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Quarterly Newsletter - Autumn 2007

Northern Rock – Rock Bottom

A run on a bank?  In the UK? These days?  Impossible!

Well, think again.  As you all know, just over a month ago we experienced something we had not seen for 150 years: a run on a major bank!  Thousands of panicking savers queued outside Northern Rock branches over a three-day period in an effort to withdraw their cash deposits, fearing that the bank might collapse and some or all of their savings go up in smoke.  Northern Rock shares came crashing down, as did those of other high-profile lenders amid fears that the contagion from Northern Rock might spread through the whole financial system.  The Bank of England needed to provide some emergency funding to Northern Rock, and after some prolonged dithering, the Chancellor of the Exchequer Alistair Darling took the unprecedented step to announce a government guarantee of all deposits to savers in Northern Rock and, indeed, initially extended that guarantee to savers in other banks in trouble!  Next we were told that the government planned to cover £100,000 of all deposits, similar to the US guarantee of $100,000.  However, realising that this potentially could have spelt disaster for the Treasury, there quickly followed a clarification: Northern Rock savers’ deposits were guaranteed in full, whereas other banks’ customers would enjoy a guarantee limited to £35,000 (increased from the previous £31,700).  Ironically, cautious savers choosing supposedly safe bank deposits get a raw deal compared to investors who are putting their money into riskier investments.  If a management group went belly up, the investors would receive up to £48,000 compensation.

It is just as well that there has been a rethink. Depositors’ claims are met by the Financial Services Compensation Scheme, and according to the FSA, there currently is a levy cap of approximately £2.7 billion available to meet depositors’ claims.  Compare that with the US equivalent of some $49 billion, and it doesn’t take a young Einstein to work out that the UK government simply cannot afford to be too generous.  Northern Rock’s savers alone had deposited £24 billion in that bank, so the £2.7 billion would have been woefully short of the potential payout.

We then had the spectacle of Bank of England Governor Mervyn King being grilled by the Treasury Select Committee about the Bank’s U-turn in handling the credit crunch and the emergency funding agreed with Northern Rock. Governor King explained the dilemma the bank had originally faced, as it had to weigh up the pros and cons of propping up Northern Rock against the moral hazard.  Moral hazard, in this context, means that if a bank feels that it would always be bailed out by the Bank of England or the Treasury if things went wrong, that bank could pursue a riskier, and therefore more lucrative, lending policy.  Clearly, Mr. King was concerned what signals he would send to other lending institutions if he was seen to be too helpful too quickly.  By carefully analysing the answers Mr. King gave, an onlooker could not help feeling that our new Prime Minister had been rather more involved in the Bank of England’s affairs than we were led to believe.  However, when Gordon Brown himself was repeatedly  asked on  the Andrew  Marr  Show about  when the  government  had  first  known about the Northern Rock problem, he dodged question after question, suggesting the crisis had been dealt with exclusively by the tripartite committee (Treasury, Bank of England and the FSA) that he had set up back in 1997.

Of course, the FSA did not look too good either in this affair. Although the Bank of England’s main responsibility lies in overseeing the money markets, it is the FSA that is responsible for the actual institutions like Northern Rock.  As its regulator, the FSA must have known that Northern Rock’s lending book was way in excess of its deposits.  The FSA’s image was not helped when its Chairman Sir Callum McCarthy and CEO Hector Sants had their session with the Treasury Select Committee over allegations that the FSA had briefed the media against Mervyn King and the Bank of England.  Sir Callum was criticised for failing to give straight answers and even refusing to answer some questions relating to the tripartite system of governance.  Not impressive when one of the eleven guiding FSA Principles states, inter alia, that “a firm must deal with its regulator in an open and co-operative way”!

