Wednesday, October 15, 2008
FLASH GORDON saves the banks...for now
The British media coined a new coin for Gordon Brown. Even diehard worry warriors at the FT now say, for example Gillian Tett, there may now be "light at the end of the tunnel" after she established only the day before that tumbling markets respond rationally to a crazed world. Today, with stock markets falling across the globe by 7%, we are reminded again that the ultimate bellweather of confidence are stock markets, but they remain nervous, volatile, uncertain, pulled between short run good news and longer run recession fears, which all are convinced we are in now (falling corporate profits, rising unemployment, fire-sale asset prices, and governments discounting private share-holders of banks and their dividends). The financial crisis losses currently measurable are huge. We have to consider what happens when malfeasance can be proved and shareholders and investors demand win compensation and damages? These will be many times that of Enron or Abestos or Tobacco. Oh to be a corporate lawyer! I suspect that key to the outcome of these will be shareholder and general public support (a complex issue). Let's take each of the shareholder issue further. Fresh equity that the UK government (and about 20 other copycat governments) and some other investors (not just Buffett) will invest, must now take banks’ Tier One ratios to assets (risk assessed loans minus loan collateral) to between 11 & 13%. These ratios are dictated regardless of how well loans (assets) are covered by deposits (liabilities). No-one can remember banks being this solid. But, unless banks buy 100% of the shares, the solidity remains based on stock markets trading those shares! And if governments buy 100% of major banks how can their share values rise? The inspiration for Flash Gordon was Ireland's Brian Lenihan, and it is instructive that since he guaranteed all bank deposits and bondholders the risk spread on government debt has soared above that of banks which have fallen - a worrying reversal just in time for the government issuing bonds that it will expect the banks to buy? One fear for governments, for some governments, is that the public will have an anxiety attack about the credit-worthiness of treasury paper!? Given the scale of banks' assets relative to GDP however well the exposures are recoverable and netted against collateral the capital reserves required are enormous and will desperately need the asset inflation power of stock markets. This is because reserves are not static; they will get eaten into by further writedowns and provisional losses, ultimately by fully realised losses, and in a recession these can easily mean that almost all of banks' reserve capital will need replenishing once more before the recession slump is history. Share values have always been recognised to be subject to confidence factors and not just technically precise valuations. Expectations and confidence factors are quantified by surveys, but remain in essence qualitative judgements, but have long been seen as increasingly important in economics, becoming classic forward indicators. This does not mean that stock markets efficiently translate these at every moment, and therefore stocks can be readily described as overbought or oversold. Today, they are being oversold for arguably exaggerated fears of recession as fast as grocery shelves would clear and cities empty if a meteor was heading for earth. That is Flash Gordon's next challenge, one that he faced very successfully, even brilliantly, in 2001/2002 (another story). If there was a Dr hans Zharkov of the financial economics world it was Prof. Dick Dale of Southampton (according to BBC Radio 4) who in 1993 predicted a 1930s style systemic banking collapse stemming from deregulation of the banks that culminated in Bill Clinton repealing the Glkass-Steagal Act as his very last Presidential Bill before exiting office. This allowed banks to engage in securities according to Prof. Dale and be subject to the very conflicts of interest (issuing and underwriting securities) that had caused the 1930s crisis after which Glass-Steagal was enacted. I would say it was less that than banks engaging in proprietary trading in securities for their own account to the extent of issuing and trading in their own assets without appreciating the illiquidity of the market for these. Securitised assets and other structured products were illiquid in the same way that fine art is illiquid, luxury items for the only the very rich. Again, the oversight was to neglect packaging these in such a standardised plain vanilla manner that all equity investors of whatever size could invest or speculate in, and do so in transparant regulated markets. But Prof. Dale's and actually many others' similar warnings were deemed irrelevent because, after all, the 1930s is so well-understood history that no-one of all our institutions and regulators will allow to return for a second time. Well, if we compare 1929-1938 with 199-2008, sure looks similar. Some commentators are even venturing to say a comparison of 2008 with 1914 could be equally sobering! The FSA and other Basel II regulators tried to