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
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
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
