Banking

It seems that the fees earned by the world’s investment banks soared to record levels last year, fuelled by the high levels of activity in mergers and acquisitions.  The problem is that the tidy $84bn generated is more than wiped out by the stated losses in the sub-prime debt crisis, which currently amount to $130bn and rising.

Of course, the easy credit which led to the credit crunch also helped to create an M&A boom so it is unlikely that they will generate this level of fees in 2008.  Having said that, although the more traditional merger activity may cool, there may be rich pickings to be had advising those with cash, such as the Sovereign Wealth Funds, which seem set to go on a bit of a spending spree.

Private investors seem intent on losing value.  One of the things they seem to like to do, and professionals are by no means immune, is to sell investments on hearing bad news.  The problem is, if they have heard the bad news it is more than likely that the purchaser will have too.  In fact, when it comes to stocks and shares, private investors, and the majority of professionals, have no choice but to trade through a stockbroker who will need a market maker to from whom to buy or sell.

Now, this market maker will be almost certain to have heard any news there is before it reaches many other investors and he or she will price this into the prices they quote.  If they did not, they would be left holding stock on which they will make a loss.  To prevent this happening, they will adjust the price accordingly and, perhaps, the spread between buying and selling prices.

This makes it very difficult for the investor looking to avoid a loss or make a quick gain as it is likely that the market will have moved well before they can.

So, having written about bank stocks last week, I was interested to read in the FT at the weekend that private investors were shedding these shares faster than the institutions.  I am not one for tips but this must be further evidence that the banks represent value for I am sure that any investment strategy which involved doing the exact opposite of private investors would have a good chance of succeeding.

That is not to say there will not be more bad news to come, especially as the banks have now started to sue each other to establish blame.  Am I the only one who is slightly disturbed by the thought that these major institutions, in which we place so much faith, had no idea of either what they were creating or buying and selling?  Next time I hear a sales pitch for something complex, I must try to remember this.

For someone who has any belief in the long term viability of the banking system, has there ever been a better time to buy shares in major banks?  With many paying a dividend of around 10% a year, the income alone represents a reasonable investment but when you add in the prospect of capital growth they must make a tempting buy for some.

Granted, it does not pay to act without caution or reasoning and, as recent events have shown, banking is not without its risks for share owners.  But, that said, banks have been hit by crises before, seemingly every ten years, or so and, whilst this crisis looks bad, is it any worse than the problems associated with the Russian Debt default, the collapse of the Savings and Loans institutions in the United States or the Latin American debt defaults?  Crises come and go, it seems, each on a little different from the last, but our need for banks carries on undiminished.

It also appears, if history is any indication, that banks recover from crises, as does the rest of the financial system.  Help is often required from Central Banks but, without sounding complacent, problems disappear.  They may not be everyone’s cup of tea but you can be certain that some will make money out of these travails.

It seems that the World’s financial markets are entirely dependent on the US and, in particular, the Federal Reserve Bank to provide any stability in times of turmoil.  On Monday stock markets around the world suffered large losses, some more than 5% as worries about the possibility of a recession in the US came to a head.  Panic fed panic amongst investors throughout the day leaving the wider public to digest lurid headlines about financial meltdown.  Monday, as luck would have it, was a public holiday in the US so no trading took place but forward contracts indicated a fall in excess of 5% was likely on Tuesday with the probability that this would trigger further falls elsewhere.

It is possible to argue for creative destruction but market turmoil does no one much good in the long run and can impact on the wider economy, meaning real people can lose their livelihood.  Globalisation may mean that the poorest people in the developing world may suffer the most.  This means positive action to avert the worst of a crisis is to be welcomed and the world was found wanting, consigned to being mere bystanders. 

The Fed, however, sees things differently and cut rates aggressively before markets opened in New York on Tuesday.  This did not prevent stocks falling but it did cushion them somewhat.  London then led the Far East in mounting a recovery of sorts.  It is clear that the current instability has some way to go yet but it may be possible to mitigate against the worst of its effects.

Of course, it is possible to lay much of the blame for these problems at the feet of the Fed but it is reassuring to see that they are not simply standing back and observing events as they unfold.

Keeping tabs on news from the UK whilst I am in Australia, I see that the headline on the BBC Business News is that Northern Rock faces ejection from the FTSE100, the index of the shares of the leading companies listed in London.  It is odd what is deemed to be newsworthy but it surprising that this Bank is still limping along at all as an independent entity.

Unfortunately, the Government, having found itself forced to preside over a fire sale following its mishandled bail out, looks to be fumbling the process of offloading Northern Rock.  All efforts to find an acceptable solution, where the bank will carry on roughly as before, look to foundering, squeezed between the demands of existing shareholders and the need for taxpayers to receive their money back at a commercial rate of return.  Hovering in the background are the European authorities, keen to ensure that no breach of their regulations takes place, who have imposed a deadline of February for the state aid to be withdrawn.

