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State of Credit

State of CreditOnce again, our banking and money system is in the headlines for all the wrong reasons.

So we thought we would pick up from our previous financial articles of 2008 ('Time for Change') and 2009 ('Riots in the Streets?') - to offer a personal view of the latest problems with national and international finance.

Our money systems are in serious trouble.

Few people, if any, will escape unscathed.

Nations, governments, banks, businesses, families and individuals are all threatened.

At the epicentre of the problem is credit.

Credit taken by individuals and businesses. Credit between banks, and credit exchanged between governments.

We see the problem as having begun with personal and business indebtedness which was allowed to grow out of control. That debt transferred first to banks (who consider it an asset), then to governments - which is where we are now.

The last stage will see it put back where it came from, onto ordinary people.

We see several strands that have separately built up heads of steam to cause this problem.

And they are now coming together in what might be described as a prelude to financial Armageddon.

The credit bubble had been growing for years, but the last straw was probably the housing scam that played out chiefly in America - where unscrupulous mortgage salesmen sold impossible mortgages with inherent and inbuilt unaffordability to poorer, unsuspecting, less savvy (and often deep south) families.

These mortgages, the so called 'sub-prime' loans (because they were cynically and knowingly sold to people who could not really afford them) carried repayments that were programmed to produce a high income for lenders. To do this, they were designed to seduce unwary borrowers with cheap repayments at first, but to rocket and ratchet-up the interest rate to wholly unaffordable levels after only a few months of repayment.

To lenders, this held out the promise of exceptionally high income from what were, in reality, very risky loans.

Banks and other financial businesses took the mortgage debts that the sharp sub-prime salesmen had sold, and mixed them with other, more reliable loans to improve its credibility.

They then took this loan mix and sliced and diced it, before re-packaging it into new loans which were then sold on to other financial institutions as (theoretically) highly profitable debt packages that would deliver their owners an unusually high income level.

They were thus very attractive (and popular) investments.

But that process assumed the mortgages and loans would be repaid of course.

And they weren't.

Those sub prime loans and mortgages were too good to be true.

And as properties in the US were re-possessed, misery and loss for homeowners in America's deep south eventually turned into panic for the banks who had bought millions of pounds worth of their (expected) income-producing repayments.

But, incredibly, because the loans were now so intermingled (and/or because their loan-buying employees had been so stupid), those who had bought the debt to produce an expected high income didn't know what proportion of them were good loans (yes, really), nor what proportion of what they had bought were bad loans, and would probably never be repaid.

This loan trading was done internationally, on an epic scale, and often, the loans were sliced and repackaged and sold on again and again.

Incredibly this situation took place in banks that were household names.

The burst US housing bubble might have been the last straw, but the voracious banks has already been hard at work in other fields storing up an even bigger problem by extending their 'leverage' under the Fractional Reserve system of banking that governments and regulators have allowed to develop.

Most people believe that when you deposit £1,000 into your bank or building society they can then lend that money out to someone else at a higher rate of interest than they give you on it. After all that's how banks make their money, isn't it?

Well, yes and no - because what less people know, is that - with widespread approval of Governments and regulators - and for many years, banks have loaned that same £1,000 to anything up to six other customers at the same time.

Yes really.

Having a 'Banking License' gives you authority, in effect, to create 'new money' and to magic-up an extra £5,000-worth of credit out of thin air from the £1,000.

This is regarded as a perfectly normal (and indeed essential) practice in the world of credit and finance.

It's called 'Fractional Reserve Banking' (because they only have real money backing "a fraction" of what they have lent to others).

If you want to see an amusing (but terrifying) story of how this practice developed have a look at 'Money as Debt' on You Tube

That practice of lending to a multiple of six was bad enough. But not content with drawing what was, in effect, six lots of interest on the same loan, the greedy banks wanted more, and, after the 'Big Bang' of 1986 when the UK Government relaxed and de-regulated the controls on banking (in order to attract banking operations to Canary Wharf to create a new financial economy for the UK and to generate money to replace what had been previously earned by manufacturing industry), the banks were allowed to increase the lending multiple or 'leverage' in the UK as some had been doing elsewhere for a while.

