The Grandmother Of All Stealth Taxes

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

Lucky we had Lehman’s!

So banks are to be forced not only to hold more capital but also to make “living wills” in order to prevent another Lehman’s. Everyone seems to think this is a good idea. The arguments centre around the practicality of the measure.

But was Lehman’s collapse such a bad thing?

Let’s remember that the interbank money markets seized up in August 2007. Lehman’s collapsed in September 2008. It was only then that governments were galvanised into taking decisive action to recapitalise the banks.

What are the counterfactual scenarios?

Well, let’s not spend too long discussing what would have happened had there been no credit crisis at all. Remember that inflationary pressures were building. Oil might now be at $200 and we could be looking at another decade of 1970s style stagflation. Lucky we had all those sub-prime mortgages!

Let’s consider a little more, though, what would have happened had Lehman not collapsed. Maybe the investment banks would still be limping along after a few more ad hoc injections of Middle Eastern capital and a few asset sales. But the interbank money markets would still be dead. And mortgage defaults would have continued and would have continued to have knock-on effects. Likely we’d still have had a recession and banks around the world would be facing secondary losses.

The dominant paradigm suggests some banks should be allowed to fail. Otherwise we run risks of “moral hazard”.

But if lots of smaller banks do fail, as in the 1930s, how do we stop the cascade of bankruptcies? Every failure puts other institutions at risk. Where do you draw the line?

To look at it another way, consider the collective pool of bank shareholders’ capital. Ultimately this risk capital supports lending. Whenever banks collectively start to lose money this pool shrinks. Regardless of the structure of the banking industry. Inevitably positive feedbacks develop as banks reduce lending, in what has been termed the “deleveraging” process, causing further personal bankruptcies or loan defaults and business failures and the need to rein in lending still more…

What happened after Lehman’s was that a number of government steps and some private recapitalisations arrested the deleveraging process after a few months.

The question is how else would this have occurred had Lehman’s not failed? I strongly suspect that we would have had a longer, more drawn-out recession. This would have allowed more time for adverse economic and social consequences, such as protectionist steps and the rise of xenophobic extremist political parties.

I put it to you that we need to retain banks that are too big to fail, so that when they do fail everyone is scared shitless and overcomes the ideological obstacles to radical steps to solve the problem!

———

I add some codas:

(1) Market lore is that financial crises only bottom out when there is the failure of a systemically important institution. There’s a reason for this. It’s only then that governments take actions they would not previously have contemplated.

(2) We’d all be in a much better place if there were better ways of getting private capital into ailing financial institutions.

(3) We’d all be in a much better place if we abandoned the ridiculous idea that “moral hazard” is best applied to corporate entities. We don’t want any banks (or other public companies for that matter) to fail – because this simply propagates a bankruptcy cascade. What we want is for them to raise additional capital and for the shareholders to fire those responsible for destroying value.

(4) Having observed recent events closely, I’m highly sceptical that mandating banks to hold more capital “in the good times” is going to work. The problem is that no government will relax the capital limits as we head into a crisis. The 2008-9 recession has broken all records. When the next downturn starts, no-one will know how deep it will be. Governments will keep their powder dry and banks will reduce lending to restore their balance sheets. Again.

So Long, And Thanks For All The Dosh!

We should never have let them have all the cod!  It helped make Iceland one of the richest countries in the world, per capita.  And the law of unintended consequences has ensured only trouble has arisen from all this easy money.

I’m a bit pushed for time this morning – I have to find a bomb shelter to hide in before the UK stock market opens – but I can’t resist the temptation to make a few observations about the financial terrorism Iceland has unleashed on the UK.

You couldn’t make it up.  It is positively surreal watching the improbably named Icelandic PM Geir Haarde take on the great clunking fist of the strangely revitalised Gordon Brown (please send me a large supply of whatever he’s on this week).  I suggest they settle it by a duel in the snow with large wet cod.

I went to an old-fashioned grammar school where I studied Latin for 4 years.  I forgot all of it.  In fact, I never really learnt the language in the first place since it was easier to memorise Pliny’s letters, because one of them was always the only “unseen” translation included in the exam.  At some point, though, I did pick up the phrase caveat emptor – “let the buyer beware”.  Which may as well be Klingon as far as the average UK council is concerned.

