Friday, November 28, 2008

Bank Nationalisation Day

Old HQ pictured. Following failure of shareholders to buy more than 0.24% (only £36m for 56m shares) of the Royal Bank of Scotland Group's £20bn share issue, RBS (1) (including Citizens Bank, USA, and NatWest Bank, England) today became the third to be formally nationalised (nearly 58%).
The small take-up of the issue by existing shareholders had been expected as the offer price of 65.5p was 10p higher than the price at which the shares were trading, so those who did buy on paper lost £5m doing so. The share issue by RBS was part of the government's plan to recapitalise banks. The government will pay £15bn for the majority stake in the bank plus £5bn of preference shares in the bank. 'Taxpayers' too have an immediate paper loss of £2.4bn based on Thursday's closing share price. This is only nominally so, since the government used off-budget, off-balance sheet funds, i.e. taxpayers' funds have not been directly spent, and over time unlikely to be at risk, while any profits from bank bail-out, funding and capital support can accrue to taxpeyers if taken on-budget or used to reduce national debt.
The bank's Chief Executive Stephen Hester said, "We regret that existing shareholders did not take up their pre-emptive rights but understand that market sentiment toward the banking sector made this uneconomic in the short term." That is the least of it. What is remarkable is that there is not more confidence in a regulated, government backed, major public company whose accounts are as transparent as the best standards demand, and whose market price is far below 'book value'? What has happened to investing in fundamentals for slightly longer than the immediate short term? Hester says,"There remain substantial uncertainties and challenges outside our control but for our part the job is underway." There are always uncertainties, but they should not any longer be called 'substantial' when a bank is covered with guarantees and writedowns and paper losses are far ahead of actual losses yet experienced in the underlying assets.
The 'nationalised' bank now needs its major shareholder's approval for executive pay and dividend settings, and has to agree to return to "normal" lending levels and to exhibit more sensitive customer relations practices (e.g. RBS's statemnent that foreclosures on delinquent mortgages will be postponed for 6 months, and last week when RBS said it is guaranteeing overdraft rates & contracts for business customers for a year at least).
The UK government's shares of banks are held by a company called UK Financial Investments Ltd, which is to maximise value for taxpayers and prevent politicians making business decisions about banks something that the Opposition Conservatives are keen to monitor to ensure this is true. The new RBS HQ (pictured) opened just as RBS-led consortium's deal to buy ABN-AMRO 'successully' closed, a deal paying 71bn euros ($91bn; £61bn) for the Dutch bank, that was the last great deal for a sold bank's shareholders, which lost RBS its creditworthiness, and also contributed to Fortis Bank's collapse after it agreed to buy ABN-AMRO's Benelux banks, while the third partner, Banco Santander, which got ABN-AMRO's Brazilian bank remained strongly priced (thanks to severe risk contols by Spain's Central Bank) and next bought Alliance & Leicester (A&L) cheap, albeit that Santander now too has to make a rights issue and has cold-shouldered its many UK shareholders in an over-hasty process. Mortgage exposure proved to be the made risk to share value for UK banks as panic spread from the USA, however, even though the UK market has been a full 2 years or more behind the USA in mortgage defaults (currently 2% in UK and over 9% in USA), confidence fell mainly because of Northern Rock's bank run - a special calamity for all UK banks. Previously nationalised UK banks are Northern Rock and Bradford & Bingley. As a statement from Lloyds TSB made clear back in early November, Government has stipulated conditions that it refuses to put into writing but only will communicate verbally. These include an obligation of the nationalkise dbanks to pay-off (redeem) the Government's investment as soon a spractical. I took my secretary to the House of Commons Treasury Committee: Nationalised Banks meeting on the 18th to find out how Government is managing its banks? Others to follow into Nationalisation soon include Halifax Bank of Scotland and Lloyds TSB, or possibly the combined Lloyds Bank Group forecast to have 43% Government ownership, even though HBoS directors warn that Nationalisation is a ‘risk’ strenuously to be avoided (even if it means selling HBoS for a fraction of its book value - subject to shareholders voting on 12 th December - turkeys for Christmas - for the takeover by Lloyds TSB that currently looks like offering a premium to the depressed shar price of less than 5%). To avoid this 'calamity' of just over 40% government ownership, which would, of course, restrict the bankers’ bonus pay, though their first anxiety they assure eveyone is to restore dividend payments to the much-abused shareholders that can only be done once the government share is bought back. Hence, why Lloyds is in talks with sovereign wealth funds and UK insurance groups about selling stakes in a future merged Lloyds-HBoS group (to be called Lloyds Banking Group), with a preliminary deal expected by January (subject to the appeal to the Competition Commission Tribunal on 3 December and HboS shareholders voting for takeover on 12 December). Lloyds want cash to redeem £4 bn of the ‘restrictive’ government-owned preference shares in Lloyds and HBOS at the earliest opportunity (as soon as HboS shares are delisted). But, what is there to fear about a commanding Government stake when this would guarantee the solvency of the bank and when major global banks such as Citigroup are finding that Government ownership is highly profitable? Reading from my secretary’s typed notes, from HoC Treasury Committee questioning of NR and B&B banks, what do I find?
1. HM Government (HM Treasury) are in daily contact by telephone with NR and B&B, but do not steer the banks' commercial decisions.
2. They face a potential conundrum, which is that while they have ‘frameworks’ in place whereby they must reduce the size of their balance sheets so as to be in better shape return to private ownership as soon as practical, Government also wants banks to maintain their lending levels, except this latter requirement is not being overtly applied to NR and B&B. 3. B&B has a £40bn mortgage loanbook of which £24bn is buy-to-let (B2L) mortgages (20% of UK total) and £8bn is self-certified mortgages (mainly for the self-employed). Government provides a £14bn guarantee. B&B’s current defaults are 1.8% but 3% among B2L. Moody’s stress tested the loanbook and estimate through-the-cycle loss will be 3% in total or £1.3bn against £1.7bn capital reserve (76% capital wipeout). The Execs did not repeat anything about weakness in the bank’s accounting system that had been originally blamed for failure because the board simply did not know how bad its position was?
4. The HoC Treasury Cmte was anxious to know if bonus culture (where execs get many times the % ratio to salary in bonus compared to all staff) was the cause of excessive book-building such as contracting to buy £6.5bn of buy-to-let mortgages from GMAC (owned by General Motors)? B&B execs explained half of these were UK mortgages and seemed to fit with the bank’s speciality. 90% of all its book came to it via intermediaries anyway (and 2.5% fees were added into the mortgage loans while the GMAC arrears are just over 3% and the long term contract proved embarrassingly inflexible as credit conditions changed). 5. NR was quizzed about bonuses too at 5 times ratio to salary as all staff (which by the way are subject to Government Approval), and about why its mortgage foreclosures seemed so much larger than the industry average. The execs countered that bonuses are linked to progress in redeeming the Government’s equity, while foreclosures only produce 1% of that revenue and its 4,200 stock of homes for sale were gathered over 18 months, not 1 year, hence it is not so draconian as the media speculated. (NR’s deposits business was sold to Abbey- Santander)
6. NR has a ‘Together’ mortgage book for high loan to value borrowers (typically 115% of home purchase price, higher now that house prices have fallen) but these only show a 3.1% default against a general arrears of 1.87% when the industry is 1.33%. Only 10% of arrears result in repossessions and one third of these are voluntary.
7. NR is designing MORTGAGE RESCUE PRODUCTS that will build on payment holidays and interest deductions 9currently negotiated case by case depending on individual circumstances). At the same time NR is writing little new business (and not trying to out-compete the market on price) and encouraging borrowers to re-mortgage elsewhere, except elsewhere doesn’t want to do so for any loan-to-value ratio of more than 80% (at present depressed and falling house prices), hence Government will probably continue to own the bank for about 3 years more.
8. The Committe asked about the cost of Government support. B&B said it was at full commercial rates (measured across a number of funding and guarantee types). NR said it was charged to them at above commercial market rates, something that may be currently reviewes. This is important to the European Commission's enquiry to ensure that Government support does not distort competition unfairly - report not expected until the Spring of next year.
9. A risk consultants report into NR found that risk management was not independent of business operations, risk culture not imbedded, and need for induction training; all matters being fixed by a new Risk Head’s new structure, and new risk policies manual. The Treasury Cmte Chairman ended the meeting with reference to NR’s “shambolic organisation” and he was not being humorous about that. (1) Note: The Royal Bank of Scotland was founded with Government support in 1728 to create a rival to the Bank of Scotland that was suspected of being Jacobite (anti-Hanoverian, supporter of the Stuarts). In 1728, the Royal Bank of Scotland became the first bank in the world to offer an overdraft facility when merchant William Hogg was allowed to take out £1000 unsecured (£65,000 today) more than he had in his account! "I warn you, Sir! The discourtesy of this bank is beyond all limits. One word more and I — I withdraw my overdraft!"
The Committe members were all knowledgeable and asking intelligent questions intelligently, just as banking professionals might do if they have that much common sense about banking. I conclude that oversight by Government seems neither draconian (unless bankers are most anxious about their bonus levels) nor is it a shadow management, but more like an anxious major shareholder that is keen to sell out when the balance sheet is made safe and prospects are stable or positively improving. Why should Lloyds, HboS or Barclays (facing shareholder anger over the bank’s choice of expensive sovereign fund investors instead of Government backing) believe ‘nationalisation’, which NR and B&B execs always describe as ‘temporary’, is such a bad risk to be avoided even at substantially higher cost? Are the objections ideological, or driven by shareholders anxious to restart cash dividends, or by bankers afraid for their bonuses, or are they afraid of Government making them behave more sensitively and empathetically to customers? Or maybe the banks worry too that they might be restrained from making major foreign investments such as buying foreign banks or such as RBS’s recent participation in a gigantic $35bn loan to support Ontario Teachers Pension fund buyout of Telcom Company BCI for 52bn, that looks like failing to proceed at the last minute?!

