Uncharted Territory

October 27, 2008

Risk Denial

Filed under: Credit crisis, Economics, Housing market, Risk — Tim Joslin @ 9:03 pm

OK, I can remember exactly where I was on 9/11; when I heard about the Challenger and Columbia disasters, the Bradford City fire and the Omagh bombing; and where I saw the Heysel disaster, the Hand of God and that 1998 England-Argentina match on TV, but I’ve rarely before felt I was seeing history in the making, day after day. This year’s Red October reminds me just a little of 1987, though. I spent an inordinate amount of time driving around the M25 that year, often in the night. So I’m listening to the music that reminds me of those journeys: Sade, for me, the sound of the ’80s.

I’m hoping that Sade Adu’s dulcet tones will help me understand the concept of risk, which is giving me a lot of difficulty just now.  Apologies if it seems I’m thinking out loud in this post, but this is my first attempt to put some anarchic thoughts on the screen.

It seems to me that the whole credit crisis has been caused by a pathology that I’d like to term risk denial.

Consider:

  • most people who think they’re “investing” in housing are in fact speculating, by any sensible definition of the term: they’re hoping to profit from capital gain.  In the US, the TV schedules of the early ’00s were apparently packed with programmes about “flipping”.  Here, many buy-to-let (BTL) investors were attracted by the prospect of spectacular rises in the value of residential property, rather than a hard-headed assessment of the realistic profit on rental income, after costs.  Vast numbers of people in the UK and elsewhere are happy to buy or remain in houses much larger than they need – often sacrificing other forms of consumption – because they believe property to be a “good investment”.  An Englishman’s home may be his castle, but, it seems, so is an Irishman’s, a Latvian’s and an American’s.  In short, millions put their money into housing because they saw it as a safe way of preserving or increasing their wealth.  But as we see now, it has proved exactly the opposite.
  • there has also been a supply-side to the huge demand for mortgages.  Take China’s Sovereign Wealth Fund (SWF), for instance.  It’s around $2trn and apparently very conservatively invested, largely in gilts, squeezing out other investors from this ultra-safe asset class by depressing yields.  There was obviously a market for other “safe” investments (or at least ones where the buyer felt the risk was accurately quantified).  Supposedly risk-averse investors, including Chinese government funds, I understand, have therefore been keen buyers of mortgage securities.

My point is this: in the dot-com boom too much money was chasing assets known to be risky, i.e. shares in tech stocks.  The fact that most investors were in no position to pick winners hardly put them off.  They simply spread their money about, bidding up the price of the latest hot stock to absurd levels.  The idea, of course, was that the overall returns for “New Economy” investments would be (improbably) huge, and by investing in many companies, the overall risk could be reduced.  And this can indeed be mathematically proven to be the case, as long as the risks are uncorrelated.  But what do we mean by correlation?  If we say the game is “winner-takes-all”, then only one search engine, say, could succeed.  But if Google had failed for some random reason – a crippling lawsuit over intellectual property, say – then some other company would have dominated the market.  If I’d invested in several search engine companies, then these investments would have been negatively correlated.  The more companies fail, the better the prospects for the survivors. In fact, the dot-com crash was not a result of correlation of risks – several companies ended up making billions for their shareholders – but of too much money chasing a type of asset, that is, “risky” investments.

Now, in the ’00s, it seems to me that we have had far too much money chasing “safe” investments – either low-risk, or for which it was thought the risk was understood.  All those CDOs, CMOs, CDSs and whatnots were not popular products because they were so clever.  They were successful because there was demand for them.

Ultimately, though, the whole edifice rested on the ability of mortgage-holders to service their debts, and as we have seen in the US, not only has a whole class of mortgage-holders (the beneficiaries of so-called sub-prime loans) proven to be unable to pay their interest, the law (in some states) does not even compel them to do so!

If it hadn’t been mortgages that pricked the bubble, though, then it would surely have been some other form of debt.

It seems that, when all’s done and dusted, the credit crunch has been caused simply by too much money chasing “safe” returns.

This “risk” thing, I’m beginning to think, is something you just can’t get away from.

Too many people have been in risk denial.

Can we escape from this trap?  I’ll have to think a bit more about that…

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October 25, 2008

We’re Right Stuffed… Or Are We?

