jka on economics UK

Dunfermline 0 Mandarins 5

When Sir Fred Goodwin reported on his RBS encounter with the Treasury he described it as a “drive by shooting”. In comparison, Jim Faulds, the Chairman of the Dunfermline Building Society has just experienced a blind date with Jack the Ripper or the mad axemen from Horseguards Road.

There was to be no bail out for the building society as the Treasury assessed the minimum £60 million the FSA had advised was needed by the 140 year old bank would fail to secure a future.

Dunfermline building society has been dismembered. The good assets of the bank, the staff, head office, 34 branches, the retail and wholesale deposits and the residential mortgage book has been transferred to Nationwide. The brand name is to be retained with no job losses over the next three years.

The less glamorous “social housing loans” rejected by Nationwide are to be held in a bridge bank owned by the Bank of England pending a further organised disposal.

Dunferline’s toxic debt, including commercial loans, high risk mortgages and subordinated debt are to be liquidated. The society had engaged in substantial commercial property lending, in excess of £650m, making many of these loans in 2005 and 2006 and are now faced with substantial write downs.

The society also purchased in 2006 and 2007, over £150m of high-risk, self-certified mortgages, from GMAC and Lehman Brothers, just before the global market for such loans completely collapsed.

Jim Faulds the Chairman of the bank accused the government of sacrificing the Society. The tripartite, Treasury, FSA and the Bank of England have demonstrated the ability to act quickly and ruthlessly to shake out the problem institutions. Gulp.

HM Treasury - Statement on Dunfermline Building Society

Is the mortgage market basing? - latest approvals offer comfort

According to the Bank of England the number of loan approvals for house purchases was 37,937 in February compared to 31,791 in January an increase of 19%. This is not recovery. Compared to February 2008 approvals were down by 56% and on an Moving Annual Total basis the February figure was just 37% of the prior year high.

In value terms the average mortgage approval was down 19% from £145k to £117k approximately.

The headline growth of 19% compared to January is misleading in terms of trend development, since the year on year and MAT comparisons are poor.  This is not recovery. Nevertheless the underlying data suggest some kind of bottoming in terms of mortgage lending activity may be underway. This will be defined by an improvement year on year activity which should take place by June and into the third quarter of the year if current trends persist.

November 2008 may prove to be the nadir in this cycle, cautioning as always nadir the anagram of drain.
Bank of England Approvals secured on dwellings - House Purchase

Obama's tough love for Chrysler and GM

Today President Barack Obama said that neither General Motors nor Chrysler had offered enough in terms of reorganisation to justify further federal bailouts. Greater changes are demanded by the administration including the departure of Rick Wagoner as CEO of General Motors. For Chrysler it’s the Italian job and a merger with Fiat but for General Motors some form of bankruptcy re-organisation seems inevitable.

In fact, Obama raised the possibility of a controlled bankruptcy to help either or both "restructure quickly and emerge stronger". Unions and management had previously warned of the damage the spectre of bankruptcy could do to the companies but Obama did not shirk from frequent use of the term.

The administration will offer General Motors "adequate working capital" over the next 60 days to produce a reorganisation plan acceptable to the administration but said that restructure under bankruptcy protection remained an option.

Chrysler's situation controlled by Cerberus Capital Management is considered to be more risky and the government will give the company 30 days to overcome hurdles to a merger with Fiat.

If they reach agreement, "we will consider lending up to $6 billion to help the plan succeed," he said. If not the company would face a cut off in government funding that would force bankruptcy as an option.

Obama said he is committed to the survival of a viable auto industry, on terms that will allow it to compete internationally and announced a number of initiatives to support the plan.

The government would move to guarantee warranties of any vehicles purchased during the period of uncertainty concerning bankruptcy threat.

The president also said he would work with Congress on a programme to encourage consumers to replace old, less fuel efficient cars with newer, cleaner vehicles. (The German model of cash for the trade in).

Discounts or subsidies on older vehicles to be introduced with a remission of sales tax on vehicles purchased within the year.

Bailout funds would be made available to suppliers to the automakers in an attempt to keep them afloat and the industry viable.

Tough love indeed, Chrysler in a forced marriage to the Italians and the GM to be split into a good car - bad car business under Chapter 11 protection.

