I’ll warn you now. If you’ve opened this article expecting a backlash against the banking backlash, you’re going to be sorely disappointed. After all, if it had been left up to us here at MoneyWeek, British banks would almost all have gone bust in one way or another back in 2008 – that’s capitalism.
So forget all those mealy-mouthed business section columnists, pleading for calm and warning of how we need the bankers, and that we shouldn’t kill the golden goose. The golden goose wrung its own neck long ago. It’s only now that it’s starting to smell a bit that everyone has noticed that it’s dead.
The reaction to the Libor scandal has been like a dam bursting. Many people working in financial services can’t work out what the problem is. On the surface, you can understand why. This is not a new story. There have been suspicions around Libor for at least five years. And if everyone was trying to nudge Libor both higher and lower, then it probably ended up exactly where it should have been.
In some ways, many consumers may actually have benefited. Because banks tried to hide how much trouble they were in during the credit crunch by pushing Libor lower, mortgage rates were almost certainly lower than they would otherwise have been. The fact is, compared to all the other stuff they’ve been getting up to, this is small beer.
But that’s the point. There’s so much other stuff. In the last month alone, we’ve had RBS’s computer debacle, not to mention the interest-rate-swaps mis-selling scandal. But what really grates is being forced to hand over piles of public money and have the Bank of England print yet more, only to be told that a big chunk is going on paying the bonuses needed to keep the ‘talent’ working for companies that wouldn’t even still be going concerns in any other industry.
The real casualty of the crisis
What’s really broken in the banking system? It’s not Libor. It’s not the monetary transmission mechanism. It’s not even the regulatory framework. It’s trust.
To any objective observer, the British banking industry must look like little more than a colossal self-enrichment scheme – a taxpayer-backed one at that – run solely for the benefit of its employees. The whole system, it seems, is riddled with fiddling, back-scratching, and the deliberate deception of customers.
As for shareholders – so often depicted as the biggest villains of capitalism – they certainly didn’t get rich out of this. If you’d invested £10,000 equally across ‘the big four’ (RBS, Lloyds, HSBC and Barclays) ten years ago, you’d be left with just £2,889 today (excluding dividends).
So anyone still trying to defend the banks at this late stage by arguing that they are vital to our economy, is missing the point. We can’t rewind. There is no way to ‘save’ the City. Without trust, the system as it stands is done for. All we’re seeing now is a tipping point as the majority of people finally ‘get’ it.
After Northern Rock blew up in summer 2007, it should have been clear to everyone that our dependence on finance was unsustainable. The boom of the last decade or more was an illusion built on a credit bubble, as a paper by Andy Haldane and Vasileios Madouros posted on Voxeu.org in November last year pointed out. The huge rise in banking sector profitability seen during the good times was put down to banks becoming better at managing risk and allocating capital. But as it turned out, there was a “much more mundane explanation”.
Banks simply borrowed more money and took on more risk. “This high-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, the ballooning balance sheet was financed using risky leverage, often at short maturities.”
The banks were, of course, aided and abetted in all this by the world’s central banks. Banks wouldn’t have been as inclined to take quite the risks they did had it not been for central bankers keeping interest rates artificially low in the hope of prolonging the boom years indefinitely.
And this is still the same basic strategy we’ve been following. Instead of tackling the structural problems in our economy, politicians have talked tough and acted soft on everything from public-sector cuts to financial industry reform. They’ve stalled and dragged out the painful process of restructuring the economy in the hope that somehow we could bring the old boom back to life with endless injections of printed money from the Bank of England.
That plan is dead in the water now. Bob Diamond’s scalp is nowhere near the end for this phase of the banking shake-up. We can expect a lot more by way of regulation and much slamming of stable doors. Will lots of it be ill-thought-out and counter-productive? Of course. These are politicians we’re talking about.
Worse still, Europe is sharpening the knives for us. The latest eurozone deal took steps towards creating a single bank supervisor and a ‘banking union’ across Europe. As the FT notes, this could “reshape the workings of the City in unpredictable ways”.
Leaving the European Union – which now seems a possibility, at least – is always an option, and could deliver many advantages to the UK. But as one banker put it in a letter to the FT (noted by Anthony Hilton in the Evening Standard), there are also risks involved.
