Uncharted Territory

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.

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9 Comments »

  1. Very good piece of writing.

    Comment by Kristina — October 22, 2008 @ 7:35 pm

  2. […] get even worse.  It would therefore have been much better, as well as fairer, for example, as I’ve argued several times for months, if the government had acted to encourage or allow private […]

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  3. […] I sense, too, that in 2009 more of the political heat in the UK will be directed at Gordon “Superhero” Brown and – perhaps this is wishful thinking – the insufferably smug and incongruously arrogant (in that he doesn’t have anything to be arrogant about) Alistair Darling.  Away over the Christmas period, I was able to access the BBC’s World News channel (why are all the BBCs channels not on cable here?) and caught the interview Darling gave to a sycophantic Robert Peston.  Apparently Freddie G said the Government’s discussion was “less of a negotiation and more of a drive-by shooting”.  Spot on! […]

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  4. […] impossible, so other than giving the Government some more prefs (with a less punitive coupon than before – why give overseas banks an advantage, they cause even more problems?), the authorities will just […]

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  5. […] ripped off (though I am cynical enough to suspect the latter, since this would be consistent with the UK’s policy to date), but I do know one thing: the basically correct strategy of muddling through is most definitely […]

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  6. […] The Government is taking advantage of the fact that the future is always uncertain and that at the moment everyone is worried about the doomsday scenario, whereas, in reality, the recession will at some point come to an end. Journalists blathering about “a near unsustainable burden” help provide a smokescreen for what will likely turn out to be the mother of all stealth taxes. […]

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  7. […] Even if Lloyds doesn’t lose another £25bn on the loan book, there is something in the deal for Lloyds shareholders. The Government is offering to underwrite a conversion of the 12% preference shares – albeit that these were outrageously expensive in the first place. […]

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  8. […] Even if Lloyds doesn’t lose another £25bn on the loan book, there is something in the deal for Lloyds shareholders. The Government is offering to underwrite a conversion of the 12% preference shares – albeit that these were outrageously expensive in the first place. […]

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  9. […] 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 […]

    Pingback by The Grandmother Of All Stealth Taxes « Uncharted Territory — October 31, 2009 @ 9:19 am


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