For a while I thought Cambridge City Council had by some fluke (working really hard to keep up the fishy theme) avoided the blunder of putting my hard-earned cash in an account with SmellsabitoffBank.com.  But no, they’d been doubly incompetent, of course.  They’d lost our money and were about the last council to fess up.

I’ve always tried to make sure my savings are insured.  Admittedly, the main way I’ve achieved this has been by never having enough to exceed the limits guaranteed by the Financial Services Compensation Scheme.  I don’t know why I bothered even thinking about it, though, since it seems the taxpayer would have just bailed me out anyway.  Moral hazard, or what?

But our councils seem to have given absolutely no thought whatsoever to whether our money was safe.  Surely, given the suspiciously generous interest rates being offered by these banks, they could have protected us all by asking investment banks to write appropriate Credit Default Swap (CDS) contracts?  Oh, sorry, lost my head a bit there.  I forgot that offering that sort of insurance is evil greed and companies doing it should be vilified and bankrupted.

Still, silver clouds and all that.  I’ve wanted to visit Iceland for a while, but have been put off by reports of people having to pay £10 for a beer.

And, boy, are those Icelanders going to regret what they’ve done when all those previously priced-out hen-night parties start arriving on easyJet flights from Newcastle to Reykjavik.

More on the immorality and hazard of policy based on moral hazard

They say that the 1930s Depression was a result of a crisis exacerbated by policies to maintain a strong dollar. When the history of the 2000s Crunch comes to be written, they’ll say it was a result of a crisis exacerbated by policies to maintain another sacred cow – the idea of moral hazard. Both policies may have made sense in the 19th century, but not in today’s world.

Let’s first ask ourselves what the priorities of the central bankers should actually be. Well, I’m in the UK and it seems to me that Mervyn King’s overwhelming priority right now should be to slow the impact of the liquidity crisis on asset values, principally housing. Since this is not being done, the danger now is that price declines become self-fuelling, of a housing-market correction turning into a crash. Over the last year or so, I’ve wavered between predicting just a shake-out in the buy to let* (BTL) market in the UK and expecting large house-price declines across the board. The swingometer right now is well into the red of a general crash. And the people who will suffer most are people like the le Roux family reported in Saturday’s Guardian. Working people, IMHO, should be able to afford to buy the house they live in (um, isn’t that why we’re building these houses?). Ensuring they can should be King’s no.1 long-term objective – but more about that some other time.

The point of this post is to clarify my views on moral hazard. I may previously have given the impression that I consider the concept worthless. This is not the case. I consider it a special case of expectations. Expectations matter. If I expect to be robbed in a particular district I won’t go there. Or, say, if I expect a government to expropriate my assets I won’t invest in that country – or will at least demand a higher return for the political risk.

The idea of moral hazard is that we should be wary of behaving in a way that may lead people to think that we will behave the same way in future, when, in fact, we want to give the opposite impression. That is, we should not reward undesirable behaviour. If a child throws a tantrum and is rewarded with sweets to make them stop, then they will learn that next time a screaming fit is a good way to get hold of some more candy. So far, so good, but “punishing” banks – and specifically their shareholders – for becoming illiquid is a bad policy on a number of counts:

1. It is ineffective because it hurts the wrong people. In more ways than one.

a. Subtle differences are important. The devil is always in the detail. For example, it is absolutely critical, as I pointed out a while ago, and as Daniel Gros notes in today’s FT, that US mortgages are “no recourse”. This is not the case in the UK. Northern Rock couldn’t sell or borrow against its mortgages because everyone was in a panic, not because the Rock took on daft risks. The Rock went under because of a US crisis, not a UK one. The institution that has been “punished” is secondary to the crisis, and, here’s another “subtle” distinction, not insolvent, but illiquid. The Rock has been allowed to fail partly because it was relatively small. Larger banks more directly involved in the dodgy lending are likely to survive.

