Britannia Radio

I don't pretend that this is easy to read.  After all it IS hideously 
complicated and and the money boys and girls have slaved well through 
many nights on it .  But at the end of the day it is the world's ever 
biggest gamble.

Quite a number of respected commentators are gloomy at its 
prospects.   Since our whole future depends on it I hope and pray 
they're wrong.

XXXXXXXXXXX CS
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SUNDAY TELEGRAPH  1.3.09
Alistair Darling's debt-defying stunt
As RBS unloads £325bn of dodgy assets on the Treasury, Philip Aldrick 
examines the potentially calamitous asset protection scheme.

Stephen Hester has grown wearily familiar with the spartan corridors 
of the Treasury in the two months he has been chief executive of 
Royal Bank of Scotland. Within weeks of taking over from Sir Fred 
Goodwin he was informed his bank would be a guinea pig for the 
Government's biggest gamble on Britain's lenders yet and he has worn 
a well trodden path on Whitehall's parquet floors since.

On Wednesday, though, the end was in sight. Mr Hester and his head of 
strategy, Jennifer Hill, were summoned to thrash out the final 
details of the Government's asset protection scheme - a pioneering 
insurance scheme for the banks' toxic waste - in order to be able to 
publish the announcement alongside the banks' results the following 
day. Receiving the call in the late afternoon at 280 Bishopsgate, 
RBS's London headquarters, Ms Hill was heard to cry: "I think we have 
a deal at last."

Legions of RBS bankers and Treasury advisers had been working on the 
scheme since its announcement on January 19, picking over the assets 
and pricing everything on the RBS book to see what to dump at the 
Treasury's door. By Wednesday afternoon, a final plan that only 
needed official sign-off was ready. Even so, the details were picked 
over until 3am by Ms Hill and Mr Hester before Shriti Vadera the bank 
and small business minister, Paul Myners, the City minister and 
Treasury mandarin Tom Scholar.

Thursday was the turn of Lloyds Banking Group. Eric Daniels, the 
chief executive and Sir Victor Blank, the chairman, took their turn 
in front of the Treasury's triumvirate of bail-out specialists. Only 
this time, it was less successful. Quarrels over pay ensued and the 
two parties could not come to a solution.

To the press the following day, Sir Victor portrayed the delay as 
merely because the Treasury's negotiators "were absolutely and 
completely knackered, if you'll excuse the expression". Insiders said 
it was more acrimonious.

The scheme was dreamed up in late December as it became clear that 
October's recapitalisation wasn't working. The Treasury's advisers, 
led by Credit Suisse with Citi and Deutsche, were asked to come up 
with something new. The idea of an insurance scheme - in which the 
banks could dump their toxic sub-prime assets and leveraged loans - 
was catching on around the world and the Treasury bit.

In the US, Citi announced something similar shortly before and in the 
Netherlands ING followed suit. But it was only the UK that decided to 
introduce the scheme on a sector level. With RBS depositing £325bn of 
dodgy assets and Lloyds close to announcing £250bn more, the scheme 
is now running.  [Assuming you're still with me! - -that's a total of 
£575 billion - or a total of £9,426 for every man woman and child  
(£37,700 for a family of 4) in this country  ---Goodwin's pension is 
around 12p a year! .  Now it's true that the state will recover some 
of this but if I were you I wouldn't bet on it! -cs]

The Government is desperately hoping that the Asset Protection Scheme 
will prove to be the silver bullet that ends the financial crisis and 
gets banks lending again. It is the culmination of more than a year's 
worth of state interventions that began with Northern Rock, gathered 
pace with last April's £200bn Bank of England special liquidity 
scheme and appeared to end with the £50bn recapitalisation programme 
in October, which came with £250bn of loan guarantees for good 
measure. Despite the £500bn scale of the bail-out, it wasn't the 
silver bullet.  [That's over a trillion in total now! - another 
£8,196 per head or £32,787 a family.  By now therefore each of you 
has got pay back £18k - or £72 for the family -cs]