Notwithstanding the damage done to the UK’s financial services industry by having to go cap in hand to the Government for funding, the spectre of intervention from Brussels is almost as worrying.  The European Commission is struggling to prevent State intervention in industry across a number of countries, which have been rightly criticised by our finance sector, who look to benefit from increased genuine competition and it ill behoves us even to appear to indulge ourselves in similar practices.

Anyway, back to the plot.  Despite the expectation of a number of bids, once the first one, from a consortium lead by and labelled as Virgin, dropped through the letter box, it was immediately accepted as the preferred bidder.  To an outsider, this did seem a little strange.  You would not have thought that a wait of a few days more to see what the others would bring to the table would have been a problem.  Now the shareholders are kicking up a fuss and threatening to prevent any sale which they would perceive as robbing them of value.  I should have thought that the shares are virtually worthless as, in the event of foreclosure by the creditors, shareholders come some way after in the division of the spoils.  However, were I a shareholder, I might spot an opportunity in the Government’s increasing desperation and discomfiture.

Politicians are always somewhat in thrall to Virgin’s boss, Richard Branson, and I am sure that the prospect of this self-styled champion of the people bailing out Northern Rock has much to commend it to them.  There is also the likelihood that Virgin would retain more of the precious jobs in the North East than would some of the other bids.  The powers that be must be praying that this affair is resolved quickly and cleanly.  They most certainly do not want to spend years fighting court cases.

For those holding cash, now could be a fantastic time to pick up some stock market investments at a knock down price, while some commodities (previously, the darling of investors)look overpriced.  Of course, it is perfectly possible that markets could drop further, after all, even if markets are efficient, they are not always rational.  At the moment, however, the stock markets, in particular, are volatile because investors are finding it hard to gauge the full extent of the sub-prime problem and its longer term impact on corporate profitability.

For those looking to hold investments for the long term, the FTSE100 looks a bit of a bargain at around 6300 when it has traded above 6700 only a matter of months ago.  The cautious, though, will be mindful of the fact that the index has yet to regain the heights of 1999 when it exceeded 6900.  It is always possible that we are in the early stages of a protracted bear market but many will find it hard to believe that the banks, even with all their problems, are as bad a profit prospect as their price would suggest.  Now, more than usual, we are seeing the benefits of diversifying.

For some investors, the January Sales have come early in the Stock Markets.

In another example of shutting the stable door once the horse has bolted, the US House of Representatives has voted to regulate mortgage brokers and lenders.  Although this Bill is unlikely to find its way past the Senate and the Presidential veto, it gives an insight to those of us in the UK into how the sub-prime crisis came about.  Some Members of Congress are seeking to force a degree of responsibility upon mortgage brokers, requiring them to select a suitable mortgage rather than the one paying the most commission, and upon lenders to take some steps to confirm affordabilty of the loan.

This commonsense proposal would impose some rather belated order, preventing America's poorest being stitched up with truly dreadful loans, which all but guarantee default in many cases after the 'teaser' introductory rate finishes and higher interest payments kick in.  By this time, however, from the lenders point of view, the loan has been securitised and parcelled off by an investment bank to some 'unsuspecting' hedge fund, insulating the lender from the consequences of its actions.

If there is a crumb of comfort for us over here, it is that these lending practices did not cross the pond to any significant degree, at least for mortgages, and the impact on the UK property market may be different.  Also, residential mortgages have been regulated since 2004 in the UK.  None of this inures us from the effects of the global fallout, however, as the international capital markets struggle to quantify the problems and regain stability.

The hunt for more scalps over the Northern Rock fiasco rumbles on in Parliament.  The most recent visitors to the dock have been the ratings agencies, who have found themselves widely vilified for their role, real or apparent, in the credit crisis globally and the small matter of a run on a bank here in the UK.

The ratings agencies, of which there are three major players, credit score companies and other institutions who are looking to borrow money in the capital markets.  There has long been a concern over the potential conflict of interest which arises because the borrower pays for their own rating, the concern being that they may shop around to get a higher rating.  Also, the agencies may be reluctant to downgrade the debt in future as it may put off future customers.

So, the ratings agencies have a fine line to walk and it cannot help having governments the world over queuing up to give you a duffing over (the US has already had a go) but it is a lucrative business and, effectively, a closed shop so they don't have to fend off too much competition.  Also, whilst there are concerns, an obvious solution does not seem to be presenting itself so, although we can expect a period of circumspection (probably when least needed), I imagine it will be business as usual pretty soon.

The City and financial markets in general are often accused of short termism and with some justification.  Many of the current problems we are facing in the credit crunch are borne out of a misalignment of the interests of investment bankers and the shareholders in their banks.  As we approach bonus season, the problems are about to manifest themselves in the pockets of bankers who are set to receive less than they had hoped.

Bankers and traders are generally rewarded for their performance in creating profits during the course of the year.  This encourages highly risky strategies which may produce fantastic returns for a few years even if subsequent losses more than wipe out past profits.  The banker will not have to return previous year's bonuses, although they may lose their job.  The shareholder, on the other hand, may see all of their returns over the years reversed within a short space of time.