Why banks failed - disaster myopia and the madness of crowds

In a further extract from the Andrew Haldane paper this makes for great reading of risk.  Why banks failed the stress test. Disaster myopia - we forget or choose to ignore just how bad it can get.

“Disaster myopia refers to the propensity to underestimate the probability of adverse outcomes, in particular small probability events from the distant past. Economic agents have a tendency to base decision rules around rough heuristics (rules of thumb). The longer the period since an event occurred, the lower the subjective probability attached to it by agents (the “availability heuristic”) and below a certain bound, this subjective probability will effectively be set at zero (the “threshold heuristic”).
 
If the period of stability is sufficiently long – a Golden Decade perhaps? - this subjective approach to evaluating probabilities looks increasingly like a fully-rational, Bayesian approach to updating probabilities.  It is perhaps no coincidence that the last three truly systemic crises, October 1987, August 1998, and the credit crunch which commenced in 2007, were roughly separated by a decade.  Perhaps ten years is the threshold heuristic for risk managers.
 
Such disaster myopia is not of course confined to the private sector.  The official sector is just as likely to succumb to cognitive bias borne of long periods of stability.  With hindsight, the stress-tests required by the authorities over the past few years were too heavily influenced by behaviour during the Golden Decade. Many risk management models developed within the private sector during the Golden Decade were pre-programmed to induce disaster myopia.

Improvements in data and IT technology were able to feed the models with vast, high-frequency datasets.  This provided, in the statistical jargon, ample degrees of freedom for modellers, enabling them to devise risk frameworks which, on the face of it, were very precisely calibrated.  
 
The sample in question was, with hindsight, most unusual from a macroeconomic perspective. The distribution of outcomes for both macroeconomic and financial variables during the Golden Decade differed very materially from historical distributions. The charts illustrate this small sample problem. The charts mark the distribution of a set of macroeconomic and financial variables, comparing the Golden Decade with a sample stretching back in the case of equities to the 17th century. The distributions plainly suggest that the Golden Era distributions have a much smaller variance and slimmer tails. (Risk will be under estimated if the Golden era data with lower volatility, frequency distribution and smaller standard deviation is used.)

For the macro time-series, the differences in variability are striking. The long-run standard deviation of UK GDP growth has on average been 4 times greater than during the Golden Decade.  As part of the Basel II regime the FSA require banks to simulate the effects of a 1-in-25 year stress.  In 2007, the worst such GDP growth outcome over the preceding 25 year period was -1.4%;  the average 1-in-25 year stress over the full sample is -3.8%. Similarly with unemployment the standard deviation over the Golden Decade was 0.6 and over the long run data 3.4.
 
Consider the distribution of equity returns Chart 7.  If we assumed the Golden Era distribution was true, the three worst monthly returns in history, the bursting of the South Sea bubble in September and October 1720, and Black Monday in October 1987 – would have been respectively 12.7, 6.9 and 6.5-sigma events.  All three would have appeared to be once in a lifetime – of the universe – events.    [Almost a flock or a wedge of black swans]
 
These examples help to illustrate that the quantitative consequences of disaster myopia may have contributed importantly to the profile and price of risk being set too low.

Why banks failed the stress test Andrew G Haldane* February 2009
Executive Director for Financial Stability Bank of England

The Black Swan : Nassim Nicholas Taleb

Extraordinary Popular Delusions and the Madness of Crowds : Charles Mackay 1841

Why banks failed the stress test - misaligned incentives

This is an extract from a great Bank of England Paper by Andrew Haldane which explains why banks failed the stress test - disaster myopia, network externalities and misaligned incentives. In this extract an insight into the latter is provided.

“A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices.  The first meeting of that group sticks in my mind.  We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.  A quick survey suggested these were very modest stresses.  We asked why.  Perhaps disaster myopia or network externalities – we understood how difficult these were to capture?
 
No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event, the (business would be bust)  authorities would have to step-in anyway to save a bank and others suffering a similar plight.
 
All of the other assembled bankers began subjecting their shoes to intense scrutiny.  The unspoken words had been spoken.  The officials in the room were aghast.  Did banks not understand that the official sector would not underwrite banks mis-managing their risks?   
 