Basically, if the City has one set of rules and the rest of Europe is following another, it loses one of its major attractions. “The business model for the City only works if it works for the European Union as a whole.” Certainly, Peter Sands, the chief executive of Asia-focused bank Standard Chartered, has warned Prime Minster David Cameron that a British withdrawal from the EU is a “key risk”.
One thing’s for sure, it’s going to take a long time and a lot of work for trust in Britain’s financial services sector to return. Even if London keeps its position as one of the major centres of global finance, the financial industry will certainly be smaller by the end of the process. Indeed, it’s already shrinking. But it’s the only way forward. That leaves us with one big problem. What will Britain do instead?
Britain’s illusory boom
Britain’s boom was fuelled by three main things: the City, the public sector, and property price inflation. Via a combination of poor-quality regulation (there was plenty of paperwork to be filed, but regulators looked in all the wrong places) and a very hospitable tax climate for foreigners, we turned London into the world’s top financial centre, competing only with New York for the title.
Tax revenues paid by the City helped to fund a boom in public-sector spending. Both booms fuelled jobs growth in other industries, such as legal services, and public-sector outsourcing. The biggest boom of all came in the property sector, with ordinary consumers getting their share of the wealth by trading houses with one another and borrowing to spend against their paper property gains.
That’s all gone now. Except, unfortunately, for the toxic legacy it left behind. Some pundits suggest that we now need a ‘reset’ for the economy. If only it were that simple. This isn’t just a matter of hitting ‘CTRL ALT DELETE’ and wiping out the mistakes of the past. Banks’ balance sheets remain fragile – research and advisory consultancy PIRC reckons that hidden losses come to £40bn, while our regular contributor James Ferguson says they could be five times that amount.
So we’re left vulnerable to any further financial shocks. And those could easily be forthcoming. Houses remain overpriced in most parts of the country, particularly in London, where they’ve been pushed to record levels by an influx of foreign investors looking to escape the eurozone while they still can.
In the rest of the country, prices remain below the 2007 peak – the further north you go the grimmer the picture gets – but they have all been propped up to one extent or another by the Bank of England slashing interest rates to near-0% levels.
The trouble is, while the Bank may have bought some time, it hasn’t been used well. According to McKinsey, Britain – similarly to Spain – has barely begun to ‘deleverage’ since the crisis began, whereas America is much further through the process.
In the meantime, the British housing market has become ever more sensitive to changes in interest rates. As a recent report from Hinde Capital points out, fixed-rate loans now account for “less than 30% of mortgages” (by outstanding balance) from more than half before the credit crunch. That leaves more than 70% of people on variable rate mortgages.
There are a number of reasons for this, but most come down to one key thing: people can barely afford the debt burdens they’ve built up. Many of those whose fixed-rate loan periods have come to an end have been forced to shift onto their banks’ standard variable rate (SVR), because they can’t remortgage elsewhere. Others have had to move onto interest-only mortgages as a form of ‘forbearance’, which again leaves them uncomfortably exposed even to small changes in rates. In all, this leaves “UK property vulnerable to another correction”.
Of course, the Bank of England has no intention of letting the bank rate rise from 0.5%. Meanwhile, the government can borrow money at near-record low rates. The ten-year gilt yield is less than 2% just now, which is below inflation. The question is: how long can this last? Britain’s gilt market has been supported by three things.
Firstly, it’s not in the eurozone, so Europeans trust it as a destination for capital they want to get out of euros. Secondly, the Bank of England has proved willing and able to print money to take any unwanted gilts off investors’ hands. Thirdly, the government has made a good job of talking tough on cutting spending (although it isn’t actually living up to the tough words).
The return of the bond vigilantes
So what would it take for the ‘bond vigilantes’ to take up their clubs and wade into the gilts market? Perhaps less than you might think. Investors have started to assume that it won’t happen, simply because it hasn’t happened so far, just as they assumed that house prices wouldn’t fall tomorrow because they didn’t fall yesterday.
