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Quarterly Newsletter - Winter 2008/09

The Second (and Final?) Bank Bail-Out

So, let’s get this straight: in the UK, we now have a bank that is wholly owned by the Government (Northern Rock), a bank where the Government owns a healthy (unhealthy?) majority of some 70% (Royal Bank of Scotland) and yet another bank where it owns over 40% (Lloyds Banking Group, the new name after the merger of Lloyds TSB and HBOS).  To top it all, we will also get a state-owned “Bad Bank” which will absorb other banks’ “toxic debts”.  The term “toxic debt” is fairly self-explanatory, but to put it into even plainer English, it means those parts of the banks’ lending books that are highly likely to default. 

Unveiling the latest desperate measures, Gordon Brown on Monday said that his Government would “continue to take all necessary measures to ensure the stability of the financial system, ensure lending to the economy, businesses and homeowners, and limit the depth and duration of the current recession and support the subsequent recovery”.

Pardon me for asking, but haven’t we heard all this before?  It was very much the terminology our Prime Minister and his Chancellor Alistair Darling applied after the initial government bailout of the banks last October when £37 billion was thrown at the problem, which frankly was too little, too late in the first place.  The only difference in the wording then was the lack of a mention of a recession, which would have been an admission that all was not well, and politicians of all hues have a notorious reluctance to give us any bad news, particularly if they might have to shoulder some of the responsibility for causing it. 

The whole idea of the first bank bail-out was to ensure stability and see lending continue.  What we have seen, however, was a clear unwillingness by the banks to lend to anybody, including other banks.  LIBOR – the interest rate at which banks lend to each other in order to adjust their liquidity positions - shot up and only very gradually came down to more normal levels, which proved that they simply did not trust each other any longer.  You don’t have to be a cynic to reach the conclusion that they all were hiding some unpalatable truths.  Mind you, at the same time that the Government made money available to the banks in order to encourage lending, the FSA demanded that the banks repair their balance sheets.  Not easy for the banks to achieve both!

Mr. Brown declared himself angry with the Royal Bank of Scotland about what had happened, saying that almost all their losses were in the sub-prime market in America and related to the acquisition of ABNAMRO.  He went on to say that these were irresponsible risks to have taken.  Well, again, that is nothing new.  What he should have been really angry about is the fact that RBS did not properly come clean about the extent of their losses, which we now learn amount to a staggering £28 billion! 

RBS shares plummeted 64% on Monday, Lloyds was down 30% and Barclays, having already fallen by 25% last Friday, fell by another 10%!

So, should we also be angry with the bankers?  After all, they caused the whole mess in the first place.  Whilst not all bankers should be tarred with the same brush, a lot of them did engage in irresponsible lending practices, reckless borrowing to finance questionable acquisitions, and some were taking unreasonable risks  on  shaky American   CDOs (Collaterized  Debt Obligations) and   other  dubious investment vehicles. Sadly, the banks increasingly embraced a new culture which focussed on short-term profits rather than long-term benefits.  Some of the revelations of what has been going on are so serious that there is now talk that some bankers should face “the rightful consequences”.  On the other hand, banks like HSBC and Standard Chartered seem to have come through this crisis relatively unscathed. 

If not the banks, should we therefore blame the Labour Government or, more specifically, Gordon Brown, who as Chancellor since 1997, and latterly Prime Minister, was in charge of our economic welfare?  As you are well aware, both Gordon Brown and all his Ministers keep telling us that we got into this terrible fix purely as a result of the American sub-prime problem that led to the credit crunch and the global economic slowdown.  Well, that is not entirely true.  Gordon Brown inherited an extremely strong economy in 1997, and he was prudence personified for the first two years after Labour came to power.  Sadly, he then reverted to type and opened the public spending taps fully.  Having bought back gilts during the early years of his Chancellorship, he changed tack and massively increased public borrowing, expecting the economy to blossom evermore which, he argued, would lead to higher revenues that would allow him to balance the books.  Misguided though that approach proved to be, including his statement that he had effectively abolished “boom and bust”, it was his tolerance of the ludicrous credit splurge which in turn led to over-indebted consumers and an unsustainable house price bubble, and we all know what happened next.  More importantly, by then the cupboards were bare, and UK plc was ill-prepared to deal with the effects of the credit crunch.  Mind you, the Tory opposition proved almost pathetically weak for a long time, and the Conservatives went along with Gordon Brown’s “light touch” regulatory framework governing the City.  They also have to take a portion of the blame.

Let us now return to the latest Brown manoeuvre, the so-called “Bad Bank” for toxic debts.  Essentially, the Government is underwriting the potentially bad debts that the banks are holding.  The term underwriting is quite apt, as this measure is not dissimilar to an insurance policy.  The banks pay a “premium” to the Government in the form of a flat fee, and the Government will then cover about 90% of any defaults.  Estimates as to how big the toxic debts are range between £120 and £200 billion.  How likely is it that there will be defaults, and how big could those defaults be?  Well, nobody knows, and that effectively means that the Government has signed a blank cheque.

Other measures include the extension to December of the £250 billion Credit Guarantee Scheme, which was due to expire in April, an effort to kick-start mortgage lending and adding money to the financial system by allowing the Bank of England to purchase £50 billion worth of high-quality assets such as corporate bonds and other commercial paper.  The latter is a first step into what is known as “quantitative easing”.  Quantitative easing often is misunderstood as printing money (although that remains a rather extreme option!) but it has more to do with increasing the supply of money.  In this case, the Bank of England is providing cash to the banks by buying some of their assets. 