Yet history now tells us that the unnamed banker was spot-on.  His was a brilliant articulation of the internal and external incentive problem within banks.  When the big one came, his bonus went (businesses failed) and the government duly rode to the rescue."

Why Banks failed the stress test - Misaligned Incentives
Andrew G Haldane*
Executive Director for Financial Stability
Bank of England 13 February 2009

Barclays shares soar - the bank passes the candles and cans test

Barclays shares soared this week on news the bank had passed the FSA stress test. Over the past few weeks the Financial Services Authority has subjected the asset portfolio of the bank to intensive testing and evaluation.

Known as “candles and cans” profiling, the test asks how the assets will perform if the UK is dining on canned food by candlelight as the economy crumbles, with no electricity and no food in the supermarkets presumably.

The test involved house prices and commercial property falling by a further 50%, recession prolonged for a period of three years, slump in employment and GDP output, varying interest rate scenarios et al.

The good news is that Barclays passed the test with flying colours. Despite having the lowest of the major banks tier one capital ratios and a significant derivatives exposure including sub prime and Alt-A, Barclays survived the bunker test. It would continue to thrive in a world in which we return to the caves, camping in camouflage and hunting at night.  The FSA decided the bank did not need additional capital and could escape the clutches of the Treasury and the Asset Protection Scheme if it so desires.

The stress test must be about as demanding as an army medical in a national emergency. Some analysts had suggested the bank may need as much as £8 billion in new capital. The proposed sale of iShares may realise £4 billion but can the bank really survive a stress test involving a 50% slump in mortgage backed securities, three year recession, surging unemployment and a national diet of baked beans and misery?

UK Retail sales increase by just 0.5% in February

According to the latest information from the Office for National Statistics, retail sales in February, increased by just 0.5% compared to February 2008 the lowest growth since September 1995.

Non-specialised stores sales fell by by 5.2 per cent and food stores accounting for 43% of sales fell 0.6 per cent. Non-store retailing and repair – which includes some aspects of internet sales was 8.9 per cent higher than in February 2008.  Textile clothing and footwear sales increased by 4% reflecting additional discounting in the period as the value of product  sales was unchanged.

According to the British Retail Consortium retail sales values fell 1.8% on a like-for-like basis in February 2009 compared to February 2008. Food sales showed slower growth and non-food sales fell further below their year earlier level as January's clearance boost faded. Homewares and big-ticket items were particularly hard hit. Non-food non-store sales (internet, mail-order and phone sales) in February were 12.3% higher than a year ago. This continued the slowdown from the 30.0% gain in December.

According to the CBI, high street sales appear to have fallen steeply in the year to March in the latest Distributive Trades Survey. 19% of retailers said year-on-year sales volumes rose in the first half of March, while 63% said they were down. The resulting balance of -44% was worse than retailers had predicted (-33%).

All in all it is tough in the high street with smaller retailers particularly badly hit
 according to the ONS data. Sales of smaller  retail organisations fell by 6.5% and the BRC warn of the toughest rent quarter day in eighteen years at the March hurdle date.
ONS Retail Sales February 2009
CBI     British Retail Consortium

UK Inflation : Governor's letter and the reply they wanted to send

Chancellor,
February's inflation out turn is somewhat higher than expected. That could reflect pass-through of the exchange rate depreciation to consumer prices since much of the strength in the out turn appears to be concentrated in components where a large share of goods is imported.

Despite the increase in CPI inflation in February, we believe that the sharp decline in CPI inflation since its peak in September is likely to resume in the coming months. This reflects two main factors.

First, a number of major gas and electricity suppliers have signalled a reduction in tariffs in response to earlier falls in global energy prices. We expect that this will act to reduce inflation in the coming months by around a percentage point and there could be a further round of tariff reductions later in the year.

Second, the growth rates of money and nominal demand have slowed sharply. The contraction in economic activity in recent quarters has created a substantial margin of spare capacity in the economy. the margin of spare capacity is likely to build in the coming quarters, pulling down on CPI inflation. Consistent with that outlook, wage pressures are muted.
Thanks Mervyn

The letter the Chancellor didn’t write in reply: Mervyn
Thank you for your letter of the 23 March, written under the terms of the remit. You only have to write to me every three months yet this is your fourth letter since May last year explaining you have missed the inflation target again. It isn’t very promising is it.