Filed under: Credit crisis, Economics — Tim Joslin @ 5:10 pm

The writer who comes to mind this weekend is the peerless Tom Wolfe.  Bo-oring, I hear you say, another reference to his 1987 classic, The Bonfire of the Vanities.  Not so fast!  Admittedly Bonfire is as appropriate to the Noughties as it was to the Eighties.  And a great read.  But the work that I’m thinking of is The Right Stuff. A book so memorable that, after investing 6 hours of video tape in recording the film, I was unable to watch more than the first few minutes because the opening scenes differed from Wolfe’s account of Chuck Yaeger’s parachute escape.

Now, in The Right Stuff there’s a memorable account of one test flight that went wrong.  I don’t have a copy of the book to hand, but it might have been Chuck Yaeger in an X-1A.  The plane became unstable.  It was tumbling towards the ground totally out of control.  Somehow the pilot managed to get it into a tailspin.  The aircraft was still plummeting downwards.  But the pilot was no longer so worried.  He knew how to get out of a tailspin.

Right now, the economy, in the UK and globally, is in a tailspin.

But we know how to get out of a tailspin.

Reading some of the headlines in today’s newspapers, you’d be forgiven for thinking that we’ll all be living on rationed leaves and acorns by the end of the year.  Perhaps each family might be permitted a fieldmouse for Christmas dinner.  According to Charlie Bean we’re in the throes of “the worst financial crisis in human history”.  I know that, in the UK, “history” started in 1945, and, in the US, 1929, so clearly Charlie Bean considers any comparison with, say, 1848 or 1870 to be entirely meaningless.  19th century thinkers were deeply troubled by recurrent “crises of capitalism”.  Marx thought such events would lead to an entirely different economic system.

Sure, there’s been a bit of a screw-up.  But is it worse than other crises, even relatively recent ones?  Specifically, why are so many economists pronouncing with such certainty that the UK faces 4 quarters of negative growth through 2009?  The justification seems to be that other post-war recessions have typically lasted 18 months to 2 years.  Why should this one be any different?  Well, I’ll tell you.

The key factor, in short, is inflation, or, to be more precise, the ability to reflate the economy.  One period I remember well is the early 1990s, because I bought a house in the middle of the recession (and David Cameron would be wise not to think I’ve forgiven the Tories for the sleepless nights just because 16 years has gone by).  The 1990s recession was prolonged because, in order to maintain the ERM peg (I suggest readers in the Baltics pay particular attention at this point), the UK was forced to keep interest rates high.  On “Black” Wednesday emergency interest rate increases brought, I recollect, grown men with mortgages to the point of tears, and yet failed to defend the pound.

Going back in our time machine, the early 1980s recession was due to Margaret Thatcher’s monetarist programme to drive inflation from the British economy.

And I can just about remember the 1970s.  The economy was in and out of recession for the entire decade.  Inflation continually reared its ugly head, beggar thy neighbour trade unionism was rampant and government policy was all over the place.  It may be an exaggeration – though not an enormous one – to say growing up during that period gives some insight into more recent economic disasters such as those resulting from the fall of the Soviet Union or France in… well, France.

So, I don’t really see why 2009-10 should be at all like the recent UK recessions.  Sure, we’re going into a steep decline, but not necessarily a long one.  Interest rates, all are agreed, are about to drop like a stone.  I doubt any members of the MPC want to be lynched.  Talk about peer pressure!

And the PM, in unholy alliance with Lord Voldemort, is going to fight like a frighteningly large Harry Potter to get the economy moving again.  Gordo the Great will stop at nothing in his efforts to win in 2010.  Capello will try to do it for Britain, well, England, that year as well, but will look like a hesitant, stammering 5 year old girl compared to the big Scot.  Expect Broon to ventriloquise Darling to bring forward spending programmes from 2011, 2012, hell, 2025 if he has to.  And there’ll be more that’s not even planned.  Infrastructure for not just 2012 but the 2018 World Cup…  My bet’s on simply giving the housebuilders some money via councils or housing associations to recruit the guys they just laid off and get them working again.  [Notes: a) This may be good news for shares in the sector – this does not constitute financial advice; and b) This is notwithstanding the fact that mass provision of social housing is an outmoded and unfair policy, as well as economically sub-optimal in numerous ways.]. And all this will be difficult to criticise.  The conditions are right for Keynesian policies.