Because we now have an interconnected global market for capital, institutions around the world have been affected by the credit crunch. Central banks should not allow any to fail simply because they are illiquid (at least so long as, prior to a crisis they have met clearly-defined capital ratio and other regulatory requirements). Banks should be allowed to go under only if they are insolvent.

b. But how can you “punish” an institution? Individuals made the decisions that caused the problem. I’m sure many of the Bear staff who’ve (literally, I read) been crying on the stairwells were not involved in buying CDOs based on sub-prime mortgages.

The shareholders in both Rock and Bear have been (pending legal action) pretty much wiped out. This is unreasonable not just because (as noted above) they have not necessarily invested in a business that has allowed its liabilities to exceed its assets, but also because there is no mechanism in place for them to exert control over management to the extent that they could prevent it running into liquidity difficulties. If the FSA couldn’t do it, how could the Northern Rock shareholders?

And what’s more, the shareholders at the time a bank runs into problems are not the same as those at the time decisions are made. Specifically, in the case of both Rock and Bear, large holdings were owned by institutions and individuals who saw the companies as recovery prospects. As I noted before, (more than once, or even twice, it seems) at least some of these investors were prepared to put more capital in to these institutions.

2. Moral hazard based crisis management also has rather serious unintended consequences.

As we already know, in the UK we don’t have “no recourse” mortgages. In fact, Gordon Brown has just created real-life counter-terrorism units – I kid you not, 24 should sue for breach of copyright – to be staffed with real-life Jack Bauers who will no doubt, among their other duties, hunt down people who don’t pay their mortgage. So, a company like HBoS is not going to go bust. But what have we got? Short-selling. Now, there’s nothing wrong with short-selling – as Nils Pratley notes in today’s Guardian – but it’s wrong not just to profit from spreading false rumours, but also if the aim of short-selling is to drive a company out of business. And in the financial sector this is possible if the central banks allow runs to occur. Short-selling can undermine the confidence in an institution and cause investors to make an otherwise irrational decision (given that they lose out by withdrawing funds early). This was a factor in the downfall of Northern Rock, and it seems Bear, as well as in the attack on HBoS last week. Rumours are probably impossible to prevent and in any case, the sight of a falling share price may be enough when everyone is on edge. And if destructive short-sellers are actually rewarded – by, say, the nationalisation of Northern Rock, to take an example at random – why, of course they’ll do it again… Hmm, aren’t we talking about moral hazard?

No, if central banks don’t stand behind institutions – or stand behind them sharpening their knives – then it is inevitable that there will be attempts to force some institutions out of business to make a profit.

Readers will be forgiven at this point for thinking that moral hazard based crisis management is more about an assertion of authority, a demonstration of power, than actually solving the problem. Perhaps central banks don’t want to feel they are becoming just another market participant in the global market-place. And perhaps they are playing as well to the mainstream media, who – as is a recurring theme on this blog – consider themselves now to be the conscience of our society, ever ready to allow subjective value judgements to take priority over cold rational, objective decision-making. Maybe I’m being too harsh. I’m sure that ultimately the problem is that people want to read exciting stories of good and evil, not abstruse analysis of systemic failures! JPM good, Bear bad? Yeah, right.

3. Moral hazard based crisis management is an obstacle to fixing the real problem.

Citibank has pointed this out. “They [the BoE] still seem to be concerned about moral hazard, but we are long past that. It is not a question of bailing out the City. We’re faced with the threat of unnecessary damage to the real economy,” say Citi. Exactly right.

But here’s one response: “Isn’t this the bank that has already written off in excess of $20bn, or thereabouts? Doesn’t that mean, by simple rule of thumb, at a 5% Tier 1 capital requirement, this bank has just had to withdraw up to $400bn from the credit markets?”

This commenter has answered his own question. We read that credit markets are seized up, but that US Treasurys are flying. Why? Because the banks have had to write down capital. They can’t therefore lend out deposits without screwing up their capital ratios. But what they can do is lend it to the US Gov’t (or UK for sterling) by buying gilts because then they effectively hold cash. The inflated price of Treasuries tells us, I suggest, that there are plenty of deposits – whether retail or money-market – in the system (cash has to be put somewhere and it’s generally not under the mattress these days), but not enough shareholders’ capital to cover the perceived default risk – or more likely the liquidity risk – of investing it either in mortgages or existing debts, however low risk and profitable they might be. That is, if I find a stash of cash in the attic, and deposit it in my bank, it won’t allow them to write a mortgage for someone else, however low a risk they might be, because this set of transactions would increase the risk of all the mortgages on their books (and no-one will buy mortgages off them). On the other hand, if I suddenly discover I have some money in a bank account, withdraw it, and invest it in new shares in the same bank, then the bank would be able to issue more mortgages far in excess of the amount of money I have invested, because I have invested some more money in covering the risk associated with those mortgages.