You say that much of the strength of inflation is in “components where a large share of goods is imported” but when I look at the changes in CPI inflation over the last twelve months, the major changes are in food and beverages and alcohol and tobacco. OK a large proportion is imported but what about inflation in household utilities, education and restaurants and hotels. And why if the fall in Sterling is so critical have prices for clothing and footwear fallen by 9.3%.

You suggest that prices will continue to fall in the months ahead because the growth rates of money have slowed sharply. Yet according to the Bank’s own figures, broad money growth has increased by 18.8% in the twelve months to February 2009 and by 24% on a three month annualised basis. What exactly did you mean?

It is true the economy is contracting, spare capacity is increasing, wage demands are moderating and utility prices are set to fall but I note that service sector inflation is increasing at 4.2%. Can I be sure you won’t be writing again in June? I cannot be confident in this matter. I also note you appear to be carrying an Apple Mac, even more worrying.
Alistair
Letter from the Governor to the Chancellor
Letter from the Chancellor to the Governor

CBI in clear warning to the Chancellor

The CBI is calling on the Chancellor to deliver a Budget, shaped around  jobs, investment and competitiveness. "Don’t spend any more money but outline a clear and credible strategy to get the public finances back under control."

The CBI is warning that the "alarming" state of the public finances rules out the option of a further  fiscal stimulus. John Cridland, CBI Deputy-Director General, said: “The public finances have been battered by the cost of rising unemployment and lower tax receipts during the recession. With economic activity expected to contract by 3.3 per cent and unemployment set to reach nearly three million this year, the outlook for the public finances is already alarming.

“A further significant fiscal stimulus is unaffordable and would lead to businesses and households retrenching in fear of higher tax bills in the future. Instead, the Chancellor needs to let the considerable stimulus already in the pipeline take effect and deliver a clear and credible plan for restoring the public finances to health.

Last week the Government borrowing figures suggested the out turn for the year would be around £95 billion up from £35 billion last year. Next year the figure is expected to rise to around 10% of GDP with some analysts projecting a total borrowing figure of £180 billion. The scope for spending is limited and is clearly of concern to the CBI.

Footnote: Today, Mervyn King, the governor of the Bank of England used an appearance before the Treasury Select Committee to warn the Government of the dangers of borrowing any more to bring the recession to an end. Mr King said Alistair Darling must keep spending under control.
"I'm sure the government will want to be cautious in this respect," he said. "There is no doubt we are facing very large fiscal deficits over the next two to three years. Given how big those deficits are, I think it would be sensible to be cautious about going further in using discretionary measures to expand the size of those deficits."

Government borrowing soars as VAT receipts slump
Telegraph : No extra cash for UK economy, BOE chief warns

February Inflation rises to 3.2% - deflation will prove elusive

UK Inflation CPI annual inflation increased to 3.2 per cent in February, up from 3.0 per cent in January. RPI inflation slowed to 0.0 per cent down from 0.1 per cent. RPIX inflation – the all items RPI excluding mortgage interest payments – was 2.5 per cent up from 2.4 per cent.

CPI based, clothing and footwear prices fell once again by 9% producing the largest move to the downside in the CPI level. Transport costs were down by 1.4% reflecting the fall in fuels and lubricants prices.  Food prices once again remained high at 11.5%. Housing utilities, water, gas, and other fuels, were up by nearly 10%. Education costs were up by almost 9%. Furniture and household goods were higher by 3.2% and restaurants and hotels were higher by 3.2%.

Service sector inflation CPI based was 4.2% compared to a 2.2% rise in goods inflation. As we have stated frequently, it is difficult to reconcile high food and service sector inflation with the low projections for CPI into 2009.

The largest downward contribution to the change in the RPI annual rate came from housing costs, with the largest contribution from mortgage interest payments. With the substantial reductions in interest rates in 2008, the headline RPI numbers will look pretty dramatic at zero inflation but the underlying RPIX and preferred CPI numbers are the real measure.

The strength of import prices, food inflation and service sector inflation may make it easier for the Bank of England to strike towards a CPI target rate than is currently realised. Deflation may be more elusive than generally anticipated and the scope for queasing may be more limited than realised.

Inflation January - Deflation may be more elusive
ONS Consumer Price increases February 2009