Even without the likelihood of concerted government action around the world, it seems to me this whole financial Armageddon thing is a tad overdone.  That’s the media for you.  The BBC was out yesterday asking shoppers how the financial crisis had affected them.  Most people said “not a lot”, they were just carrying on as normal.  Then the BBC reporter (almost old enough to buy alcohol legally) squealed: “They’re not carrying shopping bags!”, suggesting this meant people were just window-shopping.  My confident prediction is that in 2008, as in every previous year, the average Brit will charge headlong into the Christmas spending ritual with a zeal that can only be described as religious.  We always try to spend less but end up just waving a piece of plastic and not worrying about the little pieces of paper with numbers on that are shoved into free coloured bags with the goods we’ve just bought until Mr Visa or Mrs Mastercard kindly add them up for us in the middle of January.

But what about all these dire forecasts?, I hear you ask.  Well, on Thursday I was going to title a piece “Utterly Amazoning” as the online retailer forecast that this year we’d all be giving each other 10 shilling postal orders.  By Friday I had “Utterly Amazoning Son(n)y” as the consumer electronics manufacturer forecast we’d all go camping this winter.  Look, these are forecasts.  At present the state of the economy in 5 minutes is entirely unpredictable.  Let alone next quarter.  You do not get to the top of multinational businesses by being the sort of wally who says “I think it’ll be quite mild actually” when everyone else is predicting an Arctic blizzard.  No, you go with the herd.  And what’s more, you err on the side of making predictions that allow you to say “It was tough, but we beat the figures”, not “We lowered our forecast and still missed the target”, a phrase one might translate as “I resign, I want to play a lot more golf before I reach 60”.

So my prediction, for what it’s worth – this does not constitute financial advice – is that the current quarter to end 2008 is going to be grim, grim, grim.  Lots of layoffs (but most people won’t be fired).  Government policy announcements and rate cuts that appear to have little effect.

Then, in about January, and certainly (I predict – this does not constitute financial advice) by April, people will be saying “that wasn’t so bad”.  Interest rates will be so low by then that a lot of money is being put into people’s pockets as it becomes less expensive to service mortgages (house prices may continue to decline for a year or two, though – the fact that people can pay their mortgages more easily isn’t going to prevent the banks from being very cagey about lending more money).  And the extra government spending will be feeding through.

The economy may be in a tailspin.

But we know how to get out of a tailspin.

October 22, 2008

The Mother Of All Stealth Taxes

Filed under: Credit crisis, Economics — Tim Joslin @ 7:09 pm

Gordon Brown, no doubt, approved the outlines of last week’s bailout of the government by the banks. I suspect the details were left to Alistair Darling. I’m pleased therefore that the Chancellor has taken my advice and pulled back from turning British banks into Ponzi finance organisations, that is, companies unable to make interest payments on their loans from operating profits. Instead of just taking preference shares – paying 12% interest – the plan imposed on the banks involves the government most likely acquiring large blocs of ordinary shares in RBS and the new superbank that will result from Lloyds TSB’s takeover of HBoS. At first sight it seems that Darling missed the point that the way to minimise the risk to taxpayers was to do everything possible to encourage private investors to recapitalise the banks. But Darling, it seems, is happy for the taxpayer to put up £37bn. He sees it as a good investment. Beneath that inexpressive exterior, the Chancellor is Warren Buffett on speed.

I’m normally loath to reveal details of my financial affairs but on this occasion I’ll make an exception. Back in the early 1990s I was a minor cog in the mind-blowingly complex machine that was the IT department of what was then just plain Lloyds Bank. I participated in a profit-sharing scheme and was in effect paid partly in Lloyds shares, which I’ve held ever since. Rewarding bank staff with shares that must be held for some years, rather than with cash bonuses, is, of course, one way the authorities hope to avoid the reckless short-term risk-taking they believe to be a major cause of the financial crisis.

I could have sold my Lloyds shares for around £10 in the late 1990s. Last week they fell as low as £1.50 and I read that the handy dividends I’ve enjoyed are to cease for perhaps as long as 5 years. I guess I’ll be making my own Christmas presents from now on.

