixed rate for the respective 3, 5, 7 or 10 years. These were among the best-selling loan programs in the bubble states.

At the time if 30-year fixed rates were at 5.5% a 5/1 interest only for example, may have been priced as low as 4.5% with qualifying at the interest only payment rate allowed. These programs brought affordability back and housing prices soared nearly 50% in a little over 2-years. In 2004, as payments once again got to the upper end of affordability, limited documentation programs such as Stated, No Ratio and No Doc were rolled out, which carried home prices even higher.

- In mid-2004, payments again were making affordability out of reach, so lenders began pushing the Pay Option ARM as one of their top offerings. This program had been around for years at World Savings (now Wachovia) and WAMU, but when the investment banks got into the Pay Option ARM game, every middle market mortgage banker, mortgage broker and bank became a Pay Option pusher.

These loans were branded as a ’safe’ alternative to traditional loans and a way to ’save’ money by paying a rate as low as 1%. Borrowers were told ‘negative amortization does not matter because your home value will increase faster than the negative amortization and you can always refi.’ We now know this is not the case.

-By 2006, payments again reached the upper end of affordability but there was no other loan programs that they could invent that could compete with a Pay Option ARM. At the time you could get a 100% stated income Pay Option ARM! Values went flat.

-In 2006 with nothing left to sell, the banks went into the Home Equity Line of Credit (HELOC) game. This allowed people to easily borrow up to 100% of the value of their homes, which kept values stable for a year despite home sales volume falling off of a cliff. This HELOC liquidity injection lasted until the end of summer 2007 when prices everywhere fell off of a cliff. This marks the end of the great housing bubble.

-As of May 2008, prices are down some 30% in the past 12-months but payments are still far above the current affordability level. The market needs to find equilibrium and a clearing level but given the state of the economy, elevated interest rates, inflation. massive supply, consumer confidence over Real Estate, tightening lending standards and the lack of any affordable loan programs do not draw a line in my chart straight across from 2004 adjusting for rising income.

This is because all of these negatives almost make it certain that housing prices have a long way to go and will overshoot to the downside, as all popping bubbles in the past have done.

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Ilargi: Ireland’s Economic and Social Research Institute (ESRI) "... estimates that house prices were overvalued by 12.5 per cent in 2007 and is projecting a 6.3 per cent decline in house prices this year, followed by a further 1.5 per cent fall in 2009." "..overall, prices for new houses will fall by 24 per cent when adjusted for inflation".

Oh, really, boys and girls? Last week’s Elliott Wave report would seem to indicate that Irish homes are overvalued by 100’s of percentage points. So I would estimate that in Ireland, as in the rest of the "rich world" (perhaps it’s time to start using the phrase "formerly rich world") home prices will come down 80% or more, peak to trough.

Ireland teetering towards recession as bubble bursts

The Celtic Tiger appears to have lost its bite as the threat of recession stalks Ireland. These are the conclusions of a report by the Republic's Economic and Social Research Institute (ESRI), which last week forecast a recession - the first since 1983 - and a return to net emigration.

Critics have said that Ireland has become blasé about its economic success over the past 15 years and its transformation from being one of Europe's poorest nations to one of its wealthiest. It was, therefore, unsurprising that a quarterly economic commentary from the ESRI was splashed across newspaper front pages and has generated debate from the Dail, the Irish parliament, to pubs.

The institute expects that the economy will contract by 0.4percent this year after growing by 4.5percent in 2007, and, most disturbingly, that an outflow of 20,000 emigrants would be necessary to stop the unemployment rate rising above 8 per cent.
The markets reacted badly to the report, with shares in Irish companies falling and bank shares being hit particularly badly.

The main reason for the fears of recession is Ireland's overreliance on a construction boom, which has come to a crashing halt. About 75,000 units were built last year, compared with an expected 30,000 this year. House prices have fallen by an estimated 15 per cent, with no sign of the bottom having been reached. The ESRI estimates that house prices were overvalued by 12.5 per cent in 2007 and is projecting a 6.3 per cent decline in house prices this year, followed by a further 1.5 per cent fall in 2009.