Thursday, November 27, 2008


Here are some Questions & Answers that spell out what and why Government has to intervene in bailing out the banks and fiscal measures (via the size of the budget deficit) to kick-start economic recovery. Note that in 2009 the US and UK economies are on track for a 2.5% fall in GDP (business profits, earnings and unearned incomes). They are each planning an 8% fiscal boost to their respective economies that should feed through to a +4% growth impulse to the GDP trend by late 2009 or by 2010. Think of what is happening as Government seeking to place itself as a hard rock-solid support under the finance sector (and the economy) so that the banks will confidently pull up business on the one hand and households on the other hand and not let them both fall into the sea to sink or swim by themselves. Q: We are nationalising and/or Government-guaranteing private sector companies (commercial banks), thereby turning them into more versions of Fanny Mae & Freddie Mac with a wider class of assets secured beyond just residential housing mortgages?
A: Yes, but temporarily, and only where there is a greater systemic cost of not doing so. This is akin to Government taking over any failed companies that are responsible for essential services that everyone relies on in their daily lives. In the case of banks there are choices of how to do this:
1. let them merge and net-off obligations between them, effective where 2 or more large banks merge or large banks take over smaller banks (this too may allow for writedowns and capital savings sufficient to ride out losses) except that merger costs are high and banking competition suffers;
2. let well capitalised non-banks buy ailing banks - but not when the buyers are private equity (whose accounts are private and hidden) opportunist asset-strippers merely seeking to profit hugely after banks have been oversold and their share prices far below net assets (book value); it is better therefore for the taxpayers' interest (i.e. the Government's best interest too) to buy banks and gain the profit instead of 'the privateers';
3. let weak banks fail a la Lehman Brothers - but not if the result is a domino effect (systemic) of unfair losses to countless innocent others (costing years to sort out and net-off all the credits and debits from whatever can be salvaged). If a major traditional bank fails then all outstanding loans are called in and deposits & funding have to be repaid causing a massive economic knock-on cost including too possibly massive losses in tax and net cash-flow to Government itself.
Q: Is it not right to hold to the concept of fair valueand that banks' insolvencies should be allowed. the financial service sector is overbanked and banks oversupplied credit (excess money) that led to asset bubbles and far too many people in work, working with illliquid non-marketable assets? A: Don't neglect that Government is also to blame for the bubbles including policy of offloading public housing provision onto banks by getting banks and mortgage brokers to extend mortgages to sub-prime (dirt-poor) borrowers, a quarter of whom defaulted on payments as soon as the economy stumbled. This lending to the poor and even welfare classes had, it may be validly argued, valuable social benefits for many deserving poorer people (even if we all must pay something for that) who now could accumulate tangible assets, but could also borrow more, whetehr responsibly or not?! The credit boom also encourage consumer spending and sucked in imports without which hitherto 'dirt-poor' countries such as China and India would not have grown so well and gained marked improvements to the material welfare of several hundred million people in the past decade. Q: Is that what you mean by 'fair value,' how good the boom was for China?
A: It felt good at home too. No, of course, we mean 'fair value' when pricing assets at something different from the prices they would fetch today sold in the marketplace. When thinking of 'fair value' should it be always where the market is today, always PIT (point-in-time), or TTC (through-the-cycle) values? My answer is that values must be stated as both measured together. This is how home-owners think; if the house is falling in price now, it will however be worth a lot more longer term Therefore, for example, banks are right to switch some holdings from Assets-for-Sale on trading books to Hold-to-Maturity on banking books . Q: What about the falling prices for Asset-Bancked Securities (ABS) that have triggered the whole Credit Crunch?
A: These now illiquid assets are essentially normal bank loans packaged into fixed income bonds supported by interest and repayments revenue from the underlying mortgages and other loans (which for a fee continue to be managed by the loan-finance originating banks). Over a recession up to 15% (very worst case, up to 25%) of loans become 'impaired' (payment defaults) but only half will become terminal defaults and net loss will be about half that. The damage to banks and investors in the interim is that they have to writedown the maximum possible loss as reflected in market prices (even though there is insurance cover and standby loans to mitigate the losses). If banks had kept these loans on their banking books smaller losses would need to be posted against profit. So banks have big paper losses to charge against their capital reserves. And investors who bought the ABS with short-term borrowings and who could not pay margin calls and maintain collateral against loans were forced to sell the bonds at fire-sale prices thereby dragging down the market prices below the bonds' cash-flow value. Insurance companies creditworthiness also fell execessively long before compensation claims for credit losses. So Government had to step in to buy more time for everyone and is able to do so at an economic profit for taxpayers and he whole economy, profitable compared to the cost of further economic collapse. Q: You mean bailing out the finance sector and insuring it against losses?
A: Banks and insurers are not being bailed out of all their losses (which will include many legals suits too), not at all; banks and insurers are still getting 1x capital wipeouts and Government is merely saving them from 2x capital wipeouts.
Q: is it not better for the loss-making assets to be liquidated over time and let prices will fall to "real values," to market-clearing prices. Deferring this is just that a deferral, not a realisation of value. So your solution of installing a price floor under these assets is simply a tax burden on the future and unsustainable? A: ABS asset prices should rise to find their "real values" not fall further, not now, and not when measured logically in net cash-flow terms especially against a lower central bank rate and a slowly falling LIBOR rate. And, yes, it is a deferral, but a deferral only until a firm footing is achieved on rising ground.- Ultimately, all others (not just the banks alone) will, one way or another, pay for losses as they filter through all components of the 'real' or 'underlying' economy in recession, making recession deeper and longer. This, Government wants to mitigate. To let major banks fail also lets the whole economy fail, a system-wide failure with multiplier effects that will greatly amplify the original losses! Trust & confidence are critical to how any economy operates. We live in a circular money-flow 3-D world of innumerable financial 'roundabouts', not just 'swings' or 'see-saws'. There is 4-7 times as much value to be found in banks' books and balance sheets than appears to be the case among those many large banks whose share prices have falled 0-90%! Government is intervening on a basis of helping banks but also helping itself (aka taxpayers) to gain the benefit of much of this yet to be fully realised value. Q: What about the future tax burden to pay for all this?
A: You must ask whether 'the burden' will be lower or higher if Government does not run a higher budget deficit so as to spend more, and how it spends it when all others are too fearful to keeping spending and investing, across the whole economy, including to stand surety for more of banks' troubled assets? Government Deficit Spending is not extra-terrestrial, as some critics appear to believe. It is cheaper than private spending and generates benefits throughout the economy including short term return flows into Treasury coffers. Therefore there is not a 1 for 1 ratio between future tax burden and the rise in Government debt. Q: Is this just putting a floor under the economy or actually growing it?