The news that the government was finally taking heed of advice that’s been widely urged on them for 6 months – during which time my Lloyds TSB shares have lost two thirds of their value – should have been positive for the banks’ share prices. At least the threat of them going bust has been removed. Since Lloyds TSB’s share price has not recovered, I decided to investigate where the value in my shares has disappeared to. The following elements of the stealth tax on the banks is just what a layman like myself has been able to identify. It could be just the tip of the iceberg.

First, those preference shares. Their worth in “bailing out” the banks is now moot. If the government is prepared to risk £28bn of taxpayers’ money on ordinary shares in RBS (£15bn) and Lloyds TSB/HBoS (£13bn) – riskier than preference shares, of course – what’s the point in keeping £9bn relatively safe in preference shares? Answer: it’s a nice little earner. Darling has declared that the UK banks must pay 12% interest on the preference shares. That’s £480m per annum for LloydsBOS and £600m for RBS. There even seems to be some doubt as to whether the banks are permitted to redeem the prefs when they would wish – which would be as soon as possible, obviously. Of course, this is good business for the taxpayer. I mean, if I could borrow at a few % and lend to Lloyds at 12%, I would – wouldn’t you? But should the government be effectively fining the banks? Aren’t these the surviving banks who didn’t indulge in the excesses that put paid to Northern Rock, Bradford & Bingley and Alliance & Leicester? And is this the way to treat Lloyds after they stepped up to the plate and offered to take on HBoS’ liabilities a few weeks ago? If they hadn’t agreed to help they’d have been aloof from all this nonsense, like Barclays, or even the sleeping Asian elephant, HSBC. The next PM who sidles up to a bank Chairman at a drinks party is liable to get a poke in the eye with a cocktail stick.

No other country has demanded anything like a 12% coupon on preference shares. In the US 5% was thought sufficient. 8% is typical in Europe. Even Warren Buffett only dared ask Goldman Sachs for 10%! This puts the UK banks at a disadvantage, of course. It could mean that in the long-run more of us end up with our money in foreign institutions. And we’ve already seen how that makes us vulnerable in a crisis. One would have assumed that the FSA would regulate foreign banks in the same way as domestic ones. That is, the FSA’s job should be to ensure the UK operations of foreign banks are solvent at all times, since it is only the UK operations the FSA can control. Repatriation of assets or any other kind of capital flight should simply not be allowed. Serious criminal charges should follow any incident. Not so, it seems, in the case of the Icelandic banks, which, it appears, have no assets with which to recompense their many creditors in the UK. Not so, it seems, in the case of Lehman Brothers, whose £8bn bonus pot for its UK employees apparently made its way across the Atlantic just before the bank went into liquidation. What’s the point in HSBC meeting the UK government’s demand to recapitalise simply by transferring £1bn into the UK if there’s no mechanism for keeping it here in a crisis?

Second, the small matter of the guarantee for bank debt to be provided by the UK government as part of the “rescue” package. It turns out the government is going to price this on the basis of banks’ credit-worthiness over the previous year, based on credit default swap (CDS) rates, i.e. at the very high price prevailing over the period of the credit crisis. This is simply double counting after the injection of capital. Like valuing Northern Rock’s shares as if it had gone into bankruptcy when it hadn’t, the government manages to employ its own brand of doublethink. The banks are recapitalised to make them less risky, at great expense to their shareholders… and then they are charged a fee as if that hadn’t happened! Darling’s having a laugh!

Third is the Financial Services Compensation Scheme (the FSCS). It is truly absurd. The more I find out about it the worse it gets. The whole concept is a mugging of the banks by government. The idea is that the FSCS provides compensation to anyone whose savings are lost due to the collapse of a bank. That is, the well-run surviving banks, in proportion to their share of the UK saving market, cover the losses of the poorly run banks. The true madness is that the scheme will have to pay out for savers who chased the highest rates of interest in those Icelandic banks. Needless to say, those Icelandic banks were at an advantage because they had a much less generous scheme at home, i.e. a lower overall liability compared to the UK banks they were competing with. Banks subject to the disciplines of the FSA have to pay the bill for those who, as we’ve seen, the FSA is incapable of regulating effectively. Any fool can see that it would be far preferable to have a scheme involving compulsory insurance for all, not just retail, deposits, based on the risk of each institution failing (e.g. as indicated by CDS rates).