The Treasury Select Committee has been very busy in the last few weeks, and this week it was the turn of the Northern Rock management that faced the MPs.  Nearly all of the management team were accused of incompetence and failure in their duties, but they hit back accusing the Bank of England for being far too slow in making capital available to the money markets, an argument which seems to be somewhat arrogant under the circumstances.  What is worrying, though, is the fact that Northern Rock, Britain’s eighth largest bank before the crisis, had a management team that was led by a chairman who, first and foremost, is a scientist and author, and a CEO who has not got a single banking qualification to his name!

Of course, the Northern Rock was only one of the knock-on effects of the global credit crunch which in turn was precipitated by the sub-prime mortgage crisis that originated in America, and we have already written about this in our last two quarterly Newsletters.  Initially triggering a spate of profit warnings and even some bankruptcies in the US, the sub-prime crisis spread to Europe, with Germany having to bail out two banks even before the bank run in the UK took place.  The real turbulence in financial markets had started in the second half of July and continued for some weeks.  The week from 23 to 27 July, for instance, registered a fall in the Dow Jones of some 600 points, and the week from 13 to 17 August was the most volatile week for equities since March 2003.  One commentator on CNBC said that Wall Street was like a five-year-old – gullible, always surprised and never seeming to learn.

However, nobody should be naïve enough to think that this crisis is definitely over.  The situation has been far more serious than a mere correction, and it took many billions provided by central banks to oil the wheels of the money markets, as well as the Federal Reserve’s 0.5% interest rate cut.  Whilst many hedge funds took a hammering with some failing altogether and others needing huge capital injections, equity markets staged a remarkable recovery: since the low point on 16 August, the FT-SE 100 index has risen by 10.4%, the Dow Jones by 8.2%, the S&P 500 by 10.5% and the Nikkei Dow by 9.8%.  However, there are still uncertainties about how far-reaching the repercussions of the sub-prime mortgage crisis will turn out to be.  In truth, we will have to wait until spring of next year when all banks will have made public their 2007 results.  It is only at that point we will see who has been swimming naked…

A week is a long time in politics

When Harold Wilson coined the phrase “a week is a long time in politics” he could not have known what happened in the last three weeks.  It only took that short period of time for a Labour double-digit lead in the opinion polls to be overturned.   We have just witnessed  one of the most monumental swings in public perception.  The “big clunking fist” is now called a “ditherer” or “bottler”.  This may seem a tad unfair, but during the recent Labour Party Conference, everything appeared to be set for an autumn election.  Whilst Gordon Brown himself would not be drawn on this point, his ministers were openly briefing the media, and the PM’s advisers were equally upbeat about the prospect of a snap election.  The fact that Labour was some 11 points ahead in the polls clearly helped that mood. When it was then announced that both the Comprehensive Spending Review and the Pre-Budget Report would be brought forward, presumably in an effort to clear the ministerial desks for an election campaign, it looked like a November election would indeed be on. 

Undoubtedly, the Pre-Budget Report was going to include some tax give-aways, as is always the case before an election.  But the Chancellor Alistair Darling (or should that be Alistair Darling/Gordon Brown?) also had to address the fact that the UK economy is facing a slow-down.  Indeed, Alistair Darling had already softened us up by blaming the slow-down on the global credit crunch, which was somewhat disingenuous of him as we all knew the economy was heading that way long before the credit crunch problems arose.  In the event, the Chancellor predicted a reduced GDP growth for 2008 of 2% - 2.5% (down from the previous 2.5% - 3%), but city economists reckon the downturn could be much more severe. 

Furthermore, the UK now is pretty heavily indebted.  Long gone are the days of the “prudent” Chancellor Brown in the early days of Labour rule, who for a while managed to reduce Britain’s debt. Gordon Brown appointed Alistair Darling at a time when the picture looks very different.  Indeed, the OECD recently stated that the UK has the highest structural deficit among the original 15 EU nations.  It is worth noting that a structural deficit can only be reduced by either cutting back on public spending or increasing taxation.  Hence, when Gordon Brown appointed Mr. Darling to be Chancellor, he was presented with something of a poisoned chalice.