From the new-house price peak in February 2007 to the expected trough early next year, the ESRI estimates that, overall, prices for new houses will fall by 24 per cent when adjusted for inflation. Although the institute is optimistic about other areas of the economy, particularly exports, the property crash is so serious that it has wiped out growth elsewhere.

As a consequence, public finances will plunge into the red next year, sparking potential sanctions as borrowing exceeds European Union limits. Alan Barrett, a senior ESRI researcher, acknowledged that the economy may actually perform worse than his gloomy forecast. “Everyone knows the downturn in the public finances is because Government blew the finances from the boom which everybody knew would be temporary,” he said.

Personal spending is slowing significantly. Retail sales slowed by 3 per cent in April alone. Consumption growth is expected to decline to only 1 per cent at year end. The ESRI expects tax revenues to be €3 billion (£2.37 billion) below government targets this year. From an overall budget surplus of €5.2 billion in 2006, the Government is expected to incur a deficit of €7.4 billion in 2009 - a turnaround of more than €12.5 billion in three years.

Even if the Government manages to reduce public spending growth by 6.6 per cent next year, from this year's planned 9.3per cent increase, it will breach EU rules on borrowing by some €2 billion. If that happens the Government will be obliged to present a plan to the EU Commission to return the deficit below the permitted 3 per cent of GDP.

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British banks may need to pump billions into compensation scheme

Cash-strapped banks may be forced to pay billions of pounds upfront into a compensation scheme for the victims of bank failures under reforms to be proposed by the Government tomorrow.

The proposals, which come in the wake of Northern Rock’s near-collapse last September and have been backed by Mervyn King, the Governor of the Bank of England, will be announced by Alistair Darling in his latest consultation on banking reform. In the biggest shake-up of banking practices in decades, the consultation will also give further details on the triggers that the Government will use to decide when to take control of a failing bank.

The final reforms will be included in the Queen’s Speech and will be implemented next year. Having undergone their most punishing business quarter in almost 20 years, banks are desperate to avoid further costs. The financial institutions fear the Treasury will demand that they pump billions of pounds into the compensation scheme, to be held until the cash is needed to repay deposits.

The banks would prefer to pay compensation as and when it is needed. They also want a “sensible” limit on the level of savings covered by the scheme. Customers are guaranteed to receive back all savings up to £35,000 under the existing compensation scheme, but this could be raised to £50,000 or even higher.

The deposit protection scheme in America has a $50 billion compensation pot, built up over many years, but even this sum would barely cover the £25 billion of deposits held by Northern Rock before savers queued to withdraw their money. About £1,000 billion is held in British bank accounts. Bankers accused the Government of competing unfairly with the industry.

National Savings & Investments (NS&I) will be exempted from the scheme, despite being the UK’s second-biggest provider of savings products and an increasingly aggressive competitor in the savings market. A source said: “The industry is aggrieved that there’s one rule for the Government and one rule for banks and building societies. People are increasingly resentful about NS&I, which seems to enjoy unfair competitive advantages.”

It is not clear whether Northern Rock, the nationalised bank, will be required to pay into the scheme. If not, rival banks are certain to complain that it has been given another unfair advantage, on top of its government funding. The European Commission is due on Thursday to conclude its investigation into Britain’s decision to take the Rock into public ownership. Separately, the Chancellor is expected to meet Henry Paulson, the US Treasury Secretary, who is in Britain this week to discuss issues relating to financial stability.

Mr Darling will also announce details of a number of new working groups, including their membership, as part of a reorganisation of the existing high-level group that advises him on business matters. One of the groups will focus on competitiveness. Richard Lambert, Director-General of the CBI, and other business leaders have criticised Mr Darling for making policy changes that undermined the country’s competitive edge. Other groups will look at rights issues, insurance and long-term savings.

It has been a painful second quarter for the City’s biggest companies, which have not been as pessimistic about their outlook since the start of the last recession in 1990, according to the CBI. A dash by investment banks to fire staff by today could have been driven by the belief that workers are less likely to sue for an unpaid bonus if in the first half of the year.