The financial markets did not take kindly to Mr. Brown’s latest offering.  The price of Government bonds and sterling fell sharply, not helped by a comment by Jim Rogers (co-founder with George Soros of the Quantum Fund) who told Bloomberg News: “I would urge you to sell any sterling you have.”

What a scathing indictment of Britain and its currency!  Clearly, Jim Rogers did not like Gordon Brown’s latest attempt at saving the world’s financial system.  But who is to blame?  Gordon Brown, when he still was in opposition, said the following: “A weak currency arises from a weak economy, which in turn is the result of a weak government”.

On top of that, there were rumours that one of the leading agencies (Moody’s? Standard & Poor’s?) was considering lowering its credit rating on Britain’s sovereign debt.  If that were to happen, it would have serious consequences.  Put simply, it would question Britain’s ability to repay its debts, and that would significantly increase the costs of our national borrowing. 

Our national debt is already much, much higher than has been predicted by our glorious leaders, and these latest plans are increasing it further yet.  It will take years to repay the debt, and at the risk of sounding dramatic, we are lumbering our children with a very unpleasant legacy.

With all of us rather preoccupied with what is happening right now, it is almost easy to forget that we have come through a very tough time last year.

Back in 2007, i.e. the year before, the markets had risen on the seemingly unstoppable growth in China.  The ‘decoupling’ of Asia’s economic performance compared to the West was put forward as justification for the increasingly frothy nature of stocks across a number of sectors.  If nobody actually said it was “different this time”, markets certainly behaved as if it was.  Whilst more conservative and cautious commentators viewed the situation as unsustainable in the long run, there were very few who anticipated the credit crunch and its implications which stretched way beyond the initial US sub-prime mortgage crisis.  With hindsight, the sub-prime mortgage issues now appear almost somewhat trifling, even though our political leadership keeps insisting that it was the cause of the present malaise.

At Lacomp, we have on many occasions warned about the state of Britain’s public purse, worrying about the Government’s unrealistic forecasts of GDP growth and increased borrowing, but also about the very poor savings ratio (often negative!) and the personal indebtedness of the British consumer.  The Government, with all the relevant hard facts at its fingertips, seemed to have a different opinion.

Whilst we could not foresee the sub-prime crisis and the ensuing credit crunch, we nevertheless felt somewhat uneasy and adopted a more defensive stance by substantially reducing our exposure to small and mid-cap stocks at the end of 2007 and the beginning of 2008, using the proceeds to buy some more gold and retaining the balance in cash. 

In 1990, John Kenneth Galbraith, the famous Harvard Economics professor, wrote a book entitled “A Short History of Financial Euphoria”.  The following quotes from it prove both prophetic and poignant: "There can be few fields of human endeavour in which history counts for so little as in the world of finance.” In the same book, you also find the sentence “Only after the speculative collapse does the truth emerge.” and another bit of wisdom:The speculative episode always ends not with a whimper but with a bang."

Galbraith would have felt vindicated by the overoptimistic euphoria we have seen, the clear lack of attention to warning signs and the overreliance on selective data in order to support the supposedly unstoppable growth story.

As global stock markets corrected throughout 2008, culminating in a truly dreadful November, the number of commentators who claimed to have deemed the situation as “inevitable” grew with each successive bad news story.  However, these backward-looking prophets were conspicuously absent during the market highs in late 2007!

Just as stock market valuations had risen indiscriminately, the sell-off was no respecter of blue chip status or sound financial returns.  Indeed, as the process of deleveraging gathered pace – particularly by hedge funds who were victims of their “gambling” with borrowed money -  it was precisely the quality stocks (including gold!), by definition the most liquid, which were most heavily sold.  The sale of quality assets into a falling market further fuelled the downward trend.

The performance statistics for last year make truly depressing reading.  Every single market save Tunisia (!) lost money, and many lost significant amounts.  By November, most major markets had lost around 40% from their peak in October 2007, and even a half-hearted “Santa Claus rally” at the end of the year did little to soften the blow.  The UK All Share index and US Dow Jones lost approximately 33%, Japan’s Nikkei lost 42%.  The S&P 500  was down 38%, and  the Euro Stoxx 50  was a negative 44%.  Those who had gambled on an ever increasing rise in the oil price lost heavily, seeing the price of a barrel fall from $147 to $44 in a matter of months – a fall of some 70%!  The only market feature showing an actual increase was the level of volatility which reached an all-time high as traders sold into any hint of a market rally.

The Lacomp World Fund continued with its defensive policy by keeping the cash position at the maximum permissible level.  The Fund lost 25% for the year, compared to the benchmark, the MSCI World index, which lost 42%.  A  loss of 25% is  never good,  but  it  is a  relatively  good result  in  an extremely difficult year.

There can be few financial and economic crises in living memory that have triggered such a mass of analysis, retrospective reflection, forecasts and predictions from the financial and mainstream press, radio and television.  2008 was a truly momentous and memorable year, if only for the long list of high profile names which are no more, the high profile scandals as well as the examples of highly questionable corporate governance and malfeasance, particularly in the banking sector.

Where do we go from here?  Stock markets are at or near “capitulation” levels, and whilst there will be further aftershocks, the wreckage of 2008 will also present us with some opportunities.  We saw that after the Crash of ‘87, when judicious repositioning of portfolios resulted in a speedy recovery.  The outlook is somewhat different this time, though, and one should not expect a full recovery of last year’s losses in the next few months!

Let us also remember that stock markets recover before the economic recovery becomes apparent.  The feeling that things have never been so bad is, paradoxically, a sign that things have got as bad as they are likely to get – the markets appear to have bottomed, a situation that, by definition, will only become apparent with hindsight! 


20th January 2009