Buffett’s $5 billion ‘vote of confidence’ in Bank of America

By Gordon Kerr, on 30 August 11

Warren Buffett is the most successful investor on the planet and a very smart fellow. His core team also gave me a job in October 2000 at GenRe Financial Products, and I have always held him in high regard.

He has invested $5 billion in Bank of America on 25^th August. But was the Wall Street Journal correct to headline the deal a “Vote of Confidence” in the bank?

My analysis is based purely on the facts presented in this weekend’s WSJ.

In return for his $5bn cheque, Buffett will receive:

Preference shares bearing a ‘coupon’ of 6%. Technically, preference coupons are dividends; the payment can only be made out of profits. Allow me nonetheless to use the term ‘coupon’ in order to compare the risks and returns of this deal with a bank deposit. The structure here is as close to a coupon as preference share terms allow. Even if the bank experiences a choppy ride, so long as it survives and returns to profit at some future point, any unpaid dividends in loss making years are payable under a contractual cumulation provision.
Warrants (these are options to buy shares at a pre-agreed price) over 700 million shares of BofA common stock at a strike price very close to Thursday’s share price. The WSJ values these warrants at about $3 billion. Assuming that is correct, Mr. Buffett could either sell them for $3 billion or retain them as he sees fit.
The deal is not even Tier 1 equity for BofA and is considered expensive ‘bridge financing’ . However, Mr Buffett has secured a 5% penalty charge ($250 million) should BofA redeem the preference shares.

Short term deposit rates are 1% or less in US banks. On this basis, the deal can be characterised as a net investment of $2bn at a coupon of 15% (5/2x 6%). This equates to about 15 times the return on cash short term deposit accounts. Similarly, the redemption premium becomes not 5% but 12.5% of net invested funds.

Let us consider the ranking of the investment in a potential liquidation of BofA. Secured creditors of the bank take precedence over depositors. Preference Shares rank below depositors but above common equity. And yet banks have pledged so many assets to each other via repo and “failed sale” transactions that who can tell how much quality collateral could be viewed as actually supporting the deposit base?

Bearing in mind the recent history of western Bailouts, consider the following range of possible outcomes:

BofA survives and thrives. Happy days for all stakeholders, excellent return for Mr. Buffett;
BofA fails. Either there are enough assets in liquidation to redeem deposits or depositors are rescued by a possible Heurta De Soto or Baxendale plan or fresh taxpayer bailout;
BofA fails and (2) above extends to pay off unsecured creditors but not preference shares;
BofA fails and preference shareholders are covered by (2) above;
BofA fails and (2) above extends to protect common shareholders.

Politicians have rarely breathed the words “moral hazard” and “perverse incentives” when they are actually engaged in formulating the bailout package, so outcomes (4) and (5) cannot be completely dismissed, but surely they are unlikely.

But how likely are outcomes (2) and (3)? I just cannot see how governments can attempt a second bailout given that Ireland is now on its fifth. But I don’t know. I suspect Mr Buffett does not know either.

Mr Buffett, like the rest of us, knows that the banking system is in a critical state. Yet like many of us he has a problem: we all need to keep some cash in banks. When you have the quantum of funds under management that he has, you can forget about deposit insurance.

What a smart deal he appears to me to have made. A good chunk of the cash element of his investment portfolio can be parked at a fixed coupon of 15% for the foreseeable future.

Either paper money collapses, in which case all of his cash funds are in turmoil, or there will be another rescue attempt, or hyperinflation, or QE 3,4,and 5 or some ‘unknown unknown’ attempt to prop up the banking system. It is possible that a future rescue might specifically wipe out common and preference equity, and so Mr Buffett’s is seeking a huge upside against the risk of that specific downside.

So what of the headline? I concede that he picked BofA rather than another US megabank, but it is still rather a stretch to term this a “Vote of Confidence” in BofA.

Economics

Remember: Real Bankers are Fiduciaries

By Toby Baxendale, on 15 April 11

The Interim Report on our banking system by Sir John Vickers was released on Monday. There is no mention in all of the report that a banker is a fiduciary to his client first and foremost. Call me old fashioned, but the casino banking of “lets place our bets” (of course with other people’s money) is now the vogue.

I submit that on the strong foundations of the fiduciary relationship sits a solid and sound banking system. Until we understand this, we are just tinkering around the edges.

Professors Kevin Dowd and his co-author Martin Hutchinson remind us of the partnership roots of banking and how this kept bankers from being too risky, and focused them on the long term needs of their clients, to whom they had open ended liability. Fiduciary or not, this forced honesty in the system.