get banks to focus on 1 in 25 year shock events with little practical success. Trying to get them to focus on the possibility of a 1 in 100 year event would have been treated with total satirical disbelief, and yet here we are! The regulators like the FSA believed firmly in the vital importance of banks relying on equity for most of their own capital reserves. This is why Standard Life in the UK (once it also owned a bank) was pressed to de-mutualise and be publicly quoted. Other mutuals like Nationwide, Co-operative Bank and Britannia must be very glad they resisted this idea, just as Halifax if not Abbey might regret it, just as many building societies regret allowing themselves to be taken over by banks. Why this pressure to de-mutualise, because the markets would value the banks' and building societies' solvency better than even the most expert risk auditors. That stock markets are indeed the best measure was the same mindset that believed in securities markets as the most true valuation reference for all of banks' assets, supported in this by AISB's IAS & IFRS insistence on marking-to-market. I am not saying these views are wrong, merely that they are not always right? Flash Gordon has saved the beautiful banks from the stormy river, got the goods back onto a raft. With more help from disabused shareholders the raft might have a few tow-ropes to the river bank or some strong poles to steer by. The raft is otherwise still headed downstream to the recession rapids! Governments are seeking to restore trust, stability and capital restructuring and inspire shareholders to buy bank stocks and banks to lend to banks. This trust and the rest is clearly incomplete when governments insist on 10% minimum yield preference shares and control over key aspects of strategy in the name of tighter regulation. Most important for shareholders and interbank lending may be Flash Gordon's assurance that no more major banks will be allowed to fail! The confidence that these banks will not topple over, no matter how bad the recession or what toxic fall-out is yet to be discovered. This (not just carrot but also the stick of nationalisation) should, it is claimed, bring the credit markets to their senses. But what about the ordinary shareholder market? They are told that the benefit – meltdown averted – outweighs any cost, a cost still there for shareholders if for no-one else! Shareholders must suffer falling returns, mainly because of the slurry of toxic “dead” capital that their banks cannot use to support lending. I do not doubt the necessity of governments to save banks. I doubt that they can do so without something for shareholders who include general insurance, life, pension and other investment funds. The US now too is copying the example of Europe. In two other equally important aspects, Europe is not yet copying the USA. One, is that there is still no plan in Europe for treating toxic assets head-on. In the USA the plan exists but it is potentially unworkable because of the conditions attached. After spending $250bn on SARP like bailouts, there is only $450bn left and $350bn of that is subject to Congressional discretion which is unlikely to back-track on the onerous conditions. Two, in the US over 400 bankers have been arrested by the FBI and 32 banks and other financial service firms are under criminal investigation including AIG, Fannie and Freddie, Lehman Brothers, Citigroup and Bear Stearns. More will follow. At the same time there are hundreds of mass action law suits and coprorate law suits. These all focus on misrepresentation of the facts to the public, to investors, counterparties, pension funds etc. Nothing like this is happening yet in Europe. One reason is that European financial markets remain national insofar as they think of themselves as small fish in a big pond and governments are loath to undermine confidence in the stability of their financial markets anymore than they are already discredited. There may be differences in legal remedies, but most major European banks have US branches where most if not all will face legal uits of some kind or other. The USA as the biggest single national financial market in the world by far has no fears for its international credibility; whatever happens everyone will continue to have to do business with it. A BBC Radio 4 "File on 4" (Tuesday October 14) examined this and reported that, for example, Barclays is being sued for $hundreds of billions over claims it moved loss-making investments from its own accounts to outside investors. Similar claims are arising for many banks including charges of moving toxic assets into retail investment funds, for assets that were AAA one week falling 17 risk grades by the following week and so on! (click on file on 4 'Listen' on this page: http://www.bbc.co.uk/radio4/news/). Countrywide (taken over by Bank of ASmerica) is accused of gaming or misrepresenting what was prime and what was sub-prime - this is extremely serious. Banks and ratings agencies are not above the law, not in the USA, and with governments taking large shareholdings of banks they will be liable for damages (after no doubt years of litigation) and taxpayers will ultimately pay.