I stress that banks can’t lend because they are worried not just about default risks, but also about liquidity risk (otherwise the price of debt would, I suggest, have found a floor by now), that is, to put it bluntly, by the risk of a bank run. Because the central banks (OK at least the Fed and the BoE) have not drawn a line in the sand, no bank is safe from becoming the next Northern Rock or Bear. So the markets are seized up, I suggest, as a direct result of moral hazard driven crisis management. I hope everyone feels better that the “greedy bankers” have been punished (and here’s silly me thinking that the way to deal with inequality is by policies to deal with inequality, not by destroying institutions that have taken many decades to create, reducing competition, and thereby making banking services more expensive for everyone in the future, allowing the surviving bankers to pay themselves even more…).

Now, the problem is not going to resolve itself until we get more capital into the banking system. Since the sovereign wealth funds may not do this, I suggest the banks make rights issues.

Unfortunately, thanks to moral hazard madness, for a bank to suddenly announce a rights issue would be a sign of weakness, and they’d be torn apart by the wolves.

Ergo, the correct central bank policy is to take the illiquid assets onto their books, albeit at a penalty rate, committing to rolling the facility over for (say) 6 months. But, I’m a taxpayer, thanks very much, not in the mortgage business, so the quid pro quo must be that the central banks make the banks commit to substantial rights issues over that 6 month period. At the end of it, they’ll have the capital they need to take the assets back off the central banks and start trading amongst themselves.

It’s very simple. If a huge hole gets blown in the capital base of the world’s banking system then it’s got to be filled in again. Blathering about moral hazard does not achieve this.

4. Moral hazard crisis management is a poor substitute for effective long-term expectation setting.

If setting expectations is going to work – and I agree that it is necessary – then it has to be done on a deep, long-term basis. It has to be drilled into the nation’s psyche over a long period of time.

Just punishing almost at random a few managers, employees and shareholders – most of whom simply happen to be in the wrong place at the wrong time – will not be effective. It will simply leave these people feeling unfairly treated and aggrieved. Maybe they’ll simply invest their time and money in some other sector of the economy.

The sort of expectation it might be worth setting over time is that you have to pay your debts. This would have helped prevent the US housing meltdown spilling over into the whole global economy. Heck, it might even have helped prevent the bubble developing, since, at the margin, a few people might have questioned whether they really could afford the debt they were taking on. Clearly, though, no-one is ever going to be able to sell “no recourse” mortgages on the open market ever again.

Hmm, maybe we shouldn’t say never! This is the problem with moral hazard based policies. Those who are punished essentially leave the game. Those who profit (e.g. the banks that survive) are re-affirmed. JPM good, Bear bad. Yeah, right. And we end up repeating the same mistakes in the next cycle, because no-one’s left to remember the lesson.

5. An underlying cause of instability is the propensity of housing markets to develop bubbles. A moral hazard based approach will not prevent this, since it is not irrational to participate in a bubble (as I said before). Policies are needed to stop prices rising too steeply.

So the underlying cause is the fault of the regulatory authorities.

And their response has made the crisis worse.

Good work guys. But you’re right about one thing. It really is time to put those thinking caps on. This is starting to get a bit irritating for the rest of us.

* Postscript: I meant to say why BTL “investors” deserve to be hunted down by Jack Bauer. They don’t have the excuse of simply wanting somewhere to live, but nevertheless made reckless bets that house prices would continue to rise. They could make no money any other way than by capital gain. The point is that their market was tenants who couldn’t afford to buy property (at first it was people renting for convenience…). How, pray tell, can a rational investor expect tenants to pay the mortgage on a property they can’t afford to pay the mortgage for (otherwise they’d have bought it) and cover agency fees in order to provide the “investor” with a profit? Unbelievable.