torsdag 25 oktober 2007

Northern Rock and its aftermath - missing the financial point

The Bank of England and the financial commentators are missing the point about the recent Northern Rock crisis. The Guardian's commentator, Larry Elliott said today...

'The City risks financial turmoil on a renewed and intensified scale unless it learns the lessons from a catalogue of weaknesses evident in the run-up to this summer's credit crunch, the Bank of England warns today. The Bank says Britain's financial system is vulnerable to further shocks after ignoring repeated warnings about the "seriously flawed" model used by institutions to expand lending rapidly in recent years.

'It admits it would need to learn its own lessons from the handling of the three-day crisis at Northern Rock - the first run on a big UK bank in almost 150 years - but said there were already signs of a return to the lax lending practices that were the root cause of the freezing-up in financial markets, in Britain and globally.

'In its half-yearly Financial Stability Review, the Bank is critical of the way banks made risky loans and then passed them on to other institutions. "The 'originate and distribute' business model, which has facilitated rapid growth and strong profitability at major financial institutions in recent years, has been shown to have significant flaws," the FSR says. "These include inadequate information about the true credit risk underlying financial instruments; an excessive dependency on rating agencies, opaqueness about the distribution of risks in the financial system; over-reliance on continuous liquidity in financial markets; and inadequate liquidity risk management." '

Banks create money out of nothing. This can be for a perfectly legitimate purpose. Classically, it was for an enterprise such as farming, where the farmer had to survive between the time the seeds were planted and the crop was harvested and sold. The reality was that this credit enabled the farmer to live off previous years' production. The bank could be fairly certain that the credit would be repaid, unless some disaster intervened.

But when money is loaned for land purchase, things are different. Land purchase - usually wrapped up as house or other property purchase - is, in principle, nothing more than the purchase of a stream of rental income, real or imputed. The problem arises in the first instance because expectations of future increases in the rental stream are factored into the capital value. A further issue then comes into play, because land becomes a commodity to be traded in speculatively.

When loans for land purchase are secured on land prices in a market where speculative trading is going on, increasing amounts of money will become available for buying land, driving prices up higher and higher. Eventually, they will reach a point where returns on this "investment" fall to the point where, even with expectations of future income growth, the yield is unacceptable. At this stage, the market falters and crashes, with people who purchased at the peak finding themselves with large debts and an asset that is worth less than the amount borrowed. This then becomes a problem for the lenders whose loans are secured on a value that no longer exists. Historical evidence indicates that the process is cyclic, with a period of about 18 years.

Northern Rock's problems, which are related to a larger scale disruption in the USA, are an inevitable consequence of the financial system. Better oversight or control is not going to prevent these periodic financial disruptions.

If the right system of land value taxation were in place, the rental stream accruing to land ownership would be small or non-existent. Land would not be traded in the way that it is under the present arrangements which leave the rental income stream with the land owner. Land holders would be taking on the liability to pay the annual land value tax, which would still entitle them to use the land for whatever they wanted, just as leaseholders today are willing rent premises in order to use them for their business. There would be no point in holding land speculatively, however, as there would be nothing to speculate in, because the true rental value is always captured and land as such would effectively have no selling price.

The banks, deprived of the opportunity to lend on land purchase, would be limited to make their advances on the strength of the creditworthiness of the borrowers, without reliance on the shaky collateral represented by inherently volatile land values - as has been proved historically.

This change is a prerequisite for bringing about the necessary reform to promote good practice in the banking system.

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