Then, if we’re not dizzy enough by this stage – I know I’m in Wonderland now – we have another instance of the government’s new brand of counterfactual logicTM. Yes indeedy, the widows and orphans fund, the FSCS, has been tapped for £14bn for Bradford & Bingley. If you haven’t been watching the news, don’t worry, you didn’t miss anything. Not one single little old lady turned up at a branch of B&B to find she’d lost her savings. True, the FSCS will almost certainly be reimbursed the £14bn as the government liquidates B&B’s mortgage book. But in the meantime the surviving banks have to pay the interest on that £14bn. Another stealth tax. A few £100m here, a few £100m there and pretty soon you’ve made some serious money…

Fourth is the investment in ordinary shares in the banks. The government’s aim is to buy shares at roughly their lowest market price for the last 10 years or more. And it looks like they’ll succeed. The pricing and structure of the share issues makes no attempt to maximise private involvement in the share offers. This could have been done had the government underwritten deeply discounted rights issues, as I suggested. Although RBS shares are currently trading just above the offer price (and falling towards it), Lloyds TSB is hovering round the price at which new shares will be issued. The price can’t get much above 173.3p because people sell part of their holding, knowing that they’ll be able to buy shares (through a claw back) for 173.3p in a few weeks. When the price drops below 173.3p, buyers enter the market, since they know anyone intending to take up the offer at 173.3p will surely buy shares off them in the market at 173.2p instead! Supply and demand, rather than intrinsic value currently determines Lloyds TSB’s share price. It will ensure that the government ends up owning 40% of the bank. They’ll be able to claim there was no investor demand, when in fact they’ll have just exploited market dynamics, by pitching the offer to existing shareholders too high.

Much has been made of the stricture that the banks participating in the recapitalisation exercise are forbidden from paying dividends until the preference shares are repaid (and again, as a shareholder in Lloyds TSB, I’d like a little more clarity as to the right of the bank to repay these at its own convenience, i.e. as soon as possible). This doesn’t bother me since the dividend income is not “lost”. If dividends are withheld their value will be reflected in the bank’s share price. I could always sell a few shares if I wanted the money. Funds shouldn’t care either. But they do. Income funds want holdings that pay an income. The result is that some long-term holders of Lloyds TSB stock are liable to sell the shares. Or at least not buy more – hence they may as well sell some at any price above 173.3p, knowing they can buy them back at that price. The fact that many shareholders are looking to ditch at least part of their holding (at least temporarily) helps ensure there are sellers as soon as the price rises above 173.3p and helps pin the shares at the offer price.

But the main reason the government will likely end up with 40% of Lloyds TSB is that the supply of shares at 173.3p is far too much for the market to absorb. Even without the adverse market dynamics, the price of such a large share issue would have tended towards an offer price set so close to the prevailing share price. If the price had been set a lot lower, though, and tradable rights issued, new private capital may have been attracted to the issue.

And why are so many shares to be issued? Well, it turns out that the government wants to raise the banks capital far above levels that were thought prudent even a few weeks ago. I don’t think this is a bad policy. I just don’t think banks’ shareholders should suffer a 40% dilution for it. Far from apologising for not happening to mention during the boom years, when it could have been raised much more cheaply, that banks should carry more capital, the government is happy to cynically imply this is all the fault of the banks. If the whole global financial system has seized up, how can this be the fault of Lloyds TSB shareholders? Surely the people we should be blaming are those who oversee the system?

The government’s investment in ordinary shares in Lloyds TSB – on top of the preference share stealth tax, the FSCS stealth tax – is likely to make billions for the taxpayer. Darling’s role models are clearly Warren Buffett and Usain Bolt.

Jolly dee. Except that this is at the expense of existing shareholders. Which, of course, includes our pension funds. Brown, who already has form transferring wealth from private shareholders to the government coffers, must be pleased with his protégé, the little Darling.

Of course, all this is about short-term politics. Never mind fairness. Or the long-run disaster of introducing political risk into investing in the UK. Or the more insidious dangers of the message that it doesn’t really matter what business decisions you make, how wisely you invest or loan, how carefully you build up and nurture a business, because sooner or later an overspending/undertaxing buck-passing government is just going to find some excuse to take what it wants from you. The government could hardly find a better way of encouraging future short-term profit-seeking if it tried. All that bleating about “bonus culture” is just hot air. It’s about gaining votes, not solving problems.