A fiduciary duty is a legal relationship between one party, the principal, who is dependent on the better knowledge and judgement of the person he trusts, the fiduciary. This relationship exists between the doctor and the patient, the teacher and the student, the lawyer and his client, the accountant and his client and yes, the banker and the client. A fiduciary duty is the highest form of duty for you to dispense advice, offer services and do business. Your clients’ interests are above your own. You must avoid conflicts of interest, and you must only profit from your transactions so long as your client is aware of this. This is contrasted with the ordinary tort duty of care required when individual parties act only to avoid harm to others.

When you deposit your life savings with another party such as a bank, you are not requiring just reasonable tort standards of care, but absolute standards of car, i.e. fiduciary standards. Nothing can replace lost savings set aside for retirement. The banker has an enduring obligation of fiduciary care.

Now, in a modern bank from the very outset we have confusion. Its raison d’être, after providing safety for your money, is to offer to intermediate deposits to pass them through to where they are demanded, to willing borrowers of the bank. We are told by the majority of our bankers that the money in those deposits is ours. In reality, as recognised by law, a deposit is a debt from the bank to the depositor. This comes as a surprise to most, as evidenced by our Cobden Centre survey on banking. Some would say that this is fraud. I would say this is negligent misrepresentation. The latter requires only a false statement of fact being made to induce a party into a contract, which I submit is what actually happens when you go to open a bank account. Most offers of opening a bank account make no reference to the fact that you are becoming an unsecured creditor to the bank. This is a critical point, as most people are very shocked at this revelation. I am amazed that even after the total collapse of the banking system, the majority of people still think that their money is in their bank (and safe!). We have discussed on this web site before how there never is any mention of what you are actually legally getting involved with when you enter into an act of depositing or savings with a bank.

A group of us have tried to make matters very simple and clear up this confusion by supporting this Bill in Parliament. By requiring a distinction between deposits for safe custody and deposits for lending, we have cleared up some confusion in the banking system and laid the foundations for a solid system to grow and flourish.

The banker as fiduciary can then act in your best interest with your money kept aside for safe keeping and instant access, and investing the money you have allocated for lending, thus earning you interest. An honest fiduciary would then advise you according to the time-frame you choose for the investment, and your appetite for risk. You could invest in different parts of the bank to reflect this time and risk profile. At all points in time the bank could pay its safe-keeping deposits out, as they sit in the vaults as cash. Should some of the assets of the banks (the loans) turn bad, it is the liability of the partners, not the current account depositors, still less the taxpayers.

A fractional reserve bank, be it state-supported as they are today, or even a free one as some readers of this site advocate, could never guarantee this all the time. Thus they are immoral and thoroughly dishonest if tested under the fiduciary standard. A fractional reserve free bank could well exist with full disclosure as to the nature of the arrangement, but I would suggest this is not a fiduciary relationship. It implies reasonable standards of care, not absolute standards. This must be the case as the fractional reserve free banker can never say to you with certainty, “you can have all your money back when you demand it”. Only the fiduciary 100% reserve banker can. A fractional reserve free banker can say “with the law of large numbers, I am pretty sure I can guarantee you your money back, but never all of my deposits at the same time”.

That may well be fine for large numbers of people. Not for me. A humorous look at the mislabelled “Fidelity Fiduciary Bank” in Mary Poppins reveals the inherent contradictions. A boy does not want to deposit his tuppence, preferring to spend it on feeding the birds. The bankers attempt to persuade him to part with the money, eventually grabbing it from the boy. Other customers are concerned, and demand their own money back, with a chain reaction leading to a run on the bank.

To found a system of money and banking on such fragile foundations does seem insane to me. As I have said, the first step is to clarify the law with regards to the legal status of the banker and the client.

The establishment of the banker as a fiduciary is the next step in the reform process. This does not mean a banker can never earn anything other than a wage, like a law firm or an accountancy firm. They can always run their business in the most efficient manner, and thus profitably. They would only be forbidden from profiting at the expense of their clients.

Address these issues and we may well move towards an unregulated and honest money-orientated banking system that is wonderfully boring and fit for purpose. I see nothing in this Report that addresses those issues.

“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
15 April 11 | Tags: Banking, Honest Money | Category: Economics | 24 comments

Economics

Detlev Schlichter: Don’t believe the hype! Why the ECB rate hike doesn’t mean anything.