Some of the higher-leveraged banks lent the same £1,000 to more than 30 customers at the same time using the (now relaxed) Fractional Reserve system.

Thirty lots of interest when you're only paying one, is pretty much a license to print even more money than the fractional reserve con trick.

There were also other practices (which were just as, or even more risky) that commercial banks indulged in over the years.

No wonder the great glass skyscrapers - those modern wonders of the financial world - mushroomed everywhere.

Bank customers (like the good consumers they were) took whatever loans were on offer, and went off and spent the illusory money.

So with money moving around the world in loans that no one knew the real worth of, and debt multiplied by a factor of 30 - (or to put it another way, the banks holding only one thirtieth of their 'assets' in real money), it was no wonder that banking had become a disaster waiting to happen when the sub-prime mortgage scam broke.

Many of our major, household name, trusted, marble-and-mahogany, solid-reputation banks had become nothing more than huge black holes of debt, ready to suck in and devour the finance of whole nations.

They ruled the roost because they had been allowed to grow so big, and the implications of their failure had become so vast and dangerous (we're talking here of the large scale civil disorder and anarchy that would follow the realisation that banks could not repay those who had deposited money with them).

So they were judged by Governments to be 'too big to fail' - and they were bailed out by Governments. At least they were bailed out enough to restore and maintain public confidence in banking as a system.

WEAK GOVERNMENT The bail-out itself was bad enough, but governments were also storing up credit problems of their own.

It's called the National Debt.

In March this year, the UK's basic National Debt was around £1,022 billion.

But, because our Government bailed out the banks, and borrowed the money to do that, our debt is actually £2,311 billion in total.

In the UK, a 'billion' is now a thousand millions. (It used to be a million million but we've now adopted the American system of counting), Even so, the UK national debt is now a mind-boggling £2,311,000,000,000

Most people (including us) simply cannot comprehend the scale of this number. So to make it more understandable.... there are about 62 million people in the UK - therefore the total national debt is equivalent to £37,000 for every man woman and child in the country. (Or £16,000 per head if you exclude the bank bailouts)

The UK's annual income - (it's Gross Domestic Product or GDP for short) - is around £21,000 a year per head. So at present, the UK owes more than a year of our total income.

And it's getting worse. We continue to live beyond our means.

You might wonder who will keep lending to us in this sort of situation, and what guarantee there is that loans made to the UK Government will be repaid.

The answer is that the guarantee for such loans is us - the taxpayers.

We will eventually have to pay-up. (Or probably more specifically, the taxpayers who make up future generations will probably have to pay up)

UK DebtUK Government income from taxation isn't enough to cover its spending on our behalf, so we have a 'budget deficit' - or national overspend - each year. This overspend is covered by borrowing - by increasing our existing loan debt.

Courtesey of 'The Guardian' website and Mark McCormick you can see an excellent graphical depiction on what happened, just click the image above for a larger version.

(As an aside at this point, readers might be as interested as we were to note that the only times since 1979 when the UK was in surplus, was when the Chancellor of the Exchequer was someone who was educated at a grammar (or other type of  selective school), rather than at a public school.

However, for the moment, because we've been running at a loss since 2002, the loss is simply being allowed to accumulate, and it is being added to the National Debt each year. The (in our view rather hopeless) theory is that if we can get enough 'growth' going, there will be more work for people, there will thus be more folk in work, less benefit paid out, and more government income from taxation. The grand idea is that this will reduce the national debt.

But creating that 'growth' often involves more borrowing - soaking up even more credit - for individuals and businesses - and that's exactly where the problem came from in the first place!

This is what we call the credit-junkie fix.

Persuade people to start borrowing again and it will all be OK again.

No it won't.

In theory, if our government could spend less on the public services it funds (which it ought seriously to re-prioritise), or increase it's income from taxation (which it won't do because it would decrease the public's spendable income and thus harm 'growth'), it could turn the UK annual budget deficit overspend into a profit.

If it did that (it has happened on brief occasions and for short periods in out history - see graphic above), then the National Debt would be reduced by the budget surplus we make each year.

But mostly because of the political parties desire for (or their need to cling to), power, they won't prescribe the hugely unpleasant financial medicine which is really needed, and we will continue to run a deficit. Our debt keeps getting bigger, and we try to keep on muddling through.

