Wednesday, October 15, 2008

The eye of the storm has just passed over

It is a great surprise that three small islands off North Western Europe have been the cause, and the cure, of the crisis. It was Ireland's emergency guarantee of all deposits which set off the nuclear reaction: risible, because its blanket nature covering all deposits for its six banks worked out at $576bn, nearly three times gross domestic product, $130,000 per head or $200,000 per person in employment. Within these numbers was a sub-liability of nearly $50,000 per head over foreign deposits, mostly British. Despite now excellent Anglo-Irish relations, if these guarantees had been called, they could never have been paid. Immediately Germany, Spain, Greece and smaller countries followed suit. Mildly anti-EU British politicians then peculiarly started to bleat about supra-national solutions - an impossible dream - and did nothing. More sensible foreign leaders reacted nationally to the inevitable consequences of their electorates seeing their local banks disappear in a puff of smoke. Fortunately, market mechanisms then kicked in. Large British deposits were being sucked out, into unreal Irish bank guarantees at an alarming rate. Meanwhile in Iceland, the third offshore island, the entire bank system finally decided to die. Although this was assured much earlier (see Pick of the Week No. 48, "Abdul and Jorvik Go Shopping"), it had staggered on for a surprisingly long time. The twin Irish/Iceland events resulted in dramatic falls in British asset prices and even worse gridlock in the lending markets. Outflows to Ireland were swiftly followed by a sudden realisation that simply idiotic deposits worth over £5bn had been placed into hopeless Icelandic-owned institutions and were about to disappear. Depositors included over 100 UK local government authorities as well as unwise financial intermediaries. Without warning and in a single bound, the British governing class leapt from narcolepsy to sprinting at gold medal speed.

The key change has been the rapid implementation of the most comprehensive bank bail out package ever seen. It should work, because it addresses the overlapping problems of too little Tier 1 capital, the fear of bank counterparty risk, the inability to roll over corporate loans and the risk of deposit flight. The result is state directed capitalism. It has lead to howls of outrage across the investment and political spectrum, from the purists who believe market forces should be allowed to work themselves out, to the mob baying for capitalist blood. The cacophony of noise and finger pointing will continue for many years, but both arguments are irrelevant. They are based on old rules. For just as in war habeas corpus and other rights are torn up, so in a financial meltdown the old rules are shredded.

The British decision has been to save the core of the national banking system and create a more realistic structure than the blanket guarantees of Ireland. The sums pledged are large enough to meet all the capital required to support the capital of each major domestic bank. The use of high yielding preference shares and permanent income bearing securities is likely to mean the government may end up owning perhaps a mere quarter of three to six banks, yet its ability to control them all, and their lending, is a certainty. This multiple approach is already being favourably viewed in other countries; it is speedy, cheaper and turns the all-important psychology from one of utter despair to merely gloom. It is more effective, and overall less burdensome on the taxpayer than any other solution. In the UK and elsewhere, the previous drip feed of liquidity into the markets, started by Mr Paulson in the US, simply proved the law of diminishing returns. Ever larger funds had to be provided to produce ever weaker results. To be fair, the unique (so far) British solution is almost the same as Mr. Buffet's bail-out of Goldman Sachs. His very high yielding preference stock and presumably many other strings must have provided a guide.

Britain's Treasury mandarins had also dusted off and absorbed the lessons of earlier French, Swedish and Japanese models. The result is a more effective hybrid. Since President Mitterand nationalised the banks in 1980 (later part re-listed), France has had state directed capitalism dominated by three banks. Inevitably these are ponderous and suffer poor shareholder returns, but in a whacky way, the system works. In Sweden, the necessary nationalisation of anything with 'bank' on its nameplate also proved effective; although the stock market did not recover for 18 months, the economy managed weak growth in almost every quarter. Japan's Resolution Trust Corporation initially failed because the government dithered for six years after the 1990 crash, before taking any meaningful action. Subsequently, vast amounts of debt were issued to hoover up bankrupt banks and duff corporate loans. It worked. We believe that most G7 (i.e. including America) and G20 countries will adopt Britain's hybrid ruse in the near future; if so, the storm is passing for sure.

John Maudlin

No comments: