August 2009

Jonathan Freedland simply doesn\’t get what it is that banks do. Let\’s replace those nasty banks with Zopa and other peer to peer lending sites.

What if our man in Dundee can\’t or won\’t pay back the loan? Zopa\’s answer is that would-be borrowers undergo the same credit checks as imposed by any bank.

Ah, you see, the bank, as the intermediary, takes the risk of the default. That\’s why they take so much of the interest. Zopa doesn\’t take that risk thus doesn\’t take so much of the interest.

But there\’s something much more important:

The company can\’t envisage peer-to-peer mortgages, for example: how many individual lenders would want to tie up their money for 25 years?

One definition of a bank (first seen at Brad DeLong\’s) is someone who borrows short and lends long. Any system that isn\’t doing that is not going to be able to replace them.

Peer to peer lending is just fine, a useful addition to the marketplace. But it just ain\’t gonna replace the people who move savings and loans inter-temporally.

Err, this doesn\’t make sense:

\”Of course,\” he drawled, \”you\’ll offer your properties as collateral.\” \”No,\” I replied. \”We\’re not giving personal guarantees. We have a good business plan and we\’re offering a small stake. You\’ll have to take the risk with us, if you want the reward.\” The spider press-ups froze. I might as well have told him that I\’d torched his mock-Tudor semi in Purley and sold his mousy wife to Somali pirates. The idea that his bank should take an entrepreneurial risk had cast him in a Bateman cartoon, his mouth open and his cheeks flushing. He could hardly contemplate the horror of it.

OK, UK retail banks don\’t take equity stakes in business plans in return for loans. That\’s not what they do. They\’ll lend against security (like housing) or in an established business against the security (perhaps a debenture or something) of the business itself.

Nothing new there at all.

The question \”Whom does my wealth enrich?\” is not one that keeps Barclays awake at night, evidently. Its answer is simple: us. I can see Bob Diamond, president of Barclays, passing one of those \”Make Poverty History\” posters in his limo and smiling to himself, murmuring: \”Job done.\”

But to use that to go on and moan about the rewards paid to that part of a bank which does take equity stakes in return for investment….well, that\’s simply silly as well as being confused.

The suburban bank manager ain\’t getting that sort of pay…..because he\’s not in that sort of entrepreneurial world. The people who are in that world do get that sort of pay: the VC companies, the investment part of banks.

There may still be thingswrong with the pay structure in those areas but Pitcher here has got very confused, at the best, about how banking works.

Deflation, not inflation, is the swine flu that risks infecting the economy; quantitative easing is its Tamiflu.

That is, something we\’ve not really tried before, certainly not on this scale, and something which we know to have side effects which may or may not be worse than the original disease we\’re trying to treat.

Enjoy it, it\’s an experiment.

Larry Elliott, Guardian economics editor, makes a fairly silly statement:

The banks are not exactly helping King and his colleagues on the monetary policy committee; they are hoarding cash and rebuilding profits decimated by ill-judged investments in fancy derivative products by gouging their customers. Over the last two years, the bank rate has come down from 5.25% to 0.5%, but a two-year fixed mortgage has come down by 1.6 percentage points and a five-year fixed home loan by just 0.5 points. Unsecured loans are more expensive than they were before the crunch.

For while what he says is in fact true, it\’s not enough of the truth to tell people what is actually happening. For there is something called the \”yield curve\”.

Here\’s the chart for this morning, lifted from the FT.

Now, this isn\’t exactly the same as the rates at which banks lend to each other but it does give us a useful little clue as to what is happening.

That 0.5% bank rate is obvious over there at the left….but that, as the chart implies, only works for money borrowed up to 6 months. So, if you have a plain vanilla mortgage, that is indeed where the banks are getting the funding for it (remember, the definition of a bank is someone who borrows short and lends long). For they can borrow the money at this 0.5% rate for a month and lend it to you. Then next month they borrow it again, at 0.5%. If they have to pay 1.0% for it next month, they\’ll raise your mortgage payment. This is what a floating rate loan means.

However, if you want to borrow for longer than 6 months then you have to pay more. Might be people worried about repayment that far in the future, might be worries over inflation, can and could be all sorts of reasons: but if you want to borrow 10 year money then you\’re paying 4%, not 0.5%. This is of course 4% for the whole period of ten years, that\’s what you\’re doing by agreeing to the time term, fixing the rate for that term.

Note also please that these are wholesale rates, not retail: you\’ve got a whole level of offices, loan officers and bank managers to pay for on top of these before you get to what we might be charged as individuals.

Of course, when banks offer fixed rate mortgages, they do not fund them from those short term borrowings at 0.5%. That\’s the sort of thing that is very frowned upon: it leads people to going bust, borrowing both short and floating rate and lending long and fixed rate. So the banks will borrow two year money to fund two year fixed rate deals: five year to fund five year.

As you will note, two and five year money is more expensive than 6 month money.

Thus fixed rate mortgages are, in the current climate, more expensive than the base rate.

We would normally expect this to be the case although it can happen that the yield curve inverts. That borrowing longer term is cheaper than short term. Indeed, I have a feeling (from dim memory, not something I would want to have to prove) that this was indeed the situation before the crash, that long term money was cheaper than short.

All of which means that by comparing fixed rate mortgages now to base rate now Our Larry is rather muddying the picture. What can and should be compared is two year money then to two year money now, five year to five year and base to base.

All of that is bad enough, Our Larry brandishing rates which he knows are not comparable (and if he doesn\’t know they\’re not comparable then he should be fired, pronto) to make a political point. It\’s also bad enough that I doubt very much that there is anyone within the Guardian\’s walls with enough financial knowledge to call him out on this.

But what\’s really bad about what he\’s done is that he\’s missed, as St Barack would say, a \”teachable moment\”.

Governments and central banks do not, as that chart obviously shows, control interest rates beyond the short term. Medium and long term interest rates are determined by the markets, not politicans and not bureaucrats.

Sadly, the reason why the exposition of this obvious truth is missed is because it argues against one of the dearest wishes of The Guradian\’s fiscally illiterate readership. That only if we had the government directing lending then industry (all those things you can drop on your foot that they rather oddly seem to like so much) would get that lovely cheap long term money it desires. But it won\’t, because the rate at which it will is not determined by government.