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Round Tripping or How the Banks are currently reporting profits and paying bonuses

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round trippingThe banks are making profits. They are not lending to you and me - so how are they doing it? They are making enough of the stuff now to be able to stand against the moral opprobrium of not only the whole of the UK population but arguably all of the ordinary people of Western Europe and the United States in demanding the right to pay huge bonuses based upon these profits. WTF is going on? Have we seen this before? Here is a wee bit (rather lengthy) of original thinking.

The decision by the Bank of England's Monetary Policy Committee (MPC) on Thursday last to increase the scale of Quantitative Easing (QE), from £125bn to £175bn was consented to by Alistair Darling, the Chancellor of the Exchequer. The move surprised Gilt Traders (Gilts are UK government securities) who had expected the Bank to either increase the scale of the programme by £25bn or pause it to assess how the economy is performing. As a result, government bond prices jumped. Yields on the 10-year gilt initially fell by as much as 20 basis points as markets digested the prospect that the Bank will be buying more gilts over the next three months. Thus, the "Rational Expectation" is that the Bank will buy more Gilts over the next three months as part of the plan. The stock market also rose but sterling fell on fears that pumping money into the economy will stoke inflation. The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. It's hard to describe the UK public finances as anything other than a disaster area. Her Majesty's Treasury forecasts require the DMO (Debt Management Office) to borrow 220 billion pounds this financial year, or almost a billion pounds every working day. Yet while the DMO soaks up cash, the Bank of England is desperately creating it. Its "quantitative easing" (QE) programme, buying in 1.326 billion pounds of paper which looks very like the paper that the DMO was issuing just one day later. Essentially what is happening is one arm of the government is creating money for another arm of the government to borrow. The objective of the Bank of England plan (on behalf of HM Treasury) is to free banks up to lend again through buying government and corporate debt from them.

The traders can hardly believe their luck, selling expensively to the Bank of England (in the City of London) and buying cheaply from the DMO (in Westminster). Both in one way or another, executive agencies of the Crown. It is this process, termed "round tripping" by the clever monetarist "Young Turk" economists of Mrs Thatcher's government in waiting in 1978 -1979, watching the total screw up being made of the British economy by the incumbent Labour government, which inflates the monetary base, that quantity of money which remains within the banking and capital markets system. In very simple terms 'round Tripping' can be defined as taking an opportunity to make a profit by making use of a bank overdraft facility to deposit funds in the money market at rates that exceed the cost of the overdraft, something like the phenomenon known as 'the carry trade' so beloved by the Hedge Funds before the recent bust. That process of round tripping was in place, even when Thatcher came to power, Thatcher's monetarists could not control the enormous momentum of the larger measures of money supply which spiralled with lags nobody understood totally out of control, unleashing inflation, driving interest rates 'through the roof' to levels unseen before or since, for which Nigel Lawson (arguably the UK's greatest ever Chancellor post war) got the blame! How could the Thatcher government stop it? Regulation? "Thou Shalt Not!" No! STOP BORROWING MONEY MR. GOVERNMENT - JUST STOP BORROWING MONEY! The Thatcher government targeted Money Supply and realised that a thing called the PSBR (Public Sector Borrowing Requirement) was a actually driving Money Supply, driving inflation (prices) & either interest rates went to Zimbabwe levels (it was Chile back then) or the government ceased creating that money. The memoirs of Chancellors of the Exchequer and the retirement speeches of officials indicate that monetary targets were adopted in the second half of the 1970s and the first half of the 1980s primarily in an attempt to manage expectations in financial markets, to stop them from behaving in an undesirable way, and not as an intermediate target to control nominal GDP, as monetarists advocated.

Kelvin in the Mirror(Oh and just in case there are any Americans or Europeans reading this, thinking "Oh how quirkily English!" THINK AGAIN!) Exactly the same thing is happening between Washington & Wall Street and between Brussels and Frankfurt; the only guys who seem to have hit the sweet-spot right now are the Aussies, who are thinking of raising interest rates as well as taking wickets! Central banks around the world, including the Federal Reserve, the European Central Bank and the Bank of Japan, have been forced to turn to untested policies to tackle a crisis that is unprecedented in its geographical scale. Consider this: you are a beleaguered bank that has just taken $50B in TARP money from Uncle Sam to prop up your ailing balance sheet. The money is held in reserve, handed over maybe as a loan at prime +0.5% at best or maybe LIBOR +1.0% at worst. Better still, a straight equity investment. Well, lo and behold that very same government that just handed you $50B is offering you yields on bonds that, combined with the discount on the coupon, means you can make a tidy profit of up to 3%-4% free and clear, no questions asked (every month because maintaining a monetary stance is not a static thing. And all because you parked the funds back with Uncle Sam- exactly where they came from in the first place! Nice, if you can get it but you have to a member of that club to participate, authorised at the Discount Window or however they term it now, frankly all you have to do is burn a few billions to join that club these days.

This waste of taxpayers' money is bad enough, but the real damage is the false sense of security this round-tripping produces. Britain is in real danger of falling into a debt trap, where the cost of borrowing spirals up with the amount the government has to raise.

Now, before I bang on about the obvious comparison let me introduce a wee bit of cynicism here. Last week we all watched and read in amazement as Profits at the banks, HSBC and Barclays, which have not sold shares to the government, came in at £3bn each. Both were able to reap the rewards of their investment banks where profits doubled. Investment banking has had one of the best six months on record while domestic banking has fallen over. One has proved a valuable compensation for the other. The interesting common feature among the banks was how their investment-banking arms - roundly abused in the past for having helped to trigger the credit crisis through irresponsible trading and lending - have become goldmines. Barclays, HSBC and RBS all reported stellar profits from their investment-banking operations. But what is the Investment Bank trading in right now? Gilts of course! Government Securities, Central Bank paper of all sorts of flavours, "round tripping"! If you accept the logic of "Crowding Out" which we articulated here on this site in the Spring then for the most part there is no other asset class for the investment banks to play with, other than government paper of which a veritable tsunami is being thrown at them right now, why would they not find a route to profit from this government insanity? In their anti-deflationary fervour, central banks may be creating more money than depressed economies require. The surplus creates "excess liquidity" - which may be feeding a new series of bubbles. Here we go again, same old same old, only its not just the same as the nightmare times of two years ago, its exactly the same as those nightmare times of exactly thirty years ago, for those who remember them.

swedish screaming headThe Financial Services Authority (FSA) is to publish a code this week setting out how banks will have to change their policies on pay and bonuses. The FSA launched a consultation in February looking at measures to discourage excessive risk-taking. There were suggestions last week that bonuses have been returning amid this boom in profits from investment banking. The suggestion from the Turner Report in March was that bonuses should be deferred in order to reward long-term success instead of short-term risk-taking.

Round-Tripping, an opperchancity - that's what it is, conditions conducive to the opperchancity occur literally 'once in a lifetime' they are politically conditioned and can be snuffed out with the flick of a Conservative monetarist switch - indeed you might interpret the evidence as suggesting that the round tripping opperchancity is in fact evidence of the oldest extra-marital affair in the world, that between the UK Treasury and The City of London and is a process whereby 'on the nod' the UK government supports British institutions by facilitating profits from the Gilts markets over a short term period. You might but I couldn't possibly comment.


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