By Steven Baker MP, on 14 April 11

Let us establish some principles first. Central banks do indeed pose a risk to economic stability but not because their monetary policy is constantly too tight but because is it systematically too loose. Inflexible commodity money – such as gold and silver – has everywhere been replaced with state-issued fully flexible paper money under the control of central banks for one reason and one reason only: so that the supply of money can be constantly expanded in accordance with politically defined goals (such as a certain growth rate, a certain inflation rate, a certain unemployment rate….and constantly expanding bank balance sheets). Today’s consensus believes the following: When inflation is low and thus not an imminent threat, the central bank should ‘support’ economic growth via low interest rates and a moderate expansion of the money supply.

Wrong.

This is precisely the dangerous fallacy that made the dramatic events of the past four years ultimately inevitable. Yet, nobody seems willing to learn the lesson.

Constant expansion of the money supply and the persistent lowering of interest rates below the levels that would be justified by available savings – the raison d’etre of paper money and central banking – lead to misallocations of capital. Always. This – and not higher consumer price inflation – is the most immediate negative effect of monetary expansion. Today’s consensus is, sadly, still obsessed with CPI inflation (CPI= consumer price index). As long as monetary expansion doesn’t lead instantly to a higher grocery bill, the mainstream considers it a welcome boost to growth and practically a free lunch. This is a gross misconception, and this misconception is in essence still behind most of the commentary on monetary policy today. And it was again on display in the debate about the ECB’s recent move.

You can read Detlev’s superb article in full here but beware: he believes “that a collapse of the paper money system is practically inevitable”…

Economics

From Lombard Street to Easy Street

By Tony Greenham, on 25 March 11

The old adage about how to succeed in banking was the formula of ‘3-6-3’: borrow at 3%, lend at 6% and get onto the golf course by 3 o’clock. Oh how quaint and distant such times feel to us now, with the economy still suffering from the fall-out of a banking crisis for which no-one involved seems particularly willing to accept responsibility.

What would be the modern banking formula? It seems more like 0-15-7 – get money for almost nothing, lend it at double-digit rates (in all probability with nasty conditions attached) and trouser your 7-figure “performance-related” bonus at the end of the year. To those of us who have attempted at any point to earn a crust entirely off our own bat, the self-delusion of senior bankers who describe themselves as ‘entrepreneurs’, ‘risk-takers’ and ‘wealth-creators’ would be laughable if it were not so costly to the real enterprise economy. Reward and risk are supposed to go hand in hand – this is at the heart of capitalism. Banks reap the profits but are protected from losses by the broad shoulders of the taxpayer.

But then banking is anything but a normal and competitive free market. The bailout demonstrated this to dramatic effect – Woolworths can disappear from the high street almost overnight, but RBS cannot. But the problem runs deeper than the damage inflicted on taxpayers by the bailout and the impact businesses and workers by the credit crunch and recession.

Banks make too much money. Banks need to earn a reasonable return on capital, but in a recent report ‘Featherbedding Financial Services’ we at nef (the New Economics Foundation) set out several ways in which banks profit excessively at the expense of taxpayers, customers, investors and corporate clients. This allows them to be relaxed on costs, indifferent about customer satisfaction and yet still enjoy margins that would make a manufacturer or a retailer blush. This is bad news for the broader economy. Banks’ profitability has more than doubled and has outstripped non-financial sectors since the 1970s. Why?

To start with, being “too big to fail” is profitable. Based on calculations by Andrew Haldane, the executive director of financial stability at the Bank of England, we estimate the value of this subsidy to UK banks to be around £30bn a year. The subsidy arises because banks, effectively guaranteed by the government, are able to access much cheaper funds than would otherwise be the case.

But this is far from the end of the matter. We also identified windfall profits to banks from the additional trading in gilts required by the Bank of England’s programme of quantitative easing. This is ironic to say the least, as QE was brought in to revive the economy after the banking crash.

Customers are proving a good source of extra profits, too. The interest spread – the difference between the interest rate that banks pay for funds and how much they charge us – has widened dramatically since 2008. Although perhaps too narrow before the crash for some forms of consumer credit, this suggests that the burden of rebuilding banks’ balance sheets is falling disproportionately on customers instead of shareholders, executives and bondholders. SMEs are all but priced out of the market for credit – no wonder many do not even bother applying for a loan.

Investment banking is also something of a cosy club of financial returns wildly out of kilter with real economic contribution. Institutional investors and corporate customers are getting a raw deal. For example, in the case of rights issues we identify a near trebling of investment banking fees since 2000, having been at a steady level for decades. This has reaped an additional £1bn in fees just through a rise in commission rates.

