Wednesday, December 02, 2009

Hubble Bubble

Bubbling: Bank of England Monetary Policy Committee in session

A frightening article in today's FT (HTP JW):

"Some of the most controversial financing practices of the credit-bubble years – from cov lite loans to Pik toggle notes and dividend recap exercises – have returned to Wall Street, stoking fears that debt markets are growing overheated. The techniques fell into disrepute during the financial crisis because they were based to varying degrees on the same rosy expectations that encouraged companies and consumers to assume what proved to be crippling levels of debt."
Don't understand the lingo?

"In a cov light – short for covenant light – loan, borrowers are granted credit with few, if any, conditions. Pik toggle transactions make it possible for debt to be repaid with more debt – payment-in-kind notes. In a dividend recap, companies take on additional debt to pay dividends to their owners."
Or as market insider JW puts it:

Yes, junk financing is back, underlining a point we've blogged before - the bubble is reinflating. From equity markets to property to junk bonds to banker bonuses, the hubbling bubbling balloon of insanity is once again looming over us.

And you don't need to be a professor of finance to understand why: yesterday's junk debt has been shuffled off onto the taxpayer, interest rates are more or less zero, and sitting on your banking hands never earned a megabonus.

Well, that's not so bad you say, at least we've got the economy growing again, and stopped unemployment spiralling.

Except of course, we haven't. When last sighted (Q3), our economy was still contracting, and unemployment was still rising.

And then there's the horrible head-splitting issue of government debt. As we blogged here, our real national debt (including public sector pensions, PFI, and various other Enron items) is already £2.2 trillion - about 150% of GDP. Adding in the contingent liabilities we've taken on by nationalising RBS and Lloyds takes the total  to £4.6 trillion - well over 300% of GDP. And to put that in context, the normal rule of thumb based on historic experience says that 60% is the maximum safe limit.

You see, the thing is - and pay attention because you may have missed this - by nationalising all those bad bank debts, we've not only let off the bankers from the full consequences of their previous actions, we've also exposed ourselves (ie we the taxpayers) to the major risk that our credit will be cut off. Sure, we are not Dubai (quite), but a 300% debt/GDP ratio is flashing red, red, RED.

We're reinflating those dangerous asset bubbles on the back of our collective sovereign credit. Credit that is already stretched way beyond normal bounds.

So what happens? On the basis of what we've heard so far, here's what we think.

The next government will fail to deliver the spending cuts required to get our public finances back on track. Tax increases will undermine enterprise and effort. Economic growth will be very sluggish over the next few years - much less than the preposterous 3.25% pa envisaged in the last budget. At some stage the markets will take fright. Sterling will plunge (further) and interest rates will surge - long-term rates will be jacked up by the markets, and the Bank of England will jack up short-term rates in an attempt the stabilise sterling. House prices will slump. The bubble will collapse.

At which point, the only way out will be inflation. Lots of it. All that money printed by the Bank to support the bubble will finally come home to roost. And trust me, roosting bank notes are not a pretty sight, especially if you're a pensioner or a saver.

Hopefully, I'm wrong. Hopefully, Cam gets a working majority, screws up his courage, and comes up with a credible programme for sorting the public finances (ie spending cuts combined with bankable fiscal rules).

But most people we've spoken to reckon Cam is SuperMac Mk II. As you will recall, SuperMac Mk I was a so-called one nation Tory patrician who throrougly disapproved of the tough fiscal policies pursued under Thatcher. And as you will also recall, he was the PM who had his entire Treasury team resign because he would not back their plan for restraining public expenditure.

You know what? I've depressed myself again.

Think I'll stop there and maybe treat myself to a shot of morphine.

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