And although we have/had some forces in Afghanistan and Iraq in recent times, it's not even as though out national debt has been essential to fund a major world war, (as it was in 1914/18 or 1939/45).


This debt is mostly about successive Governments who have overspent, and not been truthful with the British people. In order to get elected or in order to stay in power, Government of all colours has hidden all sorts of things off the national balance sheet * (PFI Schemes are a recent and typical example), and they will not tell people how bad things are, let alone take action that is sufficient to correct the problem. * See update at end for more details.

We live in a fraudulent system. Official balance sheets are obscured. Huge liabilities are simply hidden from view.

If they told us the truth we would vote them out. So they lie, and we keep voting in those who make unfulfillable promises. Those unfulfillable promises are the root cause of the disillusion and disaffection with all who take office in the UK.

And if you think the UK's bad, there are countries and institutions that are much worse.

Auditors completely refused to sign off all of the EU budgets up to 2007. In 2010, they did sign them off, but said the accounts continued to be 'materially affected by error'

In Greece, there has been wholesale and widespread misrepresentation of Government finances which was discovered as part of the Basle III investigations.

We also keep hearing about Greece, Portugal, Ireland, Spain, Italy and others who are in an even deeper crisis than the UK because their Governments were constrained by their membership of the Euro single currency, and are even weaker, or more power-hungry, than the UK. (or maybe they were just less good at keeping the truth from being seen).

We have now learned that we cannot even trust the current income and expenditure statements of some countries - let alone their 'adjusted' National Debt figures.

On their present course, our western democracies will carry on regardless until, one after another, they follow Greece and the others into the black hole that, as Niall Ferguson says, "begins with a loss of credibility, continues with a rise in borrowing costs, and ends as governments are forced to impose spending cuts and higher taxes at the worst possible moment."

And it is at this point that the debt will return to haunt the people who caused it in the first place, and then - as in Greece (and as is starting to happen in Spain), there will be riots in the streets, and an increase in suicides and all the things that come as a prelude to anarchy. After that, the next generation or two will be faced with years of economic hardship and much reduced public services / benefits (or much higher levels of taxation) to pay off the debts.

We say 'the people who caused it in the first place'because we believe the root cause of debt lies with people of our generation.

If we had not been so keen to accept credit as a way of living, if we had valued parsimony and saving, things would have been different. But the 'me' generation was never going there as they were increasingly seduced by subliminal and cleverly-choreographed desire from the peddlers of what would become financial doom.

From the advent of mass hire-purchase in the 1950's and 1960's, the 'never-never' became the worm that gnawed away the monetary morals of our society.

Parsimonious Prudence became Profligate Pandora - and she opened her box wide.

Debt was good for us. It meant we could have whatever we wanted, and we could have it today. All the gain and none of the pain. We'd never had it so good!

Consumerism - the practice of replacing items before they were worn out - reigned supreme.

Household goods were (and still are) replaced on a whim, or to suit a change in fashion. Manufacturers introducing the concept of 'built in obsolescence' to accelerate the process.

We were what we spent.

We soaked up all the money that banks wanted to lend to us.

As the UK house price bubble swelled, people drew out 'their' theoretical 'profit' from their 'increased property value' - or took out second mortgages, to spend (what was in effect) their new debt on consumer goods and holidays.

Credit was easy to come-by, with few checks and balances on the ability to repay.

Back in the 1960s or 1970s, anyone applying for a (maximum 95%) first time mortgage with the Halifax was limited to borrowing 2.5 times the husband's salary and maybe half the wife's. And you had to wait for loan approval until the Halifax manager (who inevitably had silver hair) had satisfied himself that you could conduct a current account and a savings account properly (and in this context, 'properly' meant evidence of proper personal budgeting, and not going overspent) - for at least six months of operation, and even then, you had to wait until the building society itself had received a sufficient inflow of new funds to finance the mortgage you wanted.

Thirty-five years later, in 2005, people were being offered mortgages that were six times their salary. These were marketed at them by gelspike-haired teenagers and twentysomethings who were happy to accept self certification of unprovable self-employed income in order to ensure their mortgage sales bonus appeared. And the money the Building Society used for the loan was provided instantly - by borrowing it from the money markets. And, oh yes, you could borrow up to 120% of the purchase cost to help with fitting out the new house with those all important appliances and consumables.