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UK consumer confidence plummets as surveys reflect gloom

Consumer confidence is at its lowest level in 18 years and house prices are continuing to fall, surveys out today show. The latest consumer confidence barometer from GfK/NOP shows overall confidence dropped five points to -34 in June, only one point above the record low of -35 reported in March 1990 as the economy headed into its deepest postwar recession. The survey goes back to 1974.

"With rising inflation, gloomy forecasts for interest rates and soaring fuel, utility and food prices dominating the front page headlines, it's no surprise that confidence in the general economy is almost in freefall," said Rachael Joy, an analyst at GfK. All five of the index's subcomponents showed a fall, with confidence in the economy over the next 12 months at -45, 42 points down on this time last year. The survey was taken in the first half of June.

A separate consumer survey from Lloyds TSB released today shows job security and employment confidence have fallen to their lowest level since the survey began in November 2004. It also shows that people's expectations of inflation have risen to 4.8%.

Consumers have scaled back hope of interest rate cuts, as the Bank of England has made it clear it is as concerned about rising inflation, at a 15-year high, as it is about economic growth, which dropped to a record low of 0.3% in the first quarter of this year, according to data released on Friday.

Meanwhile, the research group Hometrack reports that house prices fell for a ninth successive month in June. The average price dropped 1% between May and June, leaving prices 3.2% lower than a year ago - the worst figure in almost three years. Hometrack also said new buyer inquiries were down 5.7% in June from May and 52% lower year on year.

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Sub-prime chill reaches the Arctic

At this time of year, night does not fall in Narvik, a Norwegian town 140 miles north of the Polar Circle. The midnight sun shines over the industrial town and the stunning mountains and fjords surrounding it. But the town has been plunged into a dark financial storm.

This Arctic municipality of 18,000 inhabitants is the surprise victim of the US sub-prime mortgage crisis, an example of how far-reaching its impact has been. Narvik, together with seven other small communities across Norway, have lost tens of millions of pounds in complex investments that went south as a direct result of the global financial squeeze.

This means that Narvik, the site of the second world war battle, faces an uphill struggle to ensure the funding of its public services. "There are going to be cuts in healthcare, schools, elderly care, youth clubs, sport activities," lists opposition local councillor Torgeir Trældal. "People don't understand that the crisis will have such an impact. They have a right to be angry. It's sad."

At the heart of the crisis is the decision by Narvik to invest £24m of its public funds into securities put together by US bank Citigroup. These products were marketed and sold via a Norwegian brokerage firm, Terra Securities. Narvik's leaders say they did not know these products were high-risk, with most thinking that they were investing in domestic companies, rather than outside Norway, as was the case.

When the credit crunch hit last summer, the town lost around £18m, coming on top of other debts Narvik ran up. The city will get back some of the money it lost, but in the end, the total debt could reach as high as £20m – small change to the banks responsible for the credit crunch, but around a fifth of the city's £100m annual budget.

Unlike in Britain with the Northern Rock scandal, the Norwegian government said it would not bail out Narvik and the other "Terra towns", arguing that the government is not an insurance policy for bad management decisions. So now the people of Narvik must find ways of paying off the loss.

"We are looking at possible 10% budget cuts over the next four years," reckons Trældal, who is a fireman by trade. "Right now we have a 24/7 fire service. In future, it could be only a daytime service, with firemen on call at home, at nights and weekends. It will delay the response time to ten minutes. And you must be on site in five minutes in order to save lives." All future investments, such as building a new school, have been frozen while the politicians try to find a solution.

Many in Narvik fear they will lose out. Edvart Solvang is a 44-year-old teacher working in Elvegaard, a small community set in a valley surrounded by breathtaking mountains 20 miles away from the city centre. He is concerned that rural schools like his, which caters to just 45 children, will be closed to make priority for the bigger ones in town. "The children could end up studying in Narvik, which means that progressively, families will not move to this area anymore," he says in the school's courtyard, surrounded by some of his pupils. "It will turn into a place where only old people live. It makes me sad, I don't like it."

