Babies And Bathwater

TUESDAY, OCTOBER 14, 2008

Babies And Bathwater

OMG! Where's the baby?

It is the biggest financial market disaster of our lifetimes and we're all in shock.

But the big government left are jubilant. Will Hutton is everywhere, and here's what the well-known son of a Labour peer says:

"I think it can perhaps be seen as the death of Thatcherism, or at least of an important strand of the dominant ideology of the 1980s and 1990s.

It was Margaret Thatcher who... gave the City the freedom to trade in everything and anything... She encouraged the free flow of capital to and from anywhere in the world, she created the notion of the City as the Great British Success...

This is the moment when future historians will say that the tide turned decisively against almost-anything-goes, laisser-faire financial capitalism which has been the prevailing ideology for almost 30 years...

Till just a few weeks ago, the City and our banks - the financial services industry - swaggered that they were the great British success in a country with few other world-beating industries."

And in fairness, it isn't just the left. As we've blogged before, Tyler Senior spent his entire working life in poorly rewarded British manufacturing. He's by no meanson the left, but he's never been able to understand how bankers have managed to grab so much for apparently doing so little (or as he puts it, who grows the lettuce?).

But before we consign this Great British Success to the status of a notion - just another grand and dangerous illusion - let's remind ourselves of a few facts.

First, a big chunk of our economy now relies on financial services. In 25 years it's powered its way from around 4% of GDP to around 10%:

Second, this has been an outstandingly good business to be in - its growth rate has been phenomenal and the global market reached over $10 trillion pa (UK GDP is under $2.5 trillion pa). In 2003, consultants Oliver Wyman forecastmarket size would triple in the next 10 years, and amazingly, actual growthexceeded that:

Third, Britain has done very well in this market. According to a recentgovernment swagger, we have "20 per cent of cross-border bank lending, 34 percent of derivatives turnover, 53 percent of foreign equities turnover and the world’s largest share of global bond trading – a massive 70 per cent". Our trade surplus in financial services is £33bn pa.

We need to keep these things firmly in mind. If financial services go down - however pleasing that might be emotional spasmwise - we're seriously stuffed.

If only we could find someone to blame. Then we could simply burn him at the stake and carry on with our lives.

Last night Newsnight mounted its financial melt-down show trial, in which market participants were invited to confess before Judge Vixy Essler, State Prosecutor Leon Mason, and a team of specially selected inquisitors.

Unfortunately, despite all the usual tricks of a rigged trial - accused made to stand in the spotlight while everyone else sat, etc etc - there were no outright confessions.

The hedge fund manager blamed government for deliberately encouraging the sub-prime mortgage boom (especially Clinton's notorious Community Reinvestment Act). The (ex) banker blamed bad bonus structures nodded through by poorly qualified bank directors. The (ex)regulator blamed central bankers for inflating a series of huge asset bubbles. And the (ex) government minister blamed the bankers for being the only successful part of the British economy.

So what's the truth?

Yup, it's that usual messy splodge - everyone's to blame.

Except the baby. The baby can't be to blame. And we'd better watch what goes down that plughole very carefully.

We may have put out the immediate fire, but nationalised banks are no basis for future prosperity. Somehow we have to get them back on their own feet without regulating them to death.

PS Apologies for lack of blogs on other government spending issues, but these Big Ones don't happen very often. And those of us who believe markets are generally better than governments are wrestling with some difficult questions.

MONDAY, OCTOBER 13, 2008

Not Quite The Full Buffett

If only we'd listened...

As we understand it, our £37bn bank equity injection will be on significantly less favourable terms than Warren Buffett's deal with Goldman Sachs.

As BOM readers will know, for his $5bn, wily old Warren got preference shares paying a 10% pa dividend, plus warrants to buy Goldman equity at below the then prevailing Goldman stock price. He set the benchmark against which we non-financial-genius taxpayers can judge the deal Brown has got us.

So what have we got?

We are putting equity into RBS, HBOS, and Lloyds. The amounts vary, but in all three cases we are getting preference shares paying 12% pa - which is about the same as Warren's 10% once you take account of the difference between sterling and dollar bond yields. But we are not getting any warrants. Instead we are getting ordinary equity shares (well, strictly speaking, we are underwriting an issue of new shares which will be offered to private investors: we only get them to the extent that private investors don't buy... but in current circs how do you think that will play out?).

And the mix of funding is very heavily slanted towards ordinary equity rather than preference shares:

• RBS - £5bn in prefs; up to £15bn in ordinary equity
• HBOS - £3bn in prefs; up to £8.5bn in ordinary equity
• Lloyds - £1bn in prefs; up to £4.5bn in ordinary equity

Which is a lot worse than Warren's deal.

Because with ordinary equity we do not rank ahead of existing shareholders in dividend distribution (we don't rank ahead of them in a bankruptcy either, but in current circs that's a bit academic since as we all now understand, outright bankruptcy would mean automatic nationalisation). We're getting no cushion - we're taking our chances right alongside existing shareholders.

And that also means our investment is fully exposed to any further downward move on the banks' share prices. Whereas Warren's warrants get all the benefit from an increase in the Goldman's share price, but little of the downside from a fall (ie they have the "asymmetric" pay-off of options).

Given where we've got to, we have always favoured recapitalisation rather than outright purchase of the banks' bad debts as envisaged in the Paulson Plan. But taxpayers would have much safer if Brown/Darling had followed the Buffett plan rather than committing to these huge outright equity purchases.