The story so far: Northern Rock did not go bust, the UK government intervened; Bear Stearns did not go bust, the US government intervened and later stepped in to support Freddie Mac and Fannie Mae who did not go bust. So far, so good! However, on the 12th August, the Financial Times reported that institutional investors were braced for a fresh big financial collapse within months. From a survey of 146 US and European institutional investors by Greenwich Associates, nearly 60% said that there would be such a failure within the next six months.
Do we think a major bank will fail? Our answer today is “No”, not because of their underlying financial strength but rather because such a failure would cause escalating systemic risk – the government could not allow it to happen.
However, what if a major bank were to fail? In the UK, deposits are covered by the UK’s Financial Services Compensation Scheme, under this all savers are guaranteed up to £35,000. Amounts above £35,000 form part of the bank’s working capital and depositors would become unsecured creditors. Are those who have deposits above £35,000 at risk? Based on our earlier statement our answer should be “No”.
In spite of this, the risk of having money on deposit with banks has changed for the worse. It is perfectly conceivable that in the absence of government support a major bank could go bust.
That banks knowingly lent money imprudently to obvious bad risks is quite unbelievable and for the senior bank executives to individually profit from such an abandonment of good practices by way of huge bonuses, was just wrong. The fact that their excuse for doing this was that they could securitise the debt and sell it on to unsuspecting third parties was an act of gigantic deceit and in conflict with all good sound and honourable banking principles.
A huge increase in bank lending simultaneously by all banks (the credit expansion) could not have taken place to only sound borrowers because there were not enough of them. So as well as lending to poor credit quality borrowers, banks regularly lent more than was prudent to good borrowers. By lending too much to good quality borrowers, they effectively turned them into subprime borrowers.
Only a year ago, when in truth they must have known better, Barclays executives were cautiously optimistic, saying that the crisis would blow over in a few months. How could they have believed that? At best the statement was self delusionary, at worst a lie. At about the same time, 5th June 2007, Ben Bernanke said “The trouble in the subprime sector seems unlikely to spill over to the broader economy or the financial systems, losses would be $50 to $100 billion”. Since then, the IMF have said that the losses will be $1 trillion. What misleading information was the Fed studying to cause them to misjudge the situation so badly? They must have known it was much worse than that. We can only think they were hoping that if they denied it, it might go away. Rampant coordinated bad lending practices by senior bankers will always create a crisis that won’t go away.
So where are we now? Banks’ balance sheets are in tatters, even after raising new capital, because further write-downs continue to undermine them. Credit card and commercial property mortgage debt as well as corporate loans are all subject to doubt and will create further bad debt provisions. In short, balance sheets will deteriorate further. The resounding conclusion is that the risk to depositors is today greater than it used to be. However, if you take the view that the government won’t allow a bank to go bust, there is no risk. Even to us in Orpington, we find that difficult to swallow. Increased risk must mean greater likelihood of loss. As unacceptable as the conclusion must be, we think it’s right to say that depositors must accept the simple truth that the risk now is greater than it was.
History is littered with undoubted situations that failed. Equitable Life springs readily to mind. Nobody thought there was a risk except a handful of individual thinkers amongst which we count ourselves. At the time, we were very pro-active persuading people to remove money from Equitable Life and indeed from all with-profit contracts well before the collapse.
The basis of “with-profits” is that the insurance company keeps reserves back to be utilised to maintain investor returns during difficult investment times. They do this by making lower payments to investors during good investment times – it is called smoothing. However, led by Equitable Life, the whole of the with-profit industry prematurely distributed their reserves as extra investment returns. As soon as the stock market deteriorated following 2000, they couldn’t honour guarantees implicit in the with-profit contracts. Worse still, they continued to make payments in excess of the underlying value of the fund. Extraordinarily, these were the actions of regulated, so-called, prudent, financial institutions of undoubted reputation. Investors who didn’t get out early lost significant sums that will never be recovered whatever happens to the investment markets in the future.
The common theme is always the same, naïve belief that nothing has changed when in fact, everything has changed. At fullCircle we toy with this question; if the credit contraction is nowhere near finished and if banks’ balance sheets are to get dramatically weaker, then how much worse does the credit contraction have to get before the increased risk to bank deposits manifests itself into either depositors losses or loss of ready access to capital?
One way or another it has all happened before. We know history doesn’t always exactly repeat itself; however, as we never fail to say, events do have a habit of going fullCircle.
• This article was written by John Robson & Andrew Selsby at Full Circle Asset Management, as published in the threesixty Newsletter