Oh, I nearly forgot. Here’s one final humiliation the Lloyds TSB board (this is Goodbank plc, remember) were forced to agree to:

“Make available a sum to be agreed(!) for the next twelve months for shared equity/shared ownership schemes to help people struggling with mortgage payments to stay in their homes, either through individual bank schemes or paid into a central fund run by industry.”

What does that mean? It implies some kind of subsidy. What’s it going to cost me? I don’t think anyone, let alone Lloyds TSB shareholders, should actually pay to keep people in homes they could never afford. Defer payments, say, to help them through temporary difficulties, fine, but to give them actual cash is an insult to those who put up with rental accommodation rather than risk getting into unmanageable debt. It’s a good job the landlord doesn’t let me keep a cat. Otherwise, on reading this clause, I’d have been at risk of attracting the attention of the RSPCA.

October 17, 2008

Countercyclical Conundrums

Filed under: Credit crisis, Economics, Rights issues — Tim Joslin @ 10:17 am

Several agendas – or should that be “agendae”?; I told you there was a brave attempt to teach me Latin at school: in fact, I now recollect, so dedicated was my teacher, that, after watching me for a good 5 minutes, he once stopped me swapping stamps in the middle of a lesson! – anyway, let’s get on with it: several agendas were at play in shaping the UK Government’s bank recapitalisation plan.  I hesitate to call it a “bailout”, as it’s not really clear who is being bailed out by whom.  It rather seems to me that the banks, by agreeing to Brown’s plan, are bailing out the economy and the PM.

One influence that seems to have come to the fore during the week between the announcement of a £25bn capital injection (with another £25bn to follow if needed) is the idea of taking measures to encourage countercyclical availability of credit.  That is, it is argued, steps should be taken to discourage bank lending during an upturn and to encourage it during a downturn.  The point is that during the downturn banks have less money for new lending because of the bad debts they have to write off.  The idea I hope I’ve encapsulated – a sort of privatised Keynesianism – is that of the latest economic guru of those who hope to defeat the business cycle, Hyman Minsky.  Even as I write the BBC Sunday evening schedule is undoubtedly being cleared for a documentary on the guy.

The amount of lending a bank can undertake is determined in large part by the amount of surplus capital on its books.  The capital can be thought of as a cushion against loans failing to perform.  The amount that a bank can loan out at any given point in time in the form of mortgages, business loans and so on, against deposits or short-term borrowings, is many times its liquid capital.  It all gets rather technical, but a bank’s capital adequacy can be measured in one or more of a number of ratios under guidelines set by the Bank for International Settlements (BIS) which is based in Basel, Switzerland.  This is why banks report their compliance with the “Basel I” or new “Basel II” sets of rules. The “Tier 1” capital ratio is the one banks most often refer to.  For example in the announcement about its fund-raising as part of Brown’s plan to save the world, RBS notes:

“The capital raising will increase RBS’s pro forma core tier 1 and tier 1 capital ratios by approximately 3 percentage points and 4 percentage points respectively, on a proportionally consolidated basis”.

One way to implement a countercyclic credit policy is therefore to stipulate that banks’ capital ratios must increase when you think credit has become too easy (during the boom) and relax the ratios during the downswing in the hope that banks will continue to lend.  The mechanism is analagous to the setting of interest rates by the Bank of England (and other central banks) but aimed at controlling credit rather than inflation.  I’m fairly sure at least China and India already implement such a policy already since I’ve seen announcements in the FT of adjustments.

It appears that the UK decided last weekend to introduce a countercyclical policy.  All very ad hoc.  And, since the banks were not ordered to increase their capital ratios during the boom years (which might have been a good idea), it’s all somewhat late in the day.  You could say that during one frantic weekend the UK took the decision to embark on an ad hoc, post hoc countercyclic credit management policy!

This policy shift is one reason why – despite having plenty of capital relative to existing regulatory requirements – the UK banks are having to raise £37bn (or more – I think this figure is just the government’s maximum commitment and doesn’t include fund-raisings by Barclays, HSBC, the Santander-owned mortgage banks and Nationwide).  The idea, it seems, is to get them to where they should have been at the end of the boom, i.e. with Tier 1 capital ratios of 9% or more.  The point is that they should then be able to continue lending without the worry that bad debts will send their ratios back down to the level (say less than 6%) where the market starts to lose confidence in them.

