In America, it seems, the cycle comes round every two decades. One of the
first acts of George Bush Sr when he became president in 1989 was to
announce a rescue of America’s mortgage lenders, the savings and loans
institutions.
The blueprint for that rescue, which set up a fund, the Resolution Trust
Corporation (RTC), to bail out irresponsible lenders, was dusted off last
week by his son’s Treasury secretary, Hank Paulson.
The names are different and so is the scale. “RTC II” - unveiled at the height
of last week’s turbulence - is intended to rescue the US financial system.
If it works, as its predecessor did, it will be seen as a triumph of
pragmatism - a Republican government again showing its willingness to
intervene when the market fails.
If it does not, then the comparisons will be to another US president and era:
Herbert Hoover and the Great Depression.
Even hardened City professionals were shaken by the scale of the carnage last
week as the world’s financial system teetered on the brink.
One economist, Ian Shepherdson of the firm High Frequency Economics, likened
it to a plague of locusts cutting a swathe through the financial system.
After devouring one target, they moved on to the next.
The swarm quickly crossed the Atlantic. Had it succeeded in forcing the
bankruptcy or nationalisation of HBOS - Halifax Bank of Scotland - then not
only would it have moved on to other UK banks but the economic consequences
would have been disastrous.
Banks are not like other businesses. The closure of a big car factory hits its
workers and suppliers; the failure of any bank of significant size hits the
whole economy.
In recent months much of the attention of the Treasury, the Bank of England
and the Financial Services Authority, the City regulator, and of their
overseas counterparts, has been on getting the banking system through the
crisis. Saving the system had to come first; saving the economy would follow.
How has it come to this, and what will be the consequences? Vince Cable, the
Liberal Democrat Treasury spokesman, suggested at his party conference last
week that this was a problem made in Britain. “New Labour incubated a
culture of financial gambling with other people’s money which has
contributed to the collapse of trust in financial institutions,” he said.
“It also bred a dangerous dependence on debt.”
Debt has increased and the housing market is in trouble, but on their own they
could not have caused the kind of problems that HBOS ran into last week.
Britain’s mortgage lenders survived the housing crash of the early 1990s.
Most people know the crisis resulted from dodgy “sub-prime” mortgage loans to
low-income borrowers in America. Even these loans, however, would not have
been enough on their own to cause the difficulties. Direct losses on them,
after repossessed properties are sold off, will probably be no more than
$200 billion (£109 billion). That is a lot of money, but small in relation
to the $14.3 trillion US economy.
A trillion dollars ($1,000 billion) is serious money. That is the likely
extent of the losses on the so-called derivatives linked to sub-prime
mortgages. These complicated financial instruments, created by investment
banks using sub-prime mortgages as a base, may have generated losses of five
times those on the original loans.
The reason this has come to a head can be found in a theory developed by
George Akerlof, the American economist. Nearly 40 years ago he published a
paper called The Market for Lemons. A lemon is something that people think
is going to be trouble and, as a result, are extremely wary about buying.
Akerlof took the example of used cars. Why would anybody sell an apparently
faultless car? Perhaps because they knew that the gearbox was about to seize
and the engine fall out. Such fears might be unfounded, but who would want
to take that risk?
The result of what Akerlof called “asymmetry” of information - sellers know
more than buyers - would be that the prices of all used cars, good and bad,
would be pushed lower. Only if people had a guarantee that their fears were
unfounded would they be prepared to pay a fair price.
In the past few days we have seen an extreme version of Akerlof’s theory at
work. It started, bizarrely, with the US government’s rescue of Fannie Mae
and Freddie Mac, the bulwarks of America’s mortgage market. After an initial
period of calm, buyers of bank shares decided the institutions that were
most exposed to the derivative instruments linked to that market were
“lemons”.
The biggest lemons, it seemed, were the Wall Street investment banks. They,
unlike the big commercial banks, did not have the capital, the financial
muscle, to fall back on. Not only did investors take fright but so did
everybody dealing with the banks, including other banks. Investment banks
rely on being able to deal with other institutions. When they can’t, they
are sunk.
Lehman Brothers was sunk last weekend and Merrill Lynch lost its battle to
survive as an independent bank. HBOS was seen as the biggest lemon in
Britain because of its reliance on the City’s “wholesale”, or inter-bank,
money markets and its exposure to falling house prices, as a result of being
the country’s biggest mortgage lender.
When nobody will buy a used car at a decent price, the response of dealers is
to offer a guarantee. When confidence in the banking system is shattered,
only governments can offer such a guarantee.
That was the thinking behind RTC II, sketched out by Paulson on Thursday
night. Although the details are still being hammered out, the outlines are
clear. The US government will set up a pot worth $700 billion to buy banks’
failed assets and provide guarantees to money market funds.
