Today the British Government announced a rescue package for the financial markets amounting to a potential £650bn (that’s $1.1tn in today’s money).
So, this is a story all about how the markets got flipped, turned upside down.
Today the British Government announced a rescue package for the financial markets amounting to a potential £650bn (that’s $1.1tn in today’s money). Now, it’s worth noting—before anybody complains at me—that “only” £50bn of this is being given away; the rest is in loans and guarantees. In a worst-case scenario, though, the British taxpayer would be out of pocket to the tune of over a trillion dollars. I’m pretty sure we don’t actually have a trillion dollars, of course, but we can certainly make £650bn exist if we have to, even if it devalues the sterling to the point where living in Zimbabwe would look like a financially prudent alternative.
The reason for this bail-out is that banks have stopped lending to one another, because they all consider each other to be too much of a risk. Not only have the banks stopped lending to one another, but nobody else will lend to them either. This poses a little bit of a problem.
You see, like most companies, banks talk about profit and loss and so forth in terms we understand. Also like most companies, if a bank takes out a loan, it’s not discounted against the turnover. If you run a business and you have a business development loan for £25,000, of which you’ve paid back £5,000, you’re not running at a loss to the tune of £20,000—the repayment terms govern what you have to pay back and when, and provided your repayments don’t exceed your income less other running costs, you’ve made a nice profit. It’s exactly the same with banks.
People have a sort of mental block with banks, though. They assume that because lots of people put money into them (either directly, or through interest on loans, charges, and so on), they have lots of money to play with and that’s where the funding for overdrafts and mortgages and loans and so on comes from. That’s only partially correct. Very few banks are actually financed wholly by the deposits their customers make, and even if they were, they would still need some kind of safety net so as to be able to deal with defaults on loans. In theory, a bank’s deposits, plus interest on repayments and fees should be able to cover that, but that places strict limitations on the level of credit which a bank could extend and in practice doesn’t happen within UK retail banking (I don’t know if any of the existing mutual building societies operate this way).
In order to finance the loans and mortgages that banks offer, they borrow money through various means: by issuing bonds (essentially IOUs for loan repayments which are then purchased—the purchaser in effect lending the money—and then traded on the markets), and various market instruments which amount to little more than carefully-calculated gambles. This all worked fairly well up until recently; because banks had plenty of assets, the overall risk of default on a loan was pretty low, so nobody was too afraid of handing over money to them. The sub-prime crisis came about because the market instruments being sold (CDOs) were rather complicated repackagings of high-risk mortgage debt and nobody really understood what the actual risk of default was until it was too late. When the worst-case scenario hit, many institutions discovered that they purchased quite a lot of CDOs (because they paid attractive interest rates) and so were staring quite significant write-downs in the face.
Had that been the extent of the problems, we likely wouldn’t have seen more than a blip in the banking sector. The problem is that all of this money-lending relies on confidence: investors need confidence in order to buy up the instruments that the banks are issuing (which, in turn, finances your overdrafts and mortgages and loans), and consumers need confidence that their money isn’t being sunk into a black hole (because cash deposits are the most solid form of asset a retail bank has, they are important in determining their own creditworthiness). If confidence wanes, a bank will find it can’t borrow money—and so can’t lend money—and its asset pool will begin to shrink at an alarming rate as consumers rush to the high street to retrieve their savings.
This is bad when it happens once. This is, indeed, what happened to Northern Rock. Arguably, the solution is straightforward: government guarantees on deposits, rules preventing business upheaval from disrupting the normal functioning of retail operations, and let the financial markets sort themselves out. In this scenario, a failing bank would be reduced to being as good as its assets; if it needed to shed some loans, it could do so by selling them off to other banks (much the same as a company will sell off its debt to a collection agency). Your overdraft would continue as before, under the same terms as before, but would now be administered by HSBC instead of Abbey (for example). Consumer protection laws very likely already contain sufficient provisions for this, though might need some shoring up.
Instead, however, the taxpayer spent in excess of £50bn buying Northern Rock. Then the Government stepped in to guarantee deposits. Around this point, Northern Rock was forced to stop offering many of its loan products anyway, and people moved elsewhere of their own accord. In the grand scheme of things, the difference between this and allowing it to fend for itself is purely a matter of taxpayer outlay.
Recently, though, it looked like it was going to happen again. This time, it wasn’t just one ailing building society—it was all but one of the well-known high-street banks. Investor confidence had crumbled, and the banks were regarded now as such a bad risk that they wouldn’t even lend to each other (more to the point, they needed to hang on to every ounce of capital they had). Given that the Government can’t actually nationalise all but one of the banks (in Soviet Russia, bank buys Government), it did the next worst thing: it bought shares in them. Lots of shares—£50bn worth. Not content with that, it injected £200bn of cash into the markets. Not content with that, it’s setting up a special company (backed by the taxpayer’s funds) to ultimately underwrite up to £250bn of loans.
The argument is that the knock-on effects of the major retail banks hitting the wall would be both significant and catastrophic to the economy as a whole.
I am unconvinced.
Markets bounce. Shares sell when investors don’t think they’re worth hanging onto. When lots of shares sell at the same time, the amount an investor is willing to pay to buy them drops (if they’re worth so much, why would everybody be selling them?). Eventually, we hit the low point, and the price begins to rise again; this is a point reflecting the knife-edge balance between “the market considers them not worth buying” and “the market considers them worth more than that”. If a stock is particularly volatile, you’ll see a lot of fluctuations in price over the course of a day—this is essentially where the market as a whole can’t decide how much it’s worth (or keeps changing its mind).
If a stock crashes, its share price hits rock bottom; or rather, its share price can hit rock bottom. When we’re talking any FTSE 100 stock, it doesn’t matter how much of a risk it is, eventually you’ll hit a point where the price stops dropping. Maybe you wouldn’t buy many HBOS shares at £10 each, but you might buy some at £1 each. Perhaps you’d buy a lot when they hit 0.1p. Someone definitely would, that much is for sure. The price would bounce. It would fluctuate for a while, and probably take quite some time to recover to pre-crash levels, but it wouldn’t cease to exist at any point.
The big problem with the bail-out is that it hasn’t actually prevented this—it’s slowed it down to a snail’s pace, but hasn’t stopped it from happening. Slowing it down is worthy (you can make a lot more deals over the course of a few weeks than you can over the course of a few minutes, after all), but is it really worth a trillion dollars?
Worse than that, though, this is a case of artificially injecting capital: it doesn’t achieve anything that wouldn’t happen on its own if you wait around for a while; the whole purpose of the exercise is to “un-bung” the markets—i.e., to encourage lending. Confidence has a habit of returning when you can see you’re not actually losing out, and investors are the cockiest types you’ll meet.
Worst of all, the financial markets get bailed out, but the taxpayer pays for it. We won’t be getting that money back. Ever.