This is a mistake. Many things could trigger a bout of fright in the gilts market. Conditions in Europe might start to improve. Suddenly everyone would realise that Britain isn’t a safe haven at all. In fact, it’s just like Ireland or Spain (its banking sector is too big for the state to guarantee), except that it has its own currency.
Or, perhaps more likely, the weak British economy might start to concern investors. We’re currently in recession, and the latest figures don’t look good – the most important part of the economy, the services sector, was flat in June, while activity in the manufacturing sector shrunk.
None of this bodes well for the government’s schedule for tackling Britain’s heavy public-sector debt load, which is based on GDP growth recovering to around 3% a year by 2015 – a very optimistic-looking target. Already the borrowing figures for this financial year suggest the government will miss its targets for 2012/2013.
The property market also looks wobbly again, perhaps little surprise given the state of the rest of the economy. House prices saw their biggest annual drop in nearly three years in June (falling by 1.5%), says Nationwide, while the number of tenants in ‘severe arrears’ on their rent shot up by 8% in the second quarter of this year, according to Templeton LPA.
Another significant slump would have everyone fretting about British banks’ balance sheets again. After all, the prospect of another slide in house prices was partly what spooked bond investors into fleeing Spain.
The counter-argument, of course, is that the Bank of England would just print more money. But there’s a limit to how much of this we can get away with. Foreign investors (who hold just under a third of the gilts outstanding) may not be too concerned about currency devaluation and inflation right now, especially compared to the threats elsewhere.
But if they start to worry that Britain’s plans for getting itself back into shape are simply unachievable, then we’ll stop looking like a relative safe haven and start looking like a basket case, every bit as bad as the eurozone periphery. If existing investors start to worry about being paid back in weaker sterling – and we know that if QE achieves anything, then it’s to make the currency weaker – then they’ll shun gilts.
So the best-case scenario is that through modest ‘financial repression’ – a concerted effort by the Bank of England to keep interest rates below inflation without inflation actually ever taking off – Britain muddles its way through, all the time walking a wire between scaring gilt investors and plunging into a deep depression. But that could take years, and in the meantime, you’re going to have to find a way to protect your wealth from steady erosion by inflation.
The worst-case scenario is that Britain finds its way on to the bond vigilantes’ hit list. As Hinde point out, a flight from gilts would hit banks’ balance sheets (they hold gilts too) “so lending conditions would tighten and mortgage rates would rise”.
Housing loans going bad would hit the banks even harder, and the Bank of England might end up having to do further ‘emergency measures’. The International Monetary Fund might even be called in. We hope it doesn’t get to that. But it can’t be discounted. And in any case, we’re looking at a long haul back to economic prosperity. We look at ways to protect your wealth below.
What to buy to protect your wealth
Obviously, we aren’t keen on gilts. We don’t see any reason to short them – getting your timing right is a matter of luck with these things – but at these levels, anyone buying now is either betting on a Japan-style outcome for Britain, or simply hoping that momentum will continue to carry gilt prices higher. That’s not a bet we’re happy to take.
We’d avoid the banking sector too. It might look cheap, but the real problem is that this is just the start of the reform process. We don’t know how this will shake out, but with regulatory changes likely to come thick and fast, and the threat of lawsuits over Libor (particularly in the US), there are too many potential costs and threats to the existing business model to make any investment in the sector much more than a punt.
In terms of diversifying your sterling exposure, stocks in Japan and, increasingly, Europe look cheap enough to start adding to your portfolio: we’ve tipped various European options in recent months, and as regular readers will know, we’ve been fans of Japan for a very long time.
The other obvious step is to buy gold as insurance. It’s one of the best forms of protection should we see a serious devaluation in sterling, and it’s also pretty handy in the sort of inflationary environment the authorities will be trying to encourage.
If you don’t want to buy physical gold, try a gold exchange-traded fund such as ETFS Physical Gold (LSE: PHAU). If you’re looking for a sector that might benefit from both a weaker pound and the scramble to find a different driver for Britain’s economy, then the engineering/manufacturing sector might be the place to look.
Panmure Gordon analyst Oliver Wynne-James reckons “the buying window is open” for these stocks, which have been hit by fears over global growth. One we particularly like is conveyor belt and advanced engineering equipment manufacturer Fenner (LSE: FENR).