So policymakers started again. The Bank of England slashed interest 
rates to 1pc and started buying up commercial paper in a prelude to 
full-blown "quantitative easing" - economists' favourite euphemism 
for "printing money". In January, a new asset-backed guarantee 
scheme, which could top £200bn, was launched and the old guarantee 
scheme extended. But, most vital of all, a plan to insure banks' 
toxic debts was unveiled.
With the exception of October's £50bn recapitalisation, every 
Government measure before the toxic insurance scheme was designed to 
replace the billions of pounds of funding tied up in frozen money 
markets. Without funding, all banks would go the way of Northern 
Rock. But the funding crisis was the symptom, not the cause.   [By 
now I've lost track!  How about you? It's gets more complicated yet! -
cs]

Counterparties have been refusing money to the banks because they 
feared lenders did not have sufficient capital to survive a nasty 
recession. And the reason why counterparties lost faith is because 
nobody could predict how big the losses on the banks' sub-prime and 
other problem assets might get.

In a terrible, self re-inforcing cycle, the more counterparties 
withheld funds, the more the economy suffered and the worse the bad 
debts on the banks' books grew. What the Government urgently needed 
was what economists like to call a "circuit breaker".

The Asset Protection Scheme is supposed to be just that. In one 
swoop, it draws a line under the losses the banks could make on their 
toxic debts and recapitalises the banks. In theory, counterparties 
should regain their confidence and the markets should revive.

Royal Bank of Scotland's core tier one ratio - the key measure of 
financial strength - will leap from 7pc to 12.4pc after it insures 
£325bn of assets under the scheme and accepts £13bn of additional 
state capital, as revealed on Thursday. RBS is now cashed up for 
financial Armageddon.

As Alex Potter, banks analyst at Collins Stewart, said in typical 
finance-speak: "Assuming no recurrences of the post-Lehman Brothers 
credit market dislocations, we believe RBS's now-elevated capital 
levels to be sufficient to absorb the glideslope in ratios we see 
across our forecast horizon."

What made the insurance scheme so attractive was how surprisingly 
cheap it was for RBS. Its £325bn of state-insured assets have been 
written down to £302bn, a tiny 7pc discount in a market in which 
credit rating agency Moody's last week said it was predicting an 
annual loss rate on AAA-rated asset backed securities of 60pc. RBS 
will bear the next £19.5bn of losses before the taxpayer steps in. In 
all, a meagre buffer of just 13pc.

In return the taxpayer is getting £6.5bn of special "B" shares that 
don't pay a penny until RBS is profitable, which equates to a fee of 
just 2pc. In effect, the insurance has given RBS £18bn of extra 
capital at a cost of just £6.5bn.
"The whole point of the scheme is to be generous," one senior banker 
close to the deal said, explaining that the goal is to return banks 
to profitability. "First the Government's got to stop the banks from 
drowning, then it's got to hope they can swim again."

Sandy Chen, banks analyst at Panmure Gordon, is sceptical about such 
a philosophy. "You could build enough wind turbines for the whole of 
the UK for £325bn," he says. "Wouldn't it be better to give people 
free power than rescuing RBS?"  [Ouch! Anything is better than 
throwing money away on wind turbines - but we get his point 
nevertheless -cs]  Mr Chen is an advocate of hard love. Britain is 
over-indebted and assets overpriced, he says, and the only remedy is 
a nasty crash. The Government, though, takes a different view.

Having learned his lesson from the history books on America's Great 
Depression, Gordon Brown believes that reinflating the economy with 
credit to keep viable businesses and households going is vital to 
prevent the recession turning into a full-blown depression. It is a 
sentiment echoed by Mervyn King, Governor of the Bank of England, who 
has said that getting "the banking system lending in any normal 
sense... is more important than anything else at present".

As a result, the Government's "circuit breaker" is - in the words of 
the eminent economist Willem Buiter - "even more disadvantageous to 
the taxpayer than I had feared". Mr Chen reckons the scheme "could 
leave the Government liable for losses that easily exceed £20bn... 
they could even get to £100bn".