A: Government intervention (both US and UK budget deficits for 2009 expected to be 8% in ratio to GDP) will support the economy by putting a floor under how far GDP (incomes) fall and pay for this by generating more tax revenue across whole economy than the gross cost of the fiscal deficit. Many taxpayers worry about Government debt because it is a debt accepted on everyone's (taxpayers') behalf. But, we should not lose sight of the context. Household, corporate and bank debt have all grown far faster than Government's National Debt such that the former are 3x, 3x and 6x Gross National Debt (GND). But actual 'net' US GND is only half of gross GND and UK net GND is only 75% of gross GND, the balance in each case being merely debt internal to Government. So the real ratios of private to government debt are even higher than 3,3 and 6. Of course, each of these sector debts have counter-balancing assets, but also much bank, corporate and household debt is unsecured (insofar as only secured by income not by tangible property or financial assets). In general, all assets that can be sold (marketable) are currently depreciating, and corporate profits are falling rapidly, and personal incomes are under threat or falling, if more slowly. Government is seeking to defend incomes (earned and unearned) by placing assets in quarantine, at least to the extent of building a floor under the falling prices.
Q: What about inflation or is it deflation and the money supply? A: Money supply was rising fast but now is rising too slowly. If inflation rises, carrying corporate and personal incomes up, this would devalue the cost of repaying of debts (though at a cost to cash savings), but we now face a deflation threat doing the opposite! Hence, Government is also seeking to put a floor under inflation. All assets and incomes are in real world measured in current cash not real inflation-adjusted. Therefore, Government wants to keep cash-flows inflation-wise moderately up (2.5% target) to make it easier for debts to get repaid or when unsecured to default less.. Q: Where you have excess banking capacity shouldn't banks be allowed to fail? It may be sad but true, that slow liquidation of 'troubled assets' and deleveraging (banks cutting their lending) is crippling to the economy and maybe to the finance sector also, which is thereby slowing up or dragging down any recovery!?
A: Banking capacity is falling with all banks facing a general 30% fall. Government wants to make sure that falling capacity does not hit household and small business lending. The capacity fall is mainly in investment, not retail, banking, but coincides with a 2-3 years 30% fall in all property and real estate (the biggest collateral class). When asset bubbles expanded the balance between wealth gains from assets values (unearned income) compared to gains from earned incomes became very unbalanced, too skewed in favour of financial & real estate asset gains. Now, arguably, there is a better balance, except the adjustment process is painful insofar as it is now feeding into lower earnings and higher unemployment. Governments are trying to maintain everyones earnings (& employment) until a new balance between unearned and earned incomes is stable.
Q: Why are banks so important to Government, compared say to the automotive industry of retail and transport services?
A: Banks are the closest to Government in how they are positioned across the whole economy. Banks less so, but like Government, have a stake in whole economy. Who banks lend to is decided, however, more by who asks to borrow from them. In recent years that demand has come overwhelmingly from real estate, from mortgage borrowers, property developers and construction companies. Property-related lending has been twice that of all lending to all other industrry sectors. Property is a big economic sector, but banks are over-exposed to it. This may not be entirely banks' fault insofar as they respond to what the economy demands. They did try to grab market share in the rising demand and thereby forced the demand up higher. No-one in authority challenged the banks for growing their assets at a speed that far outpaced the economy and for generating twice the profit rate of the rest of the economy! Governments could do the same, but have a political constituency to care about. Banks differ from Government by being commercial corporations with a more self-centred 2-dimensional view of profit/loss. When recession hits banks' p/l, they respond pro-cyclically, usually with a 2 quarter lag. Government also responds late except for 'automatic stabilisers' (spending on transfers e.g. social welfare, and services such as education and health, which are maintained or grow in recession). But, only Government feels obliged (politically) to act counter-cyclically (by fiscal & monetary means). Banks do not feel so obliged, except that if they call in too many loans they may trigger a domino effect of customer insolvencies. Therefore, when recession strikes, it is Government alone that truly manages its response to the problems of the economy. Ideally, Government would like to partner with banks in this role. But, if banks can't or won't agree to act counter-cyclically alongside Government, then nationalisation (by command or by ownership) may be necessary. The choice can be either that or Government simply has to break with normal standards of financial prudence to a degree that may cause a political panic among taxpayers. An important difference between banks and Government is the triple-A creditworthiness of Government. Its debt is safest and it can borrow most cheaply. This is important in allowing Government the luxury of balancing its financial risks in the much longer term than any other sector, whether banks or the auto industry. Government is not subject to the volatility of stock market prices or the same solvency risks, at least not the OECD Governments! More on Bail-out solutions see: and
On UK budget and recession?
UK Government meeting with banks to browbeat them into maintaining lending levels:
What US banks have lost and impacts on capital
On Obamanomics & Obama's team and policy on the US election result and then on the new team and

Wednesday, November 26, 2008

After TARP & SARP, now TALF & MALF

An $800bn email from Seeking Alpha editor, R Granby (pictured below): US government unveiled its newest initiative, called TALF, or Term Asset-Backed Securities Loan Facility. The $200bn facility will support consumer finance, including student, auto and credit card loans and loans backed by the Small Business Administration, by lending to investors who hold securities backed by that debt. The facility could eventually be expanded to cover other assets, including mortgage-backed securities. The Treasury will help cover potential Federal Reserve losses by providing $20bn of credit protection from TARP funds. This is the first time the Fed and Treasury have stepped in to finance consumer debt, and the program comes close to creating a government bank. Federal officials defended the move, pointing out that the market for securities backed by consumer debt 'came to a halt' in October, making it almost impossible for millions of Americans to secure affordable financing for everything from college to computers. Along with TALF, the government also introduced a new mortgage program [I shall call MALF - RM] whereby the Federal Reserve will buy up to $100bn of debt issued by GSEs Fannie Mae (FNM), Freddie Mac (FRE) and the Federal Home Loan Banks. According to the statement released by the Fed, "this action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved financial conditions more generally." The announcement of the new programs immediately pushed down rates on 30-year mortgages by as much as 50bp, though it's not clear whether the rates will stay down in the long-term. The initiative also includes up to $500bn in purchases of mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae.