"We have to pay for this, it's very unfair," says Turid Rosvoll, a 61-year-old pensioner, outside the Narvik Boy pub in the city centre. "I have two grandchildren. I am worried about what will happen." Like many other residents, Rosvoll is at a loss as to why a crisis such as this one hit her town. "I went to a town hall meeting, where they tried to explain what happened, but coming out of it, I was still none the wiser," she recalls.

So how could such a crisis happen? One of the main reasons is that the Norwegian brokerage firm failed to inform local politicians about the risks posed by investing in sub-prime mortgages. "Terra Securities misled them," says Eystein Kleven from Norway's Financial Supervisory Authority.

It investigated the firm and found that Terra brokers did not explain that the products they bought could be cashed out, at a loss, if their market price fell below 55% of its face value. This happened last summer, when the credit crunch began, with Narvik having to pay more money in the hope they would lose less. "Terra Securities did not disclose this mechanism to the municipalities. We are not sure whether the broker understood the mechanism himself," Kleven said.

Kleven also reckons that the local politicians did not have the required technical expertise. "Citigroup said these products should be for sophisticated investors only. The municipalities were definitely not sophisticated investors … It's the old rule: you shall not buy a financial product that you do not understand." The financial authority concluded that Terra Securities failed to respect good business practice and revoked its license last November. Terra Securities declared bankruptcy the next day.

The municipality also had such confidence in Terra Securities that it did not check the information it provided, according to a KPMG investigation. The local authorities regarded the firm as the city's financial adviser and ignored their interests as product salesmen, it concluded. Part of the reason for this trust is that Terra Securities was part of the same group as a chain of local savings banks across Norway that had been doing business with municipalities for decades. The politicians assumed they were in safe hands.

The current mayor, Karen Margrethe Kuvaas, who was not yet mayor but was part of the city council when the financial decisions were made, has now apologised to the people of Narvik. "On behalf of everyone involved in the Terra case, past mayors and councillors, past and present chief executives, I would like to offer my deepest apologies for putting the community of Narvik, with the Terra case, in a more difficult economic situation," she told the local paper, Fremover, this month.

"Many people have done wrong, but we also have our responsibilities for the whole affair. Therefore an apology is necessary," she told Fremover, adding that she would do her utmost to minimise the impact of the crisis on Narvik. She is also planning to reform internal procedures to avoid a repeat of the same crisis.

For observers, such as Kleven, the Terra case "shows the extent to which the financial markets are so integrated, and how fast the risk spread from California to the rest of the world". And for the residents of Narvik, it could mean that essential public services are cut to atone for mistakes made both at home and abroad.

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Why we should be worrying about deflation

Now that the housing market is clearly collapsing, many of the pundits who said that soaring prices were perfectly justified, are now scrabbling to find reasons why the current slump is a unique, unforeseeable and entirely new phenomenon.

According to this particular group, rampant house price growth was justified. The world was in a new era, where interest rates could remain permanently low because of the internet and globalisation and ‘independent’ central banking, and all the other good things that have happened to us over the last decade. So needless to say, the credit crunch came as a bit of a surprise for them.

And now they expect the Government to step in and bail us out. This would make things worse of course, so it’s a good thing the Government is basically too broke to do anything of the sort. The reality is that all of this was in fact predictable. You’d have to be psychic to pick the exact date, and the exact manner of the collapse. But it was obvious that there was too much money flying around the world. The bubble was bound to pop sometime.

So can we learn anything from this? And more to the point, will we listen to the lessons? The idea that monetary policy has been far too lax for the past decade at least, is not especially controversial. It’s just that people were having too much fun in the boom times to accept that it was true. No less authority than the Bank for International Settlements (also known as the central banker’s central bank) makes it pretty clear where it believes the fault for the current crisis lies.

“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in advanced industrial countries have been unusually low,” says Dr Bill White in the BIS’s latest annual report. As we’ve said many times before, Alan Greenspan and the rest of the world’s central bankers got away with keeping interest rates ludicrously low, because price inflation was kept down by cheap Asian imports.