Another banker close to the deal said RBS "must be assuming they will 
take a bigger loss than the £19.5bn they are pricing otherwise why 
would they do this?" He thinks losses could reach £50bn.

There are conditions tied to the deal. In return for its largesse, 
the Government is demanding that RBS lend £50bn to UK homeowners and 
businesses over the next two years, increasing its £250bn UK loan 
book by 20pc. Add that to the £14bn the Government will lend to 
homeowners through Northern Rock by 2010 and it seems Mr King's words 
are already turning into actions.

Participating banks will also have to reform their bonus payments, 
drawing them into line with the Financial Services Authority's new 
guidelines. The recommendations don't come as a surprise. Banks will 
have to issue smaller bonuses with two-thirds in stock and the cash 
element subject to clawback over a number of years. Profit generation 
will be rewarded, rather than revenue, and basic salaries will be 
higher. But there is no cap and the principle of performance pay is 
as enshrined as ever.

Neither condition is too demanding. Bonus reform is straightforward 
and now widely accepted. The lending demands are also easily 
manageable. RBS has been told this year to lend an extra £9bn on 
mortgages and £16bn to businesses. By comparison, last year it lent 
an extra £7.5bn to households and £1.3bn to business.

Little wonder, then, that Lloyds has been banging down the Treasury's 
door for £250bn of insurance. Even Barclays, which is reluctant to 
have the state on its register - "B" shares or not - is considering 
signing up. In all, the volume of assets insured could come to £700bn 
- half the £1.4 trillion national economic output.

But will the Government's "circuit breaker" work? The early signs are 
good. Lansdowne Partners, the £8bn hedge fund that made £500m from 
Northern Rock's collapse and pocketed £9m by shorting Barclays 
recently, has started buying RBS shares. Banks' credit default swaps 
- insurance for their debt - are falling, which translates as: they 
now look a better bet for survival. Inter-bank lending is getting 
cheaper, which could herald a recovery in the money markets.

But we've been here before. Extending his earlier metaphor, the 
senior banker says: "At the same time as stopping the banks from 
drowning, you can't expect them to start behaving like a bunch of 
synchronised swimmers. It will take a bit of time to see if this works."

Mr Chen is more downbeat. The insured assets amount to just 15pc of 
RBS's enormous £2.2 trillion balance sheet. "I think they're going to 
need to do more than £325bn," he says. For Mr Buiter, RBS "is a dead 
bank... it isn't even a dead bank walking any longer - more a dead 
bank stumbling and fumbling around".

The biggest risk is the pressure this puts on the sovereign credit 
rating. If UK gilts are cut from AAA Britain will have to pay more 
for its national debt, which is already expected to increase by 
£500bn over the next five years to £1 trillion for the first time, 
potentially imperilling the economy.

Standard & Poor's recently ratified the UK's AAA rating on the belief 
that any bank bail out would not saddle the UK with any more than 
£400bn of "contingent liabilities". But, adding the £250bn of credit 
guarantees to the possible £700bn of insured toxic assets, the 
"contingent liabilities" will far surpass S&P's worst case scenario. 
S&P has already cut Spain and Greece's ratings and may have to review 
the UK once more.

The point is that fixing the financial system - getting the banks 
lending - may come at far greater cost. But it is a gamble the 
Government believes is worth taking. Economists say that, if it 
works, banks' renewed ability to lend will help struggling households 
and businesses regain confidence, lifting the economy in time for tax 
revenues to rise sufficiently to pay down the national debt.

And, as asset prices recover, the taxpayer's stakes in the banks 
should start yielding a profit and the insurance losses should 
shrink. It is the best of all worlds.

The alternative is a lurch into the unknown. Economists point out 
that, almost without exception, recessions where economic contraction 
remains below 5pc are over within two or three years. Over 5pc, there 
is no model for what might happen. With no model, global investors 
tend to run scared, perpetuating the problem and potentially plunging 
the country into years of depression.

The Government is desperate to avoid crossing this rubicon. The asset 
protection scheme is its biggest throw of the dice yet.