How times can change!

Our son received a phone call this morning from the Royal Bank of Scotland to advise him that a direct debit is about to come off his account that will cost him a £38 penalty charge unless he deposits £40 into the account by 2pm! We are all in a state of shock, never imagining that a big bank would ever show such customer care - surely a wonderful sign of how times have changed?


Yesterday's FT editorial credits 3 Profs with pre-figuring the Citi bailout deal (who I've joined with having quanitified US bank capital, losses & recoveries). They are Perry Mehrling, Laurence Kotlikoff and Alistair Milne. For how the plan was pre-figured here see older posts in Novemnber such as halfway down "Moneygall-Yes, we can" and yet earlier posts in October and September. Full text of the FT editorial follows below. I'm very interested in your contributory thoughts too. Talk of the Citi -Nov.25 2008
Another weekend, another bank rescue. On Sunday night, the US Treasury moved to shore up Citigroup. There was no choice - the banking giant could not be allowed to keep stumbling. The rescue seems to have been generous to Citi-group, but the insurance scheme it uses is a model that deserves wider consideration.Shaken by the announcement by Hank Paulson, the US Treasury secretary, that the troubled asset relief programme would not buy distressed mortgage assets, investors gave Citigroup a wide berth. Last week, its share price fell by more than 60 per cent. A loss of confidence in a vast bank with retail and investment banking businesses is dangerous; Citigroup is systemically important several times over. The US Treasury acted in similar fashion to the Swiss government's rescue of UBS. It injected $20bn of capital from the Tarp into the bank - on top of an earlier $25bn - and insured a tranche of its assets. The terms of the Citigroup rescue seem lenient but the insurance scheme is a good innovation. The government is guaranteeing the bank against losses greater than $29bn on a $306bn portfolio, mostly of distressed mortgage-related assets. The bank paid a fee for this guarantee in preference shares. Insurance on the value of illiquid securities has been proposed on the Economists' Forum on by Professors Perry Mehrling, Laurence Kotlikoff and Alistair Milne. It has several desirable attributes. Underwriting insurance on the value of toxic assets would solve the problems they cause by putting a floor under their value. This would create enormous contingent liabilities that some governments would not be able to bear. The US Tarp would not be able to fund both recapitalisation and insurance. But an insurance model would be cheaper and easier than trying to buy enough of these securities to allow price discovery. Governments would only need to make good falls in values of insured assets below the agreed limit.There are, however, practical obstacles. A credible scheme would need measures to prevent banks from holding back on writedowns until they had insurance. overnments would also need to find ways to prevent the banks that use the insurance from engaging in yetriskier behaviour. The authorities would find it near-impossible to write a tariff for insuring the price of an unpriceable security.There are no easy answers to this crisis. But governments should consider whether they ought to become the insurer of last resort.
For more see "More to Citi's SARP..." and "Bank SARP/TARP" 2 & 3 items preceding this one below.For sceptics I spell out here what the basic are:
What this is (Government standing surety for some of banks' assets) is a win-win-win situation (perhaps Keynesian?) where banks, borrowers, and treasury (Government & taxpayers) all make gains (economic benefits & multipliers all round); win-win does happen sometimes. The basics are:
1. Banks losses as writedowns are notional until they can see who defaults completely (usually 45% of the 10-20% of all borrowers in a recession who default - payments 90+days late) and until they see how much debt can be recovered (usually 55%), which can take 1-3years;
2. Short term views of banks' assets (fear of worst case losses) and of negative P/L when 'possible notional' losses (100% or a large proportion of that, of all defaults) are booked as writedowns and loan-loss provisions and drive down short term share prices and freeze the lending between banks, which has also become fearful (credit crunch) and credit insurers are similarly subject to insolvency fears;
3. Government steps in and goes surety for losses but only above say the first 15%. This put a floor under asset values, saves banks more on capital reserve than they pay Government in a risk premium (stock warrants) for the surety. Banks still get a large loss hit. And Government buys pref shares to add capital to banks' capital reserves in return for % ownership of bank in return for fixed return e.g. 8% (very profitable for Government when share bank prices are on the floor);
4. Banks have capital reserves part restored plus lower risk weighted assets and can survive first 100% hit on reserve capital. As second 100% hit on reserve capital arrives (from corporate and credit card loans etc.) the banks have had time to make some debt recoveries, drop costs, sell assets, sell busines units etc. and the nominal losses of the first 100% capital reserve loss is netting out at only 55%. Then when the second 100% loss also nets out at 55% and underlying profits from other business and asset sales revenue are gained they can repay Government plus the Government's profit margin;
5. Government also uses legislation and pressure to force banks to go easy on defaulters and maintain lending levels and to help the Government (that is also implementing a fiscal boost to kick-start the floundering economy) by maintaining or growing but not cutting back on bank lending so that recovery arrives faster and unemployment rise is capped and then reversed;
6. This takes maybe 3 years by which time tax revenues are rising again and the economy is back in 2%+ growth of income (wages and profits) and confidence is restored and the capitalist life is back to near normal.


Government borrowing and deficit spending are not just more train wrecks. UK Budget debates are a wonder to economists. Those of us who look empirically and dispassionately are regularly stunned by the trotting out of catchpenny urban myths such as 'tax & spend' and the recalcitrant notion that Government borrowing is inevitably a 'burden' on future taxpayers. Looking carefully at the history of UK GDP and budget settings will not find one clear example of 'tax & spend'. All years except one (1969, and not particularly errant) since the 1950s, in terms of UK budget deficit size in ratio to GDP, fit even within the overly conservative Maastricht criteria! Before back then, we had exceptional years of WWII and the immediate post-war economy of dollar-shortages until the Marshall Plan and IMF.
This week the myth-making reached new heights (see also "You can't spend your way out of a recession, or can you?" in November -click older posts at bottom of page) with Conservative Shadow Chancellor George Osborne's breathless bombast, "the greatest public policy failure in a generation", "time-old truth that in the end all Labour chancellors run out of money" and "tax giveaways paid for by a lifetime of tax rises" (FT, 25 Nov. pages 1 & 5). The budget deficit is par with Conservative deficit-spending in the 1990s. It may be fair to accuse Labour's Chancellor Darling of 'tax & spend' only because this is what Labour unfairly accused Conservative Chancellor Clarke of, in the 1997 election when the Conservatives failed to answer back with cries of "what would you have done" that Labour back-benchers fling at Osborne. Underpinning these myths is The Treasury's failure to fully explain Exchequor Revenue since 1979 when HM Treasury economists were ordered never again to explain to Cabinet the difference between the gross and net Exchequer costs of public spending. The Treasury pie chart (FT, 25 Nov. page 3) shows £29.8bn of the £104bn 'clawback' as 'Fiscal drag" when this is really merely the fact that 28% of Government revenue is taxation on its own spending and returns to (much of it never actually leaving) the Exchequer in the same year it is spent. More returns in the following two years such that the net tax and economic cost of Health, Education, Police and Defence and some other spending falls to close to zero. Thus, it is silly to claim that there is always a long term cost to taxpayers from Government borrowing. A third of the National Debt is anyway internal to Government. Notwithstanding this aspect, at 40-50% gross ratio to GDP, Government Debt is only a third of household debt, a third of corporate debt, and a sixth of finance sector debt, which have all grown much faster than Government debt. Which of these are the truer costs to future taxpayers? Certainly, Government debt must be the least of these burdens! There is much anguishing this week in the UK newspapers and media about the Government deficit. But, note the symmetry between the UK and US. The British government this week unveiled a stimulus plan that will boost the 2009 budget deficit to £118bn ($181bn), the equivalent of 8.0% of gross domestic product (GDP). U.S. President-elect Barack Obama’s stimulus plan will raise the 2009 U.S. Federal deficit to $1.2tn or also 8.0%of U.S. GDP. If the UK is wrong, so too is the USA, but it strikes me that they are both doing the right thing on at least the right scale.