We descended into unbelievable and unimaginable levels of debt.

Consumers owed £1.456 trillion. (That's £1,456,000,000,000 or 182 years of food for the world’s starving children - or about £56,000 owed by every household in the country).

Sixty percent of the UK's economy is based entirely on consumption.

I spend, therefore I am.

Great out of town shopping centres became the new cathedrals.

Brand names like Rolex, Prada, Adidas, Coca Cola, McDonalds and Gucci became the new Disciples by which our religion of consumerism was evangelised, and visible evidence of adherence to the teaching of these disciples became our measure of devotion.

We took the artificial 'thin-air' money from the banks and credit card companies and created an artificially high level of spending based on debt.

That's the chicken that is now coming home to roost.

But the worst is that many of the credit-junkie Governments around the world now expect us to get back on the treadmill and behave as if nothing had happened.

Too late.

The genie is already out of the bottle for those with eyes to see.

This time in our history is possibly the only opportunity this country will ever have to totally reform control of its money supply and the banking system in the UK.

It is crying out for complete reform.

But there are too many vested interests involved, and it's not going to happen. We will teeter on the edge of anarchy for a while longer yet.

Each of these issues individually created a head of steam. They created pressure in financial systems, and the lid was about to blow.

When it became clear that the US Mortgage situation would cause many loans to default, the banks stopped lending their sliced and diced loans to each other. No-one wanted to lend money to someone who might not be able pay it back, and they all wanted to reduce their potential losses by sucking in cash.

Banks that were vulnerable to a credit squeeze (those whose business model used borrowed money from other banks to lend on as mortgages, instead of using saver's deposits), found they couldn't service their customers. The classic example was Northern Rock. The inter-bank freezing of credit meant Northern Rock couldn't offer new mortgages. They were running out of money to lend - because no-one would lend to them.

As word of that situation spread, queues of savers formed outside Northern Rock branches to get their money out. People worried the bank might empty before they could get it.

A 'bank run' had begun. And when that happens, the panic spreads like wildfire.

It started to affect Lloyds and the Royal Bank of Scotland/Natwest both of whom had to be 'bailed out' by the Government who, in effect, gave them emergency loans of around £1.3 billion. (Yes, they lent them more than our total national debt).

These big banks were seen as being too big to be allowed to fail.

The loss to shareholders and businesses of letting them go bankrupt would have been bad enough - but a big bank failure would fuel yet more bank runs on other banks. Combined, these would have been catastrophic on the UK economy and our civil society, so the Government judged that the lesser of two evils was to increase our debt, and bail them out.

But even the £1.3 billion wasn't enough. In 2008, the total net indebtedness of major UK banks was over £800 billion. The 1.3bn was - in reality - nothing more than a drop in the ocean. It's purpose was to staunch the outflow of cash in what was turning into a full scale bank-run.

Net funding gap for UK BanksThe FT has recently published a chart showing the extent of money loaned by major UK banks, net of deposits - in other words the banks collective indebtedness. It shows very clearly how indebtedness rose from 2005 to 2008 when the Great Banking Crisis began and how, since then, banks have sucked in money from everywhere possible to reduce that net indebtedness. It's now better, at around 200bn, but even at that, it's still more than 100 years of our total GDP output as a nation.

Now you see why banks were judged to be too big to fail.

To reduce their debt levels, the banking credit freeze became even tighter, and it began to affect businesses. They were unable to borrow to expand their businesses as banks sucked in every penny they could to offset potential bad debts and reduce their 'leverage ratio' - to reduce the ridiculous and illusory level of 'magic-money' indebtedness they had created with their relaxed and awful fractional reserve system.

The UK economy started to stall. Labour cutbacks by companies whose order books were (and still are) declining, and cutbacks directly by Government, (who set about reducing the number of public sector employees to cut the Government's pay bill), further reduced output and, at the same time, increased government spending on welfare and benefits (such as jobseekers allowance and housing benefit).