This is not a case of twenty twenty hindsight, it was eloquently described by Nasim Taleb in his book 'Fooled by Randomness'.  To anyone who had read this book, none of the recent turmoil will have come as a surprise.  The problem is that I think there is no chance whatsoever of a significant change to the way rewards are doled out in investment banks over the long term.  It is just not the nature of the beast.

With the 'resignation' of Chuck Prince of Citigroup this week, the pain being endured in the Investment banking world continues.  These things are relative, however.  No big player is walking into the sunset without a huge pile of cash for their efforts (supposedly, $95m for Chuck), which, I suppose, cushions the blow.

What is intriguing for the rest of us is how these organisations which shower the cream of the academic world with money to labour for them, suddenly wake up to find that they have mis priced something by billions of dollars.  Some of the investments they hold are now worthless.  They have also lent money to companies which bought investments, sometimes from the same bank, which are now worthless, so their loans are looking a little tricky.

By pursuing ever riskier and opaque strategies, they have wiped out years of profits in some departments in a matter of weeks.  It would not be so bad were it not for the fact that these institutions are well placed to spread the pain to the rest of us n the form of more expensive finance or lower returns on our deposits.  Also, they will bounce back more confident than ever and ten years, or so, from now we will see a very similar wiping out of much of the intervening profitability.

To my slight disappointment, the Bank of England Monetary Policy Committee voted to keep interest rates on hold at 5.75%.  I have to confess to having an interest in this as a mortgage holder; it would have made my life a little more comfortable had rates come down by 0.25%.  Despite my interest, I still believe they have got it wrong.  The perils facing us at the moment are unknown and could cause the economy and, therefore, real people, genuine hardship.

The US economy faces the possibility of a recession, at worst, or a serious slowdown.  House prices in the States have dropped in nominal (i.e. cash) terms for the first time since the Great Depression of the Thirties so it is impossible to overstate the seriousness of the current position, although most are relatively sanguine for the moment.  The world is by no means as dependent on the US as it once was but it still represents a large chunk of global activity and China and others have benefited enormously from the outsourcing of manufacturing.  Europe, much of which has squandered all opportunities for structural reform of sluggish economies is being hurt by the fall in the dollar.  If the US slows down by much, this will add to their woes.

It is easy to forget what happened to Japan fifteen years, or so, ago.  An asset price bubble (it is laughable to remember that it was once said that the land on which the Imperial Palace in Tokyo stood was worth as much as California) burst sending the economy into a cycle of low growth and deflation from which is yet to emerge.

No, I worry that the balance of risks lies on the side of a downturn, clearly, though, the MPC disagree.  I hope that they are right.  The old adage is that if America sneezes, we catch a cold.

It has not been a good year for the Bank of England or its governor, Mervyn King.  Firstly, they missed their inflation target and were stung into an ill-judged rate rise and recently they have overseen in part a run on a British bank for the first time sine the 19th century.

The current credit crisis has crept up on them whilst they were looking in the other direction and the fallout threatens to undo all of the good work they have done to their reputation in the ten years since independence.  Inflation (as measured by retail prices) has been slain, or, at least, seriously wounded, but a huge surge in asset prices propelled by easy credit may take years to unwind.

Some asset and commodity price increases are rooted in shortage of supply being outstripped by genuine increases in demand but many (probably some US house prices, for example) are simply a result of access to cheap money enabling people to bid prices up and up.  Get it right, sell your property, downsize and re-enter the world of ordinary RPI much the richer, and you're laughing.  Get it wrong, be born to poor parents too late, and you may never got to enter the market, which, every year pulls further away.

Where is the Bank (or, more accurately, the rate setting Monetary Policy Committee)looking now?  Is it still smarting over earlier mistakes, a collective state of mind which makes further errors more likely, or is it trying to predict where the credit crunch could take us and, therefore, where the greater potential problems may lie?

Having felt the need to react instantaneously on missing their inflation target, it is likely that the MPC will dither over reducing rates. The world has suddenly become a good deal more complicated for central bankers and the next few months will see whether the battered Bank of England can do something to restore its credibility amongst them.

It seems that the hapless executives at Northern Rock have upset the MPs on the Treasury Select Committee.  It seems that despite pay packets running into seven figures, they did not feel they could be held responsible for the fix the bank got into and they should keep their jobs.  Not surprisingly, this did not impress the committee investigating the first run on a British bank since the nineteenth century which heaped embarrassment on one of the world's leading finance economies.

In fact, it seems that Northern Rock fell over at the first sign of a crisis and, to most people, that would signal problems with its business model and failings at every management level to anticipate anything other than plain sailing in the credit markets.

Anyway, having managed to hoodwink the regulators, Northern Rock's Chief Executive, Adam Applegarth, seems not to have found such an impressionable bunch in the House of Commons.  That said, the MPs have the distinct benefit of hindsight and are prone to a degree of headline grabbing over reaction.

Once Northern Rock has been taken over, I would be surprised if the new owners decided that it would be in their interests to retain the current management.  I suspect that this saga will run for a while yet.