Tuesday, November 25, 2008

More to Citi's SARP deal than meets the eye

Citigroup's debt issuance has been phenomenal but is also typical. It's SARP/TARP bail-out is supremely important as the benchmark model for all other Government support for banks in trouble who can now go into the same Citi booth. Citigroup's own statement on the matter says the $306bn of assets involved now carry a 20% risk weight. This means that the $27bn deal has boosted the effective collateral for those assets to $244.8bn. Citigroup's capital reserve is now 14.8%. But, the minimum reserve ratio under Basel rules is 8% minimum. Citigroup's normal aggregate risk weight for assets is 52.5% (4.2% reserve capital ratio to gross assets). Hence, if the deal applied to average collateralised assets, $8bn of capital would be freed up. But, in this case $16bn is freed up. Therefore, the collateral value attaching to the $306bn assets pre-deal was only $44.8bn i.e. the deal is worth $200bn surety or collateral equivalent to Citicorp. This means that $27bn invested profitably in Citigroup by the Government has generated 7.4 times that in benefit to the bank. The bank sees a total capital reserve benefit of $40bn , but actually it is worth 5 times that, plus, if in normal business conditions, this would mean the bank could grow its assets by up to $952bn more than it could otherwise, which is a very substantial boost worth two thirds of its total current assets! This amount is worth the total losses of all banks currently insured by the FDIC, between one third and one half of all expected US bank losses! This shows just how effective judicious investment by Government can be - something those ideologues who hand-wring about Government fiscal interventionism should take note of! There should too be no doubt that this is mightily profitable to taxpayers. For example, as an additional sweetener, Citi will issue warrants to the U.S. Treasury and the FDIC for about 254 million shares of the company's common stock at a strike price of $10.61 = $2.6bn i.e. a 10% bonus to Government. There are conditions attached. One is that the medium term beneits to Citigroup are not immediately enjoyed by ordinary shareholders, who for 3 years are limited to 1cent dividend when pref stock holders get 5% & 8%. Another condition calls on Citigroup to help distressed homeowners by modifying mortgage payment contracts to avoid foreclosures. This follows the FDIC plan effected at IndyMac Bank, a major failed S&L (Pasadena, CA) whereby borrowers pay interest rates of 3% only for 5 years or whatever does not exceed 38% of their pretax incomes. This will prevent foreclosures and borrowers in negative equity walking away, and pleases Congress across the aisle. Citi has to factor this in to its P/L. But, this also puts some kind of floor under sub-prime and defaulting prime risks. Yet, arguably, it was just such deals by FM&FM that dangerously hid the signals of actual defaults pre-2008 and artificially buoyed up confidence that it was ok to continue the ballooning mortgage sales at dangerously high loan to value ratios, but then who cares about such nuances when the crisis is now fully upon us? This Indymac scheme is being applied on a larger scale now by FM&FM and has a positive knock-on benefit to AIG's (also Government-owned) exposures too. FDIC Chairman Sheila Bair has been pressing Treasury to use $24bn from the $700bn TARP program to apply mortgage contract modifications nation-wide, but Paulson is opposed this. We may expect this will no longer be opposed? Note that opposing views in the USA are being generated by M&A investment bankers and lawyers would prefer a general solution based on bank mergers arguing that these would provide mutual writedowns and free up reserve capital and with tax rebates & liabilities plus smaller Government capital infusions be enough to pay for nearly $1 trillion in losses i.e. those expected of FDIC insured banks. I think this is wishful thinking on the part of those who are trying to stop the momentum of Government nationalisations, however temporary, and further Government Keynesian interventions to put a backstop on Recession's domino collapse. All this going on in the US seems however, much more intelligent and sophisticated than UK media views following Chancellor Darling's statement worth variously an interim £20-40bn GDP boost. Most newspaper comment is mired in ideological argument mainly pushed by the Conservative Party that opposed Government fiscal intervention by creating a spectre to be feared of the future tax burden, arguing that merely a monetarist response would suffice and that the National Debt and budget deficits are unprecedented or socialistic Tax & Spend, when in fact they are no more than on a par with the last Conservative Government's fiscal stance. In a vain attempt to dislodge Chancellor Darling off his plinth as Recession-battler, the Shadow Chancellor, Osborne, is being outrageously economical with the facts. When UK finance sector liabilities are 4xGDP, Corporate debt 1.5xGDP and Households 1.3xGDP while Gov Debt is only 0.4xGDP - why should anyone think the latter is more a fearful burden to taxpayers than the former added together (over 6xGDP). All have large offsetting assets and none more so than Government. A third of the National Debt is internal to Government and what's not counted is often profitably invested and netted off. Note, by the way, that the EU is in policy catch up. Its thinking is roughly worth currently a 1% GDP boost when I suspect 2.5% is nearer what's required, and what the US and UK are both aiming at. Both UK and EU authorities may wishto consider what FDIC is enabling next.
In an email from JP Morgan I learn of the importance of the FDIC's new liquidity guarantee program - the FDIC back in Oct introduced a new facility that would guarantee the debt of financials (banks, thrifts, etc) but it wasn’t until last Friday that the final rules of the program were released. As a result, financial firms will start to come to market w/FDIC-backed issues. According to the WSJ, Goldman will be the first financial to issue under the FDIC program (~$2-3bn) and press sources say demand has been strong (we should see it price sometime today). "In effect Goldman is issuing synthetic Treasury bonds, at a much higher yield than straight Treasury bonds". Financial institutions may use the program to issue $250 billion to $350 billion of debt. That could help financial institutions make a dent in the $233 billion of debt they have to repay or refinance over the next five quarters.
At the Barclays shareholder meeting, concerning how fear was causing liquidity to evaporate for financials, Marcus Agius, the chairman, said the stock market was so nervous about investing in banks in October that “a dangerous leak that we were having trouble raising money could have been terminal” and prompted any and all liquidity to rush away from the company. Central bank guarantees like the FDIC guarantee should take such risk off the table for financials to a large degree. That’s not to say financials are above water - just that the FDIC plan helps on the liabilities side of a bank's balance sheet, but many still have problems on the asset side (Citi's problem, having offloaded assets into the Fed facility).