So whilst the immediate and first problems - the USA's sub-prime mortgages and the UK's bank-run panic of 2008 - were staunched with a huge injection of cash by Government, the financial consequences and problems in the US and the UK grew into a slow motion debt crash that has carried on moving around the world, threatening to explode in different countries until someone put a financial Band Aid on it to hold it together for a while longer, and gave it a push to roll it on to another country. This financial pressure bulge is being squeezed up to a head somewhere else today. It's like a giant game of 'pass the financial parcel' only instead of a prize at the end, there's a ticking bomb.

The UK bank-run had frightened governments around the world. So they all started to launch investigations into whether their banks were as bad.

Many were. And some were even worse.

So a new set of regulations on the minimum capital reserve any bank must hold was debated. It culminated in something called 'Basle III' (after the Swiss town where the meetings took place). It is a global regulatory standard to make sure banks have enough cash to cover likely requests for payment, and it is established broadly by ten Governors of leading Central Banks around the world.

Mind you, those are the same folk who had said that the much lower requirements set in Basle I and Basle II were perfectly adequate when they were prescribed, so why we should trust them that Basle III was OK is anyone's guess.

Essentially what they did was say that banks should 'de-leverage' - they should hold more assets to cover the loans they made. (In other words they shouldn't be so greedy as to lend on fractional reserve multiples of 30.)

This was pretty obvious of course, but it had two nasty side effects.

Firstly, banks had to open their books to scrutiny as they had never done before. And secondly, as we have seen, the banks had to suck in money from wherever they could to increase their physical assets and reduce their debt exposure.

The obvious and logical follow-on from that, is that they almost stop lending whilst they shore up their own deposits by calling-in or not renewing loans, and by not making new ones.

You didn't have to be a genius to see that this was going to dry up almost all the lending to businesses and individuals, and it has created howls of protest from business and commerce.

Less loans meant less work.

So in turn, this further credit squeeze and the restrictions imposed by the banks, hit the UK economy even harder, and it started to go into recession. More people lost their jobs, more money was needed for welfare payments, and the downward spiral continued.

It is not yet ended.

In the UK the Government was sympathetic to the bank's plight, so it began a programme of 'Quantative Easing'

If you or I did that it would be called forgery. But because our central bank is 'in charge' of our money it's supposed to be OK

It isn't OK at all.

But Government judged that the socio-political alternative was even worse, and would have produced anarchy as we predicted in March 2009, when we published 'Riots in the Streets' (There were some riots, but they were mostly opportunistic greed: not the desperation of those who have nothing).

Fortunately, the UK has not been tied into the constraints of the Euro, and we have been able to use tools such as Quantative Easing to minimise the impact. What QE has done is given the Bank of England an unprecedented 30% of the UK Gilt market (in the US their 'Treasury' owns 11%) and not long ago, QE had also sent the value of Sterling tumbling by 30% against the dollar.

The Government says that QE money was supposed to find its way into our economy and start 'growth' going again, but it hasn't, and it's obvious why. The High Street banks were desperate to increase their capital base by far more than the £1.3bn government bailout - so they have simply hung on to the QE money they got for selling their gilts to the Bank of England.

It may be no co-incidence that - as the chart above shows - the reduction in net indebtedness by UK banks from £800bn to a projected £300bn at the end of this year is £500bn, exactly the sum that informed commentators say will be the eventual total of illusory magic-money produced by the Bank of England under the QE scheme.

The figures are available for all to see. Since September last year, the cash on High Street bank balance sheets has risen by 58% (source: Stephanie Flanders Blog), whilst lending to households and companies has risen by just 0.2% in that time.

So, (apart from lowering the value of the pound and storing up huge inflationary problems for the future), what QE has really been about has been transferring debt liability from High Street banks to the Bank of England whence it will go onward to Government.

If/when it all goes pear shaped, guess who's going to have to fork out. That's right, it's the people government gets its money from. The people who pay taxes.


But at least the UK has been able to use QE in the short term in the hope that 'growth' will help to get us going again. If we had been within the Euro, our options would have been limited to those offered to Greece and its debt-ridden compatriots: significant austerity *and* huge tax rises.

