The Naked City

FRIDAY, OCTOBER 17, 2008

The Naked City

Roll the closing credits

Say goodbye to the City as the engine of UK growth. The head of the FSA has just formally announced the start of hard-line regulation, large swathes of our banking industry are now under Whitehall direction, and politicos of all parties are falling over themselves to announce further plans and controls.

There will be big consequences as bankers leave for more accommodating homes elsewhere (and see this blog).

Hedge funds are already rushing for the exit. Because of the UK's archaic bankruptcy laws, $65bn of their assets held by the London end of busted Lehman have been frozen by the administrators, with no date for their release. Hedge funds and their clients are very angry: they're switching billions in so-called prime brokerage accounts - a highly profitable business - from London to New York(HTP JW).

Now in all the circs, you're probably saying good riddance. The bill we taxpayers are now facing to clear up the high-rolling City's mess is outrageous. And the economic chasm that's opened beneath our feet has surely been caused by the City's greed and wild risk-taking.

Ah, risk.

Risk is a fascinating subject. Risk is something few of us ever want to take, but which is absolutely vital to our prosperity. Unless we're prepared to take risk, our cash lies stuffed under the mattress and economic growth becomes a thing of the past. Because growth depends on investment, and investment depends on risk-taking.

Let's take a look at how we as individuals choose to hold our wealth.

According to the Office for National Statistics, as at end-2005 our personal wealth totalled £7.6 trillion (about six times annual GDP). But over half of that was held directly in the form of property and other physical assets - assets we can see and touch every day, and which we use for our own benefit. That's wealth all right, but it's generally not productive investment in the sense of money we've risked on business ventures which will grow the economy.

Looking at the other half of our wealth - the bit we hold in financial assets - we find something just as interesting:

As we can see, a quarter of our financial assets were held in cash and bank deposits - ie they were stuffed under the mattress. These are savings that we assume to be absolutely safe. They are savings on which we accept low returns because we don't want to take any risk at all. Which is why we get so upset when banks start wobbling, and why no sane government can allow its banks to default on retail deposits.

Over half our financial assets are held in pensions and life assurance policies, which are especially interesting.

Because as any insurance salesmen will tell you, these products are sold, not bought. In other words, we mostly hold them not because we decided to do so, but because we somehow got talked into them. Sometimes that's because of a high pressure pitch from one of those salesmen, but more usually we just stumble into them via our employment (pensions), or via some other transaction like house purchase (eg those famous endowment mortgages).

Why's that important? Because it means most of us have absolutely no idea how risky such assets can be - right up to the moment they explode in our faces. That's the first time we find out that all the reassuring sounding pension promises and finely tooled endowment policies are actually no more than a "best endeavours"indication. We've been holding risky assets all right, but we never knew they were risky.

And when it comes to obviously risky stocks and shares, overall we hold less than 20% of our financial assets in that form - and most of us don't hold any.

So we make it absolutely clear in our savings behaviour that we don't like risk.

Which is a problem. Because as we've said, without someone taking risk, we don't invest. And if we don't invest, we don't grow.

We are now living with the Naked City.

The City is stripped bare. Any mystique it once had about sophisticated risk control, about delivering rocket fuelled returns without hideous risks, has been blown to smithereens. Investors have taken fright, hedge funds are in the process of imploding, and everyone realises there really are no free lunches.

Heavy regulation is on the way. There will be stacks more monitoring and control. Confidence tricks are out, and transparency is the new order.

Right now, there is no real choice. But just remember what happened when the authorities brought such regulation and control to other areas of finance:

• Heavy pension fund regulation brought in after the Maxwell scandal is largely responsible for destroying our defined benefit pension system (excluding of course, in the tax-funded public sector)
• Heavy life assurance regulation brought into control abuses by those oldtime salesmen is largely responsible for destroying the with-profits savings market

In truth, both defined benefit pensions and with-profits life assurance depended on a confidence trick. Savers believed they were pretty well riskless, when in fact they depended on the uncertain performance of financial markets. But because they were very long-term contracts, in almost all circumstances they turned out fine. They were a way of allowing us wimpy risky averse punters to invest for the long-term without worrying about the risks. And their loss is a loss to all of us.

In finance, revealing all for public inspection has a nasty habit of costing us dear.

THURSDAY, OCTOBER 16, 2008

Meanwhile...

Scoring the Audit Commission

As we've blogged many times, the £200m pa Audit Commission is a complete and utter waste of taxpayers' money (eg see here and here).

Supposedly, its job is to scrutinise local councils, NHS hospitals, and other local public sector bodies, and point out where they're wasting our cash. Which task it conducts through a vast array of detailed analyses and reports.