In fact, for a short while a few years ago, the Bank of England’s biggest challenge was to keep Consumer Price Index (CPI) inflation from falling below 1%, which would have also entailed writing a letter to Gordon Brown, the Chancellor of the time. But of course, keeping interest rates low merely fuelled other imbalances in the economy. All that borrowed money ended up in the housing market, and we know where that got us.

So what should central banks have done differently, if anything? Ambrose Evans-Pritchard argues that “in the 1990s, they should have torn up the rulebook and let inflation turn negative in light of the Asian effect.” This is a good point. But the use of the word ‘inflation’ gives away what the core problem is. When Evans-Pritchard talks about inflation here, he means the consumer price index, or some other measure of prices.

Now most central banks and policy-makers fear negative inflation, or deflation, more than anything. That’s partly because genuine deflation goes hand-in-hand with depression, but mostly because Western societies have become obsessed with the idea that the key to constant growth is consumer spending. The worry is that if prices are falling, then people will stop spending – because why buy now if you can buy cheaper later? And why spend your savings now when they increase in value by the day?

But the trouble with judging inflation and deflation by what’s happening to a basket of specific individual prices, is that it makes no distinction between ‘good’ price changes, and ‘bad’ price changes. Take milk for example. If all the cows in Britain became twice as productive overnight, and the price of milk halved tomorrow, would you buy more or less? Well, you’d probably buy the same, or maybe a bit more and stick it in the freezer. Would you put off buying it at all because you thought it might halve again next week? Of course not, it’s milk.

What would be bad about milk price deflation? Assuming it was down to higher productivity, and profit margins along the line from farmer to retailer stayed the same, then nothing. In fact, it would be a good thing. If you need to spend less on milk, that means you can spend more on something else. Or heaven forbid, you might even want to save some of that money.

All the stuff we get from Asia has been getting cheaper anyway. Computers are undoubtedly cheaper. I remember that when I bought my first laptop in 2001, the cheapest entry level PC I could find was around £700. Now you can get a far more advanced laptop for about half that price. Does this rampant price deflation stop people from buying computers? Not that I’ve noticed.

So the real problem is in the way that we measure inflation and deflation. Price changes happen for lots of reasons. Oil demand is up, supply is stable or falling, so the price goes up. Computers get cheaper to make, there are lots of factories competing to make them, so the price goes down. But none of this is about inflation. What inflation really is, is an increase in the money supply. Deflation is a decrease in the money supply.

When the amount of money available to the economy is rising, it’s got to go somewhere. In this case, it largely went into chasing house prices higher. Now that the supply of money has been cut off, as banks stop lending, house prices are falling.
And the real problem with deflation like this, is that as people get more and more concerned about the availability of money, they start to hoard it. That means that not only does no one spend money, they don’t invest it either.

They don’t take the sorts of entrepreneurial risks with their money that are necessary to make an economy grow, because they are too scared of losing their scarce cash. So the truth is that, even though prices are rising at a rate of knots just now, deflation is also a very genuine threat to Western economies. How it plays out remains to be seen, but a period of inflation followed later be a longer period of deflation does look quite possible.

But what does this mean for ‘policy’? Well, arguably, if central banks are going to target anything, they should be looking at something objective like the money supply, rather than something subjective like a basket of goods that is believed to be representative of the average person’s spending. Using the term ‘average cost of living’ when referring to the various price indices, rather than inflation, might help make the distinction clearer for everyone.

Better yet, we could just scrap central banks and let the market decide where interest rates should be. After all, that’s pretty much what’s happening now that everything’s gone horribly wrong.

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The ECB's eurobankers are beating the Fed at their own game

For my entire adult life, I've assumed - and argued - that "Anglo-Saxon" policy-makers are best. Give me free markets and low tax any time. Not for me the cloying statism of Continental Europe. It's hard not to notice, though, that since sub-prime exploded last summer, while the US Federal Reserve has made a hash of it, the European Central Bank has played its cards quite well.

In theory, America's central bankers - having been educated in the Anglo-Saxon tradition - should be the most vigilant about inflation, the most determined to rebuff populist pressures. And one would have expected the eurocrats of the European Central Bank - trained in les grandes écoles and the German corporatist school - to react to a financial crisis by caving in and bowing down to their political masters.