We've now had it confirmed that the Bank of England is going to 'create' yet more 'magic money' by restarting the programme of 'Quantitative Easing' with another £50 billion. They keep applying these cardiac jump-leads but the financial body simply won't spark back into life. Some informed commentators envisage the BoE will end up having magicked a total £500 billion out of thin air (so far they've created £350bn). Even worse, the Bank of England is now strongly suggesting that commercial banks should start to lend more and stop hoarding the cash, because, they say, there is now less chance of a domestic bank failing'

Don't you believe it.

This is simply a politically inspired ploy designed to get credit-junkies back on the borrowing treadmill; to once again start up artificial 'growth' and spending (based on credit lent by the banks), and this that caused the problem in the first place! Words fail.

Political expediency trumps reality.

In yet another example of misrepresentation, we currently see household-name banks fiddling the figures on interbank lending rates, together with what we are sure will eventually be shown to be the collusion of the Bank of England and politicians in Westminster who, in 2008, were desperately anxious to avoid giving the impression of financial meltdown in the British banking system.

Readers will form their own view about which of the pressures will cause the most problems, and whether this or that issue can be resolved.

But in the great scheme of things, we believe a process has begun where, throughout the world, our expectations about growth and wealth creation will have to be adjusted downward.

Clearly that won't be popular, but we don't see it as necessarily a bad thing. It means stemming - and probably reversing - population growth. It means breaking our addiction to credit. It means getting back to the proper values of goods and services with all the inflationary and credit costs stripped out of them.

But in reality, we know we probably won't actually get there.

We might end up a bit nearer to it than we are now, but the credit-mongers will always be able to seduce vulnerable credit-junkies. And in order to get elected, Government will be complicit in maintaining the great debt and credit con that is being played on us.

To mis-use a current expression - we have been 'mis-sold' our Government; and it's been going on for years.

Don't expect it to change anytime soon, We see it dragging on for years to come. "Kicking the can down the road" is a very apt description of our current predicament.

The long term solution is likely to be ever bigger monetary and political unions until the world has only one Government, one currency, and one taxation system, but it might take a world war on a scale no-one has envisaged to bring that about.

By now our readers are probably fed up of our doom and gloom, and might well ask - how would *we* fix it?

Well, the sensible, practical answer for individuals and families is to diversify any assets you have as broadly as possible, and don't overlook tangible assets like land and property in case paper money ceases to have the worth you expect it should retain. You should also begin to look at how secure you can make your home, and have some sort of plan in place to minimise the impact of civil unrest on you and yours if that were to come about. It is not currently likely, but it is a clear possibility.

The less practical, but more effective solution would be to stop, or drastically reduce, the use of credit.

Micawberism rather than Keynesiasm.

A quick and easy way to bring that about would be to make the payment of interest unlawful.

And do it for future loans as quickly as possible.

Loans should become something you do for a good friend or for a family member, or as a mutual society. Something that is repaid over time without benefit to you except the knowledge that you have helped someone.

We say this is the solution - because the underlying cause of the problem is credit.

And credit is the monster that is currently eating up all the Hope that was the only thing left in Pandora's Box.

However, the idea of abolishing interest payments will never come to be, because politicians would never adopt it. They would not do it because a competing political party would always be prepared to use borrowing to promise higher growth/better living standards in order to get elected.

And each time they offer such a promise, we're stupid enough to fall for it.

From which situation we must conclude that democracy and capitalism, as a system of societal organisation, can offer mankind no hope in the longer term.

And that *is* a frightening thought.

Dated:  8 July 2012

UPDATE 29 July 2012
In a piece by Dan Atkinson in the Sunday Mail today, he recounts his investigation into our Government's off-balance-sheet accounting. For as long as the Mail Leaves it up you can follow this link to see the full article, but in essence he shows how there is an incredible £612bn of debts that are not included in the usual Government figures.

That's £337.6bn in "Remote contingent liabilities", £144.6bn in Private Finance Initiative schemes, £49.5 in "Contingent Liabilities", and £40bn in the new scheme of guarantees and underwriting of business loans recently announced by the Chancellor.

He shows how Government ministers are committing to spending that does not show up in the national debt accounts, and which will only become a problem for future governments - and more particularly future taxpayers - as they fall due. These disastrous practices will yet see us marching down the same road as Greece.


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