In practice, it's yet another box-ticking quango. Its sheaves of forms and reports are largely self-assessment, and local bureaucrats are now fully adept at filling them in correctly. They mean virtually nothing.

Worse, the AC reports not to local taxpayers and their elected representatives, but to central government. Just like in some classic Russian play, they are bungling government inspectors sent out by the commissars in a vague attempt to keep the provincials in line.

Now, the flaming limit - we've just learned these guardians of financial probity had £10m deposited with the busted Icelandic banks. These low-grade clowns aren't even capable of understanding the clear warnings spelled out in the Daily Mail financial pages 7 months ago.

Mr Meldrew couldn't believe it.

We can believe it only too easily. And we say to George, write this down in your notebook, George, because it's another £200m pa you can save.

And another thing - while you're at it, take due note of today's devastating National Audit Office Report on our old friends at the £5bn pa Department for International Development. The NAO confirms DfID is wasting many millions of our cash on half-baked "development" programmes which are poorly targeted and grossly mismanaged.

Which will come as no surprise to BOM readers, where we've blogged the grotesque waste in our aid spending many times (start here). It needs a serious pruning.

Blowing Off The Froth

Moments of madness always have a price

Much commentary this morning about the further slide in stock markets. What's going on? Does it mean the bank bail-out has failed? What's Plan B? We need action now!

From a taxpayer perspective this is careless talk. And careless talk has a nasty habit of costing taxpayers whole shedloads of money. Having already bailed out the banks at a combined global cost of £2 trillion, the last thing we need is to have our politicos stampeded into somehow (how?) bailing out the equity markets as well.

There's no doubt that stock markets are signalling a serious recession. And there's no doubt their decline will feed back into that recession and make it worse - after all, a lot of wealth is being wiped out before our very eyes (some of it belonging to Tyler, we might add).

But we need to understand the markets are still blowing off the accumulated froth of the last 15 years.

As always it's helpful to take the long view. The chart above shows a widely used valuation measure of the US equity market*. It's the ratio of the market price to the underlying earnings of the companies whose shares are being traded - the Price-Earnings ratio (PE ratio). Note that this PE is based on a trailing average of real earnings over the previous 10 years, in order to smooth out short-term fluctuations*.

[For those unfamiliar with the PE ratio, think of it as being the cash price you'd have to pay to own £1 (or $1) of annual company earnings; so a PE ratio of 20 means you're paying £20 for £1 pa of earnings, whereas if the ratio falls to 15, you only have to pay £15 - ie the market has got cheaper. Of course, this can never be more than a rough guide because in reality we don't actually know whatfuture company earnings will turn out to be - which is why the chart above uses a moving average of the previous ten years earnings].

As we can see, over the entire 127 year period for which we have data, the average PE ratio on the US equity market (S&P composite index) has been around 16. And after yesterday's sell-off, the market closed on a PE of 14.4.

That's good. It means we've returned to the realms of sanity after the ludicrously high market valuations reached under Brown mentor Sir Alan Greenspan (the"Greenspan put" - see this blog). But unfortunately, it doesn't mean we've hit the bottom.

Because we can also see that the equity market undershoots as well as overshoots. And given the current circs, it would not be at all surprising to see at least one more major downward lurch. A return to the 70s would suggest another 30% off current market levels.

It's painful. No doubt about that. But ideas that governments can somehow ride to the rescue of equity markets are a delusion. Short of wholesale nationalisation and the closure of financial markets, we equity investors simply have to accept what's coming.

Sustainable economies cannot be built on financial froth.

(And at some stage there will be some stellar bargains out there).

PS Should central banks take more account of asset bubbles in setting monetary policy? With hindsight, everyone now agrees they should. Just as everyone now agrees having the Bank of England target an inflation measure that excludeshousing costs is lunacy. But let's not kid ourselves that's a painless panacea. For example, it would have meant the Fed keeping interest rates higher in the early years of this decade and almost certainly triggering a global recession then. Although it must be said it would have been a whole lot milder than the winter we now face.

PPS Talking of Plan B, it's good to see Marks and Sparks' smug PC Plan A campaign to save the planet ("because there is no Plan B") has been surreptitiously dropped. The most visible bit of Plan A was to charge food customers 5p for plastic carrier bags. But in a central London M&S yesterday I - along with every other customer - was given a free plastic carrier in which to cart off our salt and cholesterol supplies. Apparently, they've had many customers dump their shopping and walk out rather than pay the 5p - free carrier Tesco Metro is just 2 mins walk away. Aren't markets wonderful.

*Footnote: the US equity market data comes from the website of Prof Robert Shiller, the world's foremost expert on speculative asset bubbles, and author of the must-read Irrational Exuberance. Shiller's measure of earnings is based on average inflation adjusted earnings over the previous ten years.