Monday, November 24, 2008


The Citigroup share price, like other banks whose prices have fallen 90% is in a crisis of confidence, which reflects the losses that have to be accounted for in the profit/loss but may not reflect a relative and fundamental value of the bank. Essentially what is happening to US banks (and banks in the UK and Eurozone) is that the credit crunch is nominally wiping out 1xBCR (Banks’ Capital Reserves, which in the USA is $1.1 trillion) and the recession is wiping out another 1xBCR. A ‘normal’ recession wipes out 90% of banks’ capital before recoveries, which are worth half of writedown losses. The Government is supplying replacement for 1xBCR (for a % share of the bank + preferred dividend + fee + insurance premium + asset discount). Banks have to recover the other 1xBCR themselves from recoveries, reserves, asset disposals, business unit sales, and cost-cutting). The recoveries over 1-3 years should be sufficient to redeem the capital infusions from Government and the taxpayers should via the Treasury make a medium term profit. The banks are also major holders of treasuries and government bonds not just of the US but of many others countries. Fears about corporate bond defaults are also added to by forced redemptions of government bonds should major banks collapse, but this should be only a temporary embarassment for most governments. Hopefully cognizent of the strategy of helping banks to ensure they help the Government's efforts to reflate the economy, President-elect Barack Obama will introduce on Monday his National Economic Council Director, Lawrence Summers)pictured below), and his Treasury Secretary nominee (subject to Senate Approval) Timothy Geithner (pictured above - see also two men from the same supposed wing of the Democratic Party (if it has wings?) who have worked together before under President Clinton, but with new roles in the Obama administration. Geithner has a double role for the next 2 months as President of the NY Fed and as Treasury Secretary nominee. With, and across-the-table, Geithner was much involved with Robert Rubin in this weekend's bail-out of Citigroup. Rubin is the main eminence in the wings of the new 'Obamanomics team'. The Obama team appears to reflect Rubin's choices. The team projects weight more than ideology, which makes a change from its predecessors (according to James Galbraith, economist at Univ. of Texas in touch with President-elect Obama's economics advisory team). In the opening months of President Obama's administration, Geithner and Summers will be shepherding through Congress some of the most dramatic fiscal policies since The Great Depression (of the 1930s, or The Second Great Depression if the first was the 1880s), and observers caution that President-elect Obama cannot afford politically to look as if he is exploiting the crisis for an ideological agenda, which he won't be. Larry Summers was UK readers may wish to note a major influence (before, during and after his time as US Treasury Secretary) on UK Government Treasury policy since 1997 (when his student Ed Balls was Gordon Brown's principal adviser). A third key appointment is Peter Orszag (pictured below) as President Obama's budget director, who is already Congressional Budget Office Director (the CBO is obsessed with health and pension costs as future unsustainable burdens on the budget, when actually mostly self-financing). He has to calculate the economic reflation packages and their budgetary impacts, including a likely 2009 deficit of $1tn and what the taxation and revenue implications are. For more on the Obama team see comment #1. The political debate in the UK has turned on a £100bn deficit and its tax implications (presented in preview today) that are much exaggerated by CBI and Conservative Party simplifications that assume all higher borrowing translates into higher future taxes. Given that there are tax implications of doing nothing and given that reflation spending generates more tax revenue to pay for it, not necessarily higher tax rates, just as higher rates will also not necessarily generate higher taxation revenue, and given the multiplier effects of a weak banking sector unable to expand lending then it is profitable for both Government and taxpayers that Government should borrow and spend whatever is required to restore positive growth. This should be Alistair Darling's message today. To understand what these decision-makers have to do with banks, take the case of this weekend’s bail-out of Citigroup. Robert Rubin who is a major influence on the Obama team, having served as the 70th United States Secretary of the Treasury during both the first and second Clinton administrations, is also Director and Senior Counselor of Citigroup (and from Nov=Dec. '07 served temporarily as Chairman of Citigroup). He washeavily involved (from all sides) in the agreement for the US government’s $27bn capital infusion into Citigroup. I'm sure he deserves to become its next Chairman(see comment #2) and could not have been more important and better placed at this critical time for Citigroup. The deal (a $20bn SARP preferred stock purchase paying 8% + $7bn payment for preferred stock already pledged to the Federal Reserve) is attached to a TARP agreement that provides a loss floor aka ‘a surety guarantee’ covering $306bn of assets (many of which are not impaired or defaulted). Citicorp was the world’s biggest bank ($270bn share value 2 years ago) and is now the USA’s no.2 i.e. “way too big to fail”. The deal is not unlike a super-securitization issue (off balance sheet ‘bad bank’ like an SPE/ SIV with a massive CDS or standby ABCP); Citi absorbs the first $29bn (9.5%) in writedown loss (from residential and commercial mortgages and real estate, including RMBS and CMBS, also leveraged loans, CDOs and auction rate securities, but excluding credit card assets). Federal government entities stand surety for losses from the remaining 89.5% ($249bn if there are any further defaults in these assets. Treasury is on the hook for the next $5bn, FDIC for the next $10bn, and the Fed everything after that. Prof. Mehrling of Columbia pointed out to me that if the Treasury, instead of the Federal Reserve, had insured the entire $306bn, it would have had to charge $306bn against remaining TARP funds. As it is, Treasury only has to charge $5bn, and gets $4 billion in premium payments for that. The FDIC gets $3bn for its coverage of the next $10bn. The Fed’s involvement comes from its commitment to fund the remaining pool of assets with a non-recourse loan subject to the 90/10 risk sharing co-pay arrangement.
The news sent Citi’s ordinary shares up 55% in Germany before US market open after they lost over 60% last week. Analysts (including myself) estimate Citigroup, like many big banks such as HboS or RBS whose shares have fallen 90% in a year, is really worth six times its present share price just to get back to something close to book value or reserve capital! Citigroup has 200 million customer acvcounts across 106 countries! In addition to the $27bn preferred stock capital infusion, the reconstruction of Citi’s balance sheet that this deal makes possible frees up $13bn, so the total additional buffer is $40bn and adds 50% to reserve capital (on top of a $25bn loan loss reserve). This follows $25bn and over £3bn in Citi’s preferred stock and warrants invested in by Government in October. At the end of 3Q’08 Citi had a strong Tier 1 ratio of 8.2% plus the loan loss reserve. Tier 1 is now a whopping 14.7%!. The bank's capital will be further strengthened by the sale of its German retail banking operation and assets finalizing in the fourth quarter. With revenues running at over $70bn annually ($14bn costs) less $13bn in writedowns and provisions plus $2bn cost savings and over $300bn lower year on year assets to about $1.6tn now or about 5% of all US banking assets (non-gov. loans). At Friday’s share price, the bank’s ordinary share capitalisation stood at $20.5bn (implying even after share price leaps up today by over half that Government will still own a majority of the bank!) Following the agreement Citi will cut its dividend to 1c. per share and restrict executive compensation. The bank with $80 rising to 120bn capital reserve should now withstand the current market downturn. Responding to a criticism that Citi was getting special treatment the Government insisted the arrangement is deliberately “plain vanilla” so it can be applied to other banks that pose risk to financial system stability. The 9.5% first loss equates to the current default rate on mortgage asset and securities. This I expect could rise over the next year to a maximum of 20% whereby the impairment loss = $60bn, but should be only $30bn after recoveries i.e. fully absorbing the bank’s $29bn but not a loss to the Government. Citicorp’s credit card losses could mount up to $10bn leaving it with $81bn capital just sufficient to support $1.9tn assets ($350bn more than currently). Further losses from corporate bonds and loans etc. should be manageable during next year. For the moment the bank has excess capital that may be employed, according to some officials and commentators, buying securities in the secondary market that has been frozen up since the Treasury’s announcement that it would not buy distressed mortgage securities through TARP. Further significant losses from Citigroup's $43bn mortgage book (Sept '07) is unlikely after so many writedowns already from all related exposures, totallying $65bn. My friend Prof. Mehrling tells me this deal for Citicorp is akin to a co=pay insurance deal, and that the agreement permits Citigroup to use the $306 billion of assets as collateral in borrowing from the Fed at the overnight index swap (OIS) rate plus 300 bp, the rate currently being charged for asset-backed commercial paper at the Fed’s Commercial Paper Funding Facility. This ensures the full liquidity of these assets. Citigroup could possibly afford to buy toxic assets at the right price and thereby provide private (nationalised) sector support for TARP. Actually, in some respects buying assets, but as a mix of good and bad, is what Government is now doing only doing so indirectly. In that respect TARP lives, but only as an aspect of SARP (the recapitalisation strategy credited to Brown & Darling, though also modeled on the Sfr60bn Swiss National Bank ‘bad bank’ deal with UBS). Given the losses yet to be booked it seems unlikely to me that recapitalised banks will begin to use such “excess capital” to buy troubled assets in size in the secondary market along the lines envisaged by TARP – even at levels that many believe are artificially depressed – to create a floor for prices, that in turn could break the logjam and kick-start lending in the interbank credit market, the primary bank bond issuence market and trading in the always illiquid secondary market for securitized assets. This seems to me a hope expressed only for political reasons. Much more likely is that hedge funds, when they have repackaged themselves following a drop in fund under management from $2-3tn to 1.7-2.7tn (depending on how estimated) will be the only vulture fund buyers of impaired assets and at something well below 55% of face value.