Gordon Brown’s address at his Party Conference was very light on new policies, but he kept talking a lot about “change” and his “vision for the future”.  It seems odd that the co-architect of Labour policy for more than a decade now wants to distance himself from anything that had gone before, prior to his move next door to Number 10.  Furthermore, the man who has renounced spin (although he had used it endlessly before) then chose the middle of the Conservative Party Conference to go and see the troops in Iraq, making the by now infamous “1,000 troops will return to the UK by Christmas” announcement, which seems to have backfired massively.

The Tories, being faced with an election that they in truth did not want this early, were forced into airing their policies which they had been working on for some time.  Remember all the jibes the Tories had to suffer over months because they seemed to be bereft of policies of substance?  Well, maybe it was just a question of keeping their powder dry.  Be that as it may, their Party Conference was a resounding success as it clearly helped unite the party.  Most of their policies were very well received, not just by the Conference but also the wider public, as was evidenced by the Tories’ resurgence in the opinion polls.  David Cameron’s unscripted (but undoubtedly well-rehearsed) speech was clever and well-delivered, but it was Shadow Chancellor George Osborne’s proposed changes to the tax regime (raising the IHT threshold to £1million, taxing the so-called non-doms and abolishing stamp duty for first-time buyers) that really caught the public’s imagination. 

Before Parliament reconvened, the Prime Minister chose another interview with Andrew Marr – clearly his favourite interviewer – to tell the nation that there would be no election after all.  This was a big surprise,  as most political analysts felt Labour would still have won with a good majority, despite the opinion polls that actually showed the Tories ahead.  Whatever the real reason  in Gordon Brown’s mind, it  is entirely understandable  that, having  waited and battled for ten years to get the “top job”, he was not going to risk becoming one of the shortest serving Prime Ministers.

Following that, we had the Pre-Budget Report last week. Alistair Darling is hardly the most dynamic orator, but his speech nevertheless was dynamite.  The reason?  The contents appeared to be a slightly different version of what George Osborne had promised at the Tory Party Conference, and one could not help feeling that Mr. Darling’s speech had been rather hastily rewritten.  Accusations of policy theft abounded, and seeing Gordon Brown smugly grinning throughout the speech was a spectacle in itself.  One could go as far as saying that one policy, the one about charging a green tax on aircraft rather than passengers, had been stolen twice, as it was the Liberal Democrats who first mooted it before it was adopted (or stolen!) by the Tories.  The Shadow Chancellor had a field day, accusing Brown and Darling of “followership” rather than leadership, and claiming that we had just listened to a pre-election Budget without an election to follow.  Similar scenes were played out at the following day’s Prime Minister’s Question Time, and Gordon Brown clearly was rattled by the exchange across the Floor of the House.

What do we make of the proposed tax changes?  Most of them are welcome, but we are very concerned about the flat CGT rate of 18%.  This is not good news for smaller businesses who will see their funding dwindle as investors query the wisdom of backing the riskier end of the market if they face the same tax rate as the one applicable for investments in well established, solid companies.  Equally, we can see management groups promoting a whole new raft of growth orientated (but relatively low risk!) equity funds.  After all, why would you keep substantial sums on deposit if you are going to be taxed at 40%?

We believe that the flat CGT rate was politically motivated and predominantly designed to stop the private equity “fat cats” paying only 10% on their gains.  It would have been better to introduce rules that made the highly leveraged, and therefore fiscally neutral, deals a thing of the past.  Whatever the reason, the new rules fly in the face of the promotion of enterprise that New Labour has been so proud of over the last ten years. Small business start ups, and with it wealth creation, already have significantly declined over recent years, whilst the public sector has become bloated by the creation of nearly 700,000 new jobs, all of which are paid for by the state.  

Undoubtedly, there will be a lot of lobbying in an effort to get Alistair Darling to change his mind.  Trouble is, governments hate to make a U-turn as it would be perceived as a sign of weakness.  That is a pity.  In real life, it takes strong people to admit fault and take corrective action, and they invariably are admired for it.  Politicians please take note.


17thOctober 2007