A real giveaway that the government is trying to do more than just free up the interbank money markets is the stipulation as part of the bailout that banks must “maintain the availability” of “competitively priced lending… at a level at least equivalent to that of 2007…” (this quote is from Lloyds TSB’s announcement).  The FT may have described the move as a “demented diktat” (curiously this phrasing was noted by various secondary sources on the web, and then apparently removed from the original article), and it may be impossible to enforce, but the banks will have got the point, even if most commentators are baffled.  The danger now is indeed that we go from one extreme to another.  I think Minsky is probably right about that, and – though other aspects of the bailout are demented – the government is right to be doing everything it can to prevent the economy going into a tailspin.  Might have been a good idea to have stopped it flying too close to the Sun in the first place.  I guess there’re a lot of votes in rising house prices.

I do have some qualms about the countercyclical prescription, though.  I dislike the way it relies on the omniscience of policy-makers and regulators.  Make no mistake, this crisis was first and foremost a regulatory policy failure.  We need to understand why they’ve failed before we take the medicine of more regulation prescribed by empire-building bureaucrats.  I suspect what we really need is for the FSA to work smarter, not harder.

More specifically my worry is that you never know exactly where you are in the business cycle.  You may start ordering banks to raise their capital ratios, but asset prices continue to rise so you’re compelled to continue raising ratios.  And on the downside you may allow banks to lower their ratios, but they have no way of knowing the extent of the bad debts on their books, so may still not start lending.

I prefer an agenda of:

1. Trying to damp down price fluctuations in those assets that have most effect on the real economy, i.e. we should be more concerned about residential property bubbles than ones in the stockmarket.

2. Assisting banks and other companies in raising private, not public, capital to cover losses.  Essentially I’m saying that (in the case of the present crisis) the banks paid out too much in dividends in the good years.  There was no way to predict it reliably, but now they need that capital on their books.  Fine, the shareholders may have been able to put it to good use in the meantime.  But now they should pay it back.  Hence my interest in getting rights issues to work properly.

October 10, 2008

So Long, And Thanks For All The Dosh!

Filed under: Credit crisis, Economics, Moral hazard — Tim Joslin @ 7:53 am

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.

October 8, 2008

Banking on Darling’s Plan

Filed under: Credit crisis, Economics, Housing market, Rights issues — Tim Joslin @ 10:37 am

This piece was prepared for the Guardian’s excellent Comment is Free (CiF) site, and appears there under the title “Risky business”.

The phrase “Swedish model” must have a special resonance in the Treasury. The former Swedish finance minister has made a whistle-stop tour urging other countries to adopt a plan similar to the one credited with saving the Swedish financial system after their banking crisis in the early 1990s. Never mind that, soon after they had been rescued, the Swedish banks invested heavily in the Baltic countries, where they are now running into new difficulties. The UK is now to adopt a similar plan to inject taxpayers’ funds into several of its banks, in return for preference shares, seemingly because it’s the only idea we can come up with for recapitalising the banks. But several commentators have suggested an alternative scheme that would put far less taxpayers’ money at risk and treat bank shareholders more fairly.

Compared to ordinary shares, preference shares are trumps. They are first in line for dividends. Depending on the precise terms, preference shareholders receive proceeds from the sale of a business, or from the liquidation of the assets of a failed company, before ordinary shareholders. But they are still just shares.

The plan to issue preference shares does nothing to reduce taxpayers’ exposure to losses on banks’ assets, because it doesn’t bring a penny of additional private capital into the banks. In fact, the taxpayer’s explicit risk will increase, because the preference share issues are equivalent to guarantees (up to the amount paid for the preference shares) not just to retail savers but to all the banks’ creditors. The point is that, in the event of liquidation, ordinary shareholders are wiped out first, then preference shareholders and only then bond-holders, depositors and so on. Why would we want to put the taxpayer in the firing line like this?

The problem for shareholders is that the government is likely to demand very favourable terms for its investment, in the hope of making a handsome profit for the taxpayer (at the expense of private pension holders and other investors) or in its anxiety to avoid a loss. But the more the government takes, the more difficult it will be for the banks to raise private capital should conditions deteriorate further. The result could be that even more taxpayers’ money ends up being poured into the banks.