Friday, November 21, 2008

Banks not 'on message'; they just don't get it

Bankers are showing immense difficulty in living in the present; their heads are in the past imagining all that is troubling the footnotes and bottom lines of their balance sheets and capital reserves is merely temporary before returning ASAP to business as usual? The impossibility and undesirability of that dream they just don't get. Banks failed even before the crisis to understand the implications of the extent that a vast majority of their customers mistrusted and disliked them. That seemed to matter less when share values were riding high and profitability was double that of the rest of their stock markets. This year, all that has changed by a full 180 degrees, and now what customers and clients and shareholders think and feel should matter a whole lot, and not least what Government thinks whose politicians have no choice but to be sensitive to public opinion. Customers and politicians are angry with the banks. Shareholders are apoplectic. Banks have resisted firm guidance from their bail out masters, the Governments, to be supportive of small businesses and households through the recession. They also resist being part-nationalised (witness the extreme embarassment of Barclays Bank, which may yet turn into a resignation matter for the Chairman and CEO) and yet appear to be indifferent to the counterpart of that, private shareholders and shareholder value (the now discredited mantra of private enterprise). HBoS management (like Wachovia and Bear Stearns earlier but before recapitalisation bail-outs) have agreed to sell the bank to Lloyds TSB which is half the size of HBoS for a sum that values the bank at less than a quarter of the minimum it should be. The suspicion in all this is that when push comes to crunch, banks' managements look after no.1 and all the feel-good mission statements about serving shareholders, putting customers first, and the family values of staff loyalty and mutuality were just eyewash rhetoric. When can trust in whatever new mission statements emerge be ever restored?
At the core of much of the anger are bonuses, which seem to be the very last thing managers will forego. Banks, to improve their earnings power and share price could and should cut bonuses at least in half, historically half of net revenues. By reducing compensation from 45 to 35% of investment banking net revenues would alone boost earnings per share by about 40% (equating to a bonus pool of half that for 2007, a record year). The outgoing bosses of RBoS, for example, have apologised to investors for poor performance in shareholder return, but like many other banks, they should be apologising for having said and disclosed far to little when their stocks were falling, for failing to evidence the basic soundness of their balance sheets, and for not reassuring investors with forecasts of recession impacts. There are other serious outstanding matters that banks have yet to apologise for. But, it seems that they will wait until the markets have fully floored themselves on recession fears across the whole of the piste.
Yesterday was a historic day for the market. The Standard & Poor's 500 Index plunged by 6.7% to 752.44. The bear market low of October 2002 was 768.63 — and the index squitted through it like a hot dose of salts. Stated another way, every last £ or $ or € of profit an investor earned — even buying at the absolute low 6 years ago has been wiped like just so much bog-roll. If you bought the S&P just over a year ago, you've lost more than HALF. Furthermore, one third of S&P500 stocks no longer qualify to be in the index! The DOW bounced off my 7500 forecast and the S&P can sink yet lower. Banking shares were among the chief casualties yesterday (November 20th - Wall Street's worst day for over a decade) on the back of rising unemployment figures and a stalled bailout of the US auto industry (where many question why 1% of Government support for Banks cannot go to Automotive?)
Citigroup was hardest hit, its stock falling by 26% in a day and 50% in a couple of weeks). Citi now has a market value of around $25bn or a tenth of two years ago. Relative to book value even if heavily discounted, many banks are obviously over-sold that one can only conclude there is no confidence in bank managements and immense suspicion of the balance sheets. And yet, no-one can point to whatever it is that must be hidden in the balance sheets to justify present share values? What does all this do for the idea of stock markets as information markets? Relatively strong banks saw their shares falling and had little to say; JP Morgan Chase down by 18%, Bank of America down 14%, HSBC only down 1.5% but after hefty loss in the previous session. US unemployment figures are an obvious anxiety factor.
DJIA at 7552.29, S&P 500 at 752.44 - lowest closes for 11 years. Life insurers also fell; Aviva down 16.7%, Prudential -16.3%, Legal & General -13.5% and a bunch of weak U.S. insurers. RBoS jumped 8.8% as investors met to vote on its capital plan of a UK government infusion. Lloyds TSB gained 5.7% and HBOS up 12% on the LTSB vote by 96% of shareholders to support the takeover. Given that the same institutional investors hold shares in both banks, this is however not to taken as a firm belief in the economics of the deal. Barclays fell 1.5% on shareholder discontent over the bank's private Gulf fundraising that continues to hurt the stock.
There will be continuing volatility, short-selling and shareholder gnashing of teeth until other indices rally for some temporary hope and dead cats bouncing to Christmas bonus accounting. Two to three $trillions worth of effective help may yet be needed from Government in various cash and non-cash surety initiatives? President Bush may seek some more last minute interventions given that he must be fearful of his already war-torn legacy being added to by accusation of having destructed the economy and betrayed American Auto, costing millions of Republican votes at next mid-terms, and his being treated as a pariah after he leaves office on 20 January, a self-destructive halo around his ideological brand, now associated with 'Anglo' financial capitalism that the leading officers of banks believed themselves to be the oustanding examplars of. They appeared to believe that the economic system is something to know only from precepts 101, but the global economy does not perform merely according to abstract principles dressed up with the rubric of 'modernisation'. The new generation of banking managements had better decant or recant and embrace an altogether more robust understanding of economics to include social and political responsibilities and go back to rediscover anew the supposed ancient banking traditions of trust, fundamental and ethical values.

Monday, November 17, 2008

Lloyds TSB + Halifax Bank of Scotland?