Will it work? George Magnus, the veteran international economist at UBS, the
Swiss bank, sees it as the “beginning of the end” of the financial turmoil.
World stock markets appeared to agree and shares leapt on Friday. But Magnus
also warned that we were nowhere near the end of the process in which the
banks would “deleverage” - cut back on lending - and in which assets,
including houses, would carry on falling in price.
America’s actions may have stopped the panic but they do not mean that the
heady days before the credit crisis broke in August last year will return.
When banks failed on a grand scale in the 1930s - about a third of US banks
folded - the Great Depression ensued. The consequences of the banks reining
back this time may be something like the “new austerity”, a long period in
which the economy grows weakly if at all. Even before the events of the past
few days, economists were gloomy about the outlook, predicting 1.2% growth
this year and just 0.5% next. Those numbers could prove optimistic.
It will mean higher unemployment, far beyond the direct job losses resulting
from the City’s woes and the Lloyds-HBOS merger. The claimant count, now
900,000, rose by 32,500 last month. At that rate it will hit 1.4m at the end
of 2009. The monthly rises may get worse over the winter. For Alistair
Darling, faced this week with the most testing party conference speech for a
chancellor in years, an uncomfortable job will grow even stickier.
Next month he will publish his prebudget report and be forced to cut his
growth projections sharply, while acknowledging that the government has been
forced into tens of billions of extra borrowing. In March he said public
borrowing would drop to £38 billion next year. Instead, say researchers at
the Centre for Economics and Business Research and Capital Economics, it
will rise to between £90 billion and £100 billion over the next two years.
Economists say that Darling, or his successor, will have no option but to
raise taxes or cut public spending. The National Institute of Economic and
Social Research says he will have the choice between a 3% cut in public
spending and raising taxes by the equivalent of 5p in the pound. The effects
of current events will last for five to six years, it says.
“There is a choice to be made between sticking to present spending plans and
raising taxes, or changing those plans,” said Ray Barrell, senior research
fellow at the institute. “The world is a different place.”
Beyond the immediate crisis, the prospect is of only a slow economic
recovery.The banks will remember this bloodletting and panic for years.
That will make them more reluctant to lend than we have been used to in the
past 15 years. Lending feast has been replaced by borrowing famine, and that
famine will last.
People in Britain have been accustomed to easy money. Over the past year they
have seen the credit taps being turned down and it has hurt. Last week’s
crisis tells us that is not going to change for a long time. Combine that
with the likelihood of higher taxes and slower growth in government spending
and it does not look like a comfortable picture. Welcome to the new
austerity.
If only they had listened to Warren Buffett
Who, or what, is to blame for the meltdown? Amid all the finger-pointing and
the chaos, one voice stands out - that of Warren Buffett, the greatest
investor of the past 40 years, writes Richard Woods.
Every year he writes a report to shareholders in his company, Berkshire
Hathaway, and two key themes he addressed in 2002 now seem brilliantly
prescient. Financial instruments called derivatives and bad corporate
governance, he wrote, were dangerous threats.
“Charlie [his investment partner] and I are of one mind in how we feel about
derivatives and the trading activities that go with them,” wrote Buffett,
whose wealth was last week estimated at $50 billion by Forbes magazine. “We
view them as time bombs, both for the parties that deal in them and the
economic system.”
The nature of derivatives, which are based on the value of assets but don’t
actually involve exchanging them, meant that firms “could record profits and
losses, often in huge amounts, without so much as a penny changing hands”.
Imprecise methods of valuing derivatives meant their true value might not
become apparent for years.
“Errors will usually be honest, reflecting the human tendency to take an
optimistic view of one’s commitments,” he said, “but the parties to
derivatives also have enormous incentives to cheat in accounting for them.”
He warned that traders and bosses were pocketing huge rewards on earnings
that would later turn out to be “a sham”.
In one of the most telling passages, he wrote: “When Charlie and I finish
reading the long footnotes detailing the derivatives activities of major
banks, the only thing we understand is that we don’t understand how much
risk the institution is running. In our view, derivatives are financial
weapons of mass destruction.”
Not all derivatives are toxic and by no means all bankers are involved in the
trade. Nevertheless, these WMD and debt have proliferated like mad. By one
estimate the nominal value of certain derivatives ballooned to $62 trillion,
based on only $6 trillion of underlying assets.
If Buffett saw the dangers, why didn’t others? Because they were having too
much fun making too much money.
“Too many of these people have in recent years behaved badly in office,
fudging numbers and drawing obscene pay for mediocre business achievements,”
Buffett said.
“These otherwise decent people simply followed the career path of Mae West: ‘I
used to be Snow White, but I drifted’.”