Of course, it’s unlikely that any of the banks receiving taxpayer funds will have to be liquidated or even sold at a loss for the taxpayer, but an alternative scheme could put much less taxpayer money at risk.

Darling has said that the banks have agreed to increase their capital, but rather than take up the government’s offer to take preference shares, they could raise new funds themselves. In present market conditions this would be very difficult. However, the government could help simply by offering to underwrite deeply discounted rights issues by the banks. If this is what is meant by the clause in the Treasury’s announcement that the government “is also willing to assist in the raising of ordinary equity if requested to do so”, then Darling may have covered all the bases.

In a rights issue, each existing shareholder receives rights to put more money into a company by buying new shares at a price less than the prevailing share price. Such rights can be sold, but to allow them to lapse is to leave money on the table, since shares could be bought at a discount by exercising the rights and then immediately sold at a profit.

Recent rights issues by banks such as HBoS and Bradford & Bingley failed, because the share price fell below the rights issue price, taking away the incentive for holders to exercise their rights. There are various reasons why share prices tend to decline during the rights issue process. The ability to short-sell shares can amplify the price decline; in fact it is asking for trouble to permit short-selling during rights issues. The ban on short-selling financial stocks which is currently in force would give rights issues at a large discount to the current share price a good chance of succeeding.

Because recent rights issues have failed, the belief has developed that there are no holders of private capital willing to invest in UK banks. This is nonsense. It is true that large investors prepared to inject billions are yet to come forward. But the shares are being traded in the market every day; there are buyers as well as sellers. The problem is simply one of organising a successful fund-raising exercise and discovering a price at which investors will buy into the banks. Rights issues are a possible solution.

At present, underwriters for rights issues by banks are very thin on the ground. Normally, underwriting would be done by other financial institutions, but in the current conditions such organisations are likely to be wary and charge a great deal for their services. Especially as the Bradford & Bingley underwriters may have taken large losses. The government, though, could take on the underwriting role. To avoid later accusations of having provided state aid, the government could charge a reasonable (but not fire-sale) fee (e.g. 1%, raising a figure in the £100s of millions) for its underwriting service. Perhaps the fees, after costs, could be given to the Financial Services Compensation Scheme (FSCS) fund, which is currently short of £14 billion after the B&B nationalisation and will require further funds to compensate Icesave account holders. Only shares not taken up by existing shareholders (or those to whom they sold the rights) would end up owned by the taxpayer and these would be very cheap. It might even be possible to stipulate that any shares left with the underwriter (the government) would have preference status.

The announcement of a scheme for the banks to raise funds by rights issues could immediately improve confidence in the banking system, especially if rapidly followed by (pre-arranged) statements of support by major shareholders. The market would know the banks would definitely receive the funds, because the government would be underwriting the share issues.

The worst case for the public finances is that one or more of the rights issues fails and shares end up with the government, as underwriter for the issue, but nothing would be lost compared to the other option on the table, partial nationalisation by issue of preference shares, as long as the rights issue price is less than the government would have paid for a stake anyway.

Going down the preference share route could seriously backfire for the taxpayer. If the economy deteriorates further (e.g. credit conditions are slow to improve, interest rates remain high, house-prices fall by 50% and unemployment rises dramatically), the market may eventually judge one or more of the “rescued” banks to be worth no more than the preference shares (especially if the government is greedy), and the ordinary shares could be effectively worthless. Raising private capital by rights issues or otherwise would then become next to impossible, and the taxpayer would be left holding the baby, i.e. effectively guaranteeing the bank’s creditors up to the value of the preference shares. The government could be forced to put even more than the initial £50bn at risk, by buying more preference shares.

In contrast, if capital is initially raised through rights issues, it would be possible to repeat the exercise should the economy deteriorate badly. One presumes Alistair Darling wants to avoid being recalled in the same breath as Denis Healey as a Chancellor who had to go cap in hand to the IMF for a loan to bail out the UK’s public finances. Perhaps before committing taxpayers’ billions for preference shares he should satisfy himself that all possible alternatives have been exhausted. An informed parliamentary debate on the issue might reassure the rest of us.

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