Senior bank officers these days are a haggard, hang-dog guilt-ridden looking bunch, often shunned at dinner parties and blanked at the club, late home every night, working weekends, enduring weeks, months, of relearning old skills such as spreadsheeting and how to make one's own assessments now that it is dangerous to delegate strategic capital adequacy matters to the hired help. Thus, be assured that the leaders of Lloyds TSB and HBOS, for example, are very much on the bridge of their banking (listed) ships examining the instruments and taking measurements, a taxing experience. How does one value a bank today? There is no one way, only a triangulation of approximations. Looking back and trying to see ahead it is reasonable to assume that banks are losing capacity to write new business and support existing exposures, so much so that the combination of Lloyds TSB and HBOS, if it goes through, may during this recession shrink to a size not much more than the present size of HBOS alone and shrink more than they both would if they remained separate competing entities! This may be factored into the very low share values and P/E ratios.
There is excessive fear among share investors attaching to mortgage assets that only to AI Hedge funds are now looking like solid high profit investment opportunities, the main reason for the share value difference between Lloyds TSB and HBOS that is the inverse of the sizes of their respective balance sheets. And yet, it is not clear why HBOS should be so devalued by its mortgage book. The loan to value ratio of HBOS's mortgages are 10% lower than those of Lloyds TSB, and by end of 3Q '08 loan defaults remained low for both banks and even as these grow dramatically should be manageable. Mortgages are at least backed by bricks and mortar in an economy that still evidences a severe housing shortage. What is more to be feared are the knock-on effects once actual (not yet registered) unemployment rises (expected to double) and this time among the highly indebted South East white-collar professionals. When Halifax and Bank of Scotland merged (merger of equals) to form HBOS this made a lot of sense given that BOS had been financing the bulk of H's mortgage book for years. There is now we learn at least £10bn of loan recently agreed between Lloyds TSB and HBOS as part of their boards agreeing to the takeover, but there would have to be a lot of other outstanding finance between them that could be internalised to justify the new combined mega-bank, which is not justified by the estimated £1.5bn in annual cost savings (by 2011) since this is likely to be less than the costs of merging in the short to medium term (where the costs of new core banking systems will be singularly large and potentially risky) and certainly not in the public interest to have one bank accounting for 30% of UK domestic bank loans. Additionally, there is much to be said for Scotland's economic benefit in retaining the independence of HBOS and having it fully headquartered in Scotland. (It is instructive to re-read Walter Scott's Malachi Malagrowther letters in 1826 - see comment). This morning I received the following opinion by email.Men love in haste, Byron’s Don Juan noted, but detest at leisure. Shareholders might long for Halifax Bank of Scotland to dump Lloyds TSB and for Barclays to ditch its high-maintenance Gulf sheikhs but worry the alternatives are worse. Institutions have no plan to reject the measly terms on which HBOS is being plundered by Lloyds. Whether they have the stomach for a real fight with Barclays’ boss John Varley at next week’s vote on his plans to raise £7bn from expensive private sources rather than the government is to be seen. Barclays and HBOS have alienated investors by being slippery, disingenuously suggesting, for example, that the government might refuse to make public cash available if they were to return to it with their begging bowls and that any money offered would come on worse terms than those Barclays spurned in October. Thus shareholders must accept the deals on the table or risk being diluted to oblivion when the government imposes higher capital requirements on costlier terms. (A view that I take to be much exaggeratd since there has to be a floor beyond which further dilution is too incredible and in any case the higher capital reserves are what all banks have to find and wih Government help are so doing). Dennis Stevenson, HBOS’s chairman, wrote in the bank’s last annual report: “In times of uncertainty, communication is vital and transparency is essential.” The bank has lately delivered little of either. Only on Friday did it belatedly reveal critical information it has had since October 11 – namely that the government would require HBOS to raise £12bn if it remained a standalone entity, barely more than the £11.5bn the Financial Services Authority says it needs to merge with Lloyds. The Treasury believes its refusal to disclose the terms on which it might now fund either bank is tactically smart for a government keen to ration public funds. It is mistaken. There is a strong public policy argument against creating an anti-competitive superbank in Lloyds Banking Group and for helping Barclays out of the costly hole it has dug for itself in the sands of the Middle East. Both should be given access to public funds on the same terms offered to other UK banks.
It is a delightful oddity of the credit crunch crisis to read similar views daily firmly stated yet leading to no tangible conclusions, merely subjective opinion. My own view, not a subjective one, is that former Royal Bank of Scotland CEO Sir George Mathewson and Sir Peter Burt, former chief executive of Bank of Scotland, quite rightly have written to shareholders and gone public with a firm view supported by The Scotsman and other newspapers (as a perfectly proper challenge to which no clear answer has yet been received) that HBOS shareholders are being bounced into a mispriced takeover when there is no reason to suppose HBOS with Government investment (temporary) cannot survive and competition among UK banks maintained.
My analysis, which I shall report more about later, is that HBOS has a sound balance sheet worth twice as much at twice the size of Lloyds TSB despite Lloyds TSB being priced in the stock market as worth double HBOS.
The FT has written that major investors view the two knights' challenge to the takeover with derision, but cannot supply any tangible facts to support this wholly negative view of, even plain insults to, Mathewson and Burt. At the weekend we learned that UK Treasury officials are considering offering pension funds and other City investors the chance to buy the Government's £9bn lucrative preference shares in the clearing banks (RBS, HBOS and Lloyds) to reduce the public cost of its bailout plan (report by The Times. This would represent a U-turn on the anti-cyclical conditions attaching to SARP, the Government's £37bn bailout of the 3 banks, which together represent over half of UK domestic banking. The preference shares pay 12% a year. The idea of allowing fund managers to buy some, if not all, of the preference shares, is ostensibly to encourage them to also to buy more of the banks' ordinary shares. Under the original plan, the government took the preference shares, leaving ordinary shareholders with stock that paid little or no cash or shares dividend in the short term so long as the preference shares were outstanding. Government now appears to recognise this as unfair or draconian. It does not follow however, why fund managers would buy ordinary shares whether or not the superiority of the preference shares is reduced. This might be another blow to Barclays deal with Gulf sovereign investors. It might also be a bribe to ensure the Lloyds TSB HBOS takeover is voted through? Worst of all, it might mean the Government is retreating from insisting that banks maintain 2007 levels of mortgage and small business loans to domestic UK borrowers?
If a bribe it is not the only one. Last week we learned that Lloyds TSB secretly provided financial support to HBOS through a £10bn loan facility, in a covert agreement between the two banks. HBOS also agreed a £11.5 bn capital injection backed by the government on the condition that it proceeds with the Lloyds takeover. If it stays independent it will need to raise additional capital, but this need has recently been estimated at currently only about £500m.
Burt and Methewson say “The takeover by Lloyds is not in the public interest, and it is not in shareholders’ interests ...This is a business that under normal circumstances would make a lot of money. To cast it all away for a mess of potage does not seem to be in the public interest.” (There was also an initiative mounted by James Spowart to lead an alternative takeover, but he has had to gove up on this.) The two knights are campaigning to win support from 10% of HBOS investors to vote down the deal when HBOS shareholders meet on 12th December to vote for or against the Lloyds TSB offer. Shareholders' scepticism has to be based on not beleiving the published accounts, that they fully disclose toxic exposures, and anxiety about the impact on P/L of recession. Mathewson and Burt would have to be able to evidence more certainty about why such fears are exaggerated and for that they would need access for a team of analysts to HBOS books. But, as yet, they do not qualify for such access. I agree with the two knights errand that Lloyds has “fared little better” than HBOS in the financial crisis and HBOS shareholders are at least entitled to a larger share of the new company. This is a valid view based on both banks' last reported figures even if neither bank's quarterly results are fully transparent as to their credit crunch and economic recession risk exposures. As for future insolvency or share value dilution, at present it looks as if each bank's share values might rise on the takeover/merger not proceeding. Above all, it is unclear why competition rules should be ignored and HBOS lose its independence if Government can bail out the banks and ensure their survival through the crisis. One reason may be that a foreign bank taking over either Lloyds TSB or HBOS is as unwelcome to London as HBOS's loss of independence is unwelcome to Edinburgh?
There is a site for those questioning the HBOS takeover by Lloyds TSB. (See: and comment 2 below. The FT have reported a speech by Chancellor Darling ( that is interpreted as a rebuff to Mathewson and Burt in their attempt to keep HBOS independent, but I do not see the logic of the FT's interpretation being so definite in practise.