But it hasn't happened. The Fed has cut rates willy-nilly while the ECB has stood firm. I don't downplay America's economic predicament for one second, but the Fed has been outclassed. The credit crunch has clearly sent the world's two largest economies into a financial tailspin. On Friday, equity markets worldwide were heading for their worst first-half performance since the early 1980s - with America and Western Europe leading the way.

The Dow Jones index of leading US stocks ended the week 20 per cent off last October's record high. The FTSE Eurofirst finished 21 per cent down on the start of the year. And London's FTSE100 is now more than 14 per cent down year-to-date. We're clearly in a bear market.

The eurozone economy, in particular, just endured a slew of bad data. Price pressures are rising - with eurozone inflation leaping to 3.7 per cent in May, a 16-year high. And index-linked government bonds are now priced for annual inflation above 2.4 per cent over the next six years - way above the ECB's 2 per cent target.

But amid this inflation, eurozone growth has stalled. The region's purchasing managers' index fell in May - the first drop in private sector output for five years. Not just Spain and Italy, but now Germany and France are facing a serious slowdown. It was striking, though, that when the eurocrats weighed this inflation-growth policy dilemma last week, they came out firmly in favour of tackling inflation.

The ECB remains on "a heightened state of alertness", said its President, Jean-Claude Trichet. And because he has held rates at 4 per cent throughout the sub-prime crisis, his words rang true. In the face of disappointing growth data, the ECB's tone became slightly more hawkish - so building credibility and convincing the markets rates will rise to 4.25 per cent at next week's meeting. That is smart central banking.

The ECB is now actively trying to emulate West Germany's widely admired Bundesbank - which built a formidable inflation-fighting reputation during the 1970s and early 80s. Back then, as now, high oil costs threatened the Western world - derailed growth, while pumping up price pressures. But through tight money and higher rates, the Bundesbank kept inflation low, providing the platform for West Germany's strong economic performance.

Trichet also made intelligent noises about oil last week. As crude soared once more - touching $142 on Friday - he rejected notions that sky-high prices are being driven by speculators. "The major issues," he said, "are associated with supply and demand" - which shows the ECB gets it. High oil is here to stay.

Many claim $100-plus crude is a "bubble" - with the implication prices will soon come crashing down. But the plain truth, for those allowing themselves to accept it, is that by 2025 the world will be consuming at least 50 per cent more oil than now and global reserves are falling. So the more central bankers point to "speculation" in the oil markets, the more they damage their inflation-fighting credibility.

We should worry, then, that America's Commodity Futures Trading Commission - a body with close links to the Fed - last week launched an investigation into commodity traders. This not only shows an important regulatory body to be tackling the wrong problem, but also that it's ultimately controlled by ignorant, finger-pointing politicians.

I'm afraid that much the same can be said of the Fed itself. Since sub-prime broke, US rates have dropped 325 basis points - all the way down to 2 per cent - despite headline inflation now running at 4.2 per cent. This is way too lax - and the resulting negative real interest rates will pump inflation higher still.

Earlier this month, Fed Chairman Ben Bernanke began to tackle his inflationary demons, suggesting the rate cuts were over, and the next move would be up. The markets took him at his word - and priced in a rate rise, so immediately reining in inflationary pressures.

Within a week, though, the Fed's resolve was spent. Officials briefed the markets that a rate rise may, in fact, not happen. And last week, Bernanke dropped the ball again. It wasn't that the Fed kept rates on hold. To have increased now, having cut just weeks ago, would have smelt of panic.

But, in a statement alongside its decision, the US central bank missed an opportunity to show how seriously it takes inflation by conveying that inflationary expectations are flat, and oil prices could soon tumble. Both assumptions look badly wrong.

Above all, at this crucial juncture, the Fed failed to make clear that when it comes to a straight choice between spiralling inflation and slower growth, it would always chose to stamp on inflation. In this regard, US policy-makers would do well to look to their counterparts in Continental Europe. And I don't say that very often.

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