Reform is desperately needed. Until we see genuine competition, and some customer power, in retail and investment banking, and until incompetent and failing banking institutions and executives are guaranteed to suffer the same fate as they would in any other sector of the economy, our banking industry will be a drag on the UK’s prosperity.

Economics

At the ASI: Mervyn King and narrow banking

By Steven Baker MP, on 9 March 11

Via Tom Clougherty at the Adam Smith Institute, Mervyn King and narrow banking:

Ultimately, the problem with modern banks is that they do not operate in a free market. They haven’t done for decades. Deposit insurance means depositors take no interest in the stability of the banks they give their money to. The inevitability of bailouts means bondholders and shareholders take no interest either. Expansionary monetary policy encourages banks to lend too much and reserve too little. Accounting regulations encourage all banks to invest in certain asset classes, ensuring that when problems emerge, they are likely to be systemic. All of these things are government interventions, and all of them make the financial sector more risky and less stable.

Economics

My Journey to Austrianism via the City

By James Tyler, on 4 March 11

Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.

I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.

I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.

I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.

I am a trader.

I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.

I eat what I kill.

Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.

Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.

I make money work.

I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.

My analysis was steeped in the neo-classical, efficient markets paradigm.

Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.

Credit flowed, people got wealthier, economies developed and all was well.

And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”

Economics

News from Korea: Bank run fears engulf savings bank industry

By Steven Baker MP, on 19 February 11

With a hat tip to Sean Corrigan, via the Korea JoongAng Daily, we learn that their savings industry has been engulfed by a panic:

More than a thousand customers lined up in front of the Busan II Savings Bank located in Busan yesterday as soon as the nation’s financial regulator announced a six-month business suspension of Busan Savings Bank and its affiliate Daejeon Mutual Savings Bank.

The line formed by depositors extended about 100 meters (328 feet) from the door of Busan II Savings Bank. “You won’t be allowed to withdraw your money if you are just standing there without a queue ticket number,” a bank employee told the crowd using a microphone.

Those without a ticket then headed to the automated teller machines to withdraw their money, but the machines quickly ran out of cash.

Read the rest of the story.

Bank runs are only possible because banks, uniquely, operate in an environment of unconventional property rights, supported by central banks and the socialisation of risk. I explain further here: The legal nature of banking contracts.

What to do about it? Here are ten plans for reform.

Economics

The importance of traders and the evils of bankers

By James Tyler, on 18 February 11

Another classic article from James Tyler, brought forward

Trader: One whose business is trade or commerce.

Trade and commerce is the lifeblood of wealth creation. Without specialisation and exchange, we would all starve. You have oranges, I have apples. Individually we are bored, together we have a fruit salad.

For specialisation, exchange and commerce to work its magic, firstly we need some common ground: a market. Now, mention that word to a Socialist, and he starts to froth and foam at the mouth. The evil of markets, how the market forces this and exploits that, blah blah.

Unfortunately, they are confused. You see a market is just a bit of space, physical or virtual, where people who want to buy meet those willing to sell. That’s it. It has no power of its own. No influence. No horns and a pointy tail.

However, badly aimed as their invective is, they do have a fair grievance lurking in those passionately beating breasts. What they are trying to say is that they object to those who have power in a market. Who wields the power in a market, and where does it come from? That is a fair question to ask.

I contend that power always comes, ultimately, from Government. They hold the monopoly on power, they set the rules, and their arbitrary decisions can mean life or death for any businessman taking a risk. They get the keys to the gun cabinet.

Markets and traders

Only loons attack commerce between good old wholesome types looking to exchange the hard earned fruits of their labour for other stuff they need: I exchange my apples for your oranges.

Unless, that is, you want pears. The free interaction of people that is the market decided on a clever mechanism to get around this problem. It created an intermediate commodity called money.

Money is just a commodity like any other. The free market chose something that was durable, portable, respected, and consistent. The free market originally chose gold and silver as money, and gold remained money until governments came along and nationalised then destroyed it. Money now is a fraud – the greater fool theory of acceptance only because somebody else will too.

The creation of money was a fantastic innovation – a neat solution to the problem of the double coincidence of wants… or rather what to do when there wasn’t a coincidence.

But what happens if an orange farmer wants to sell next year’s crop now? Maybe there is a great demand for oranges and the farmer has cultivated trees to meet the demand, but does not want to take the risk of a craze for plums depressing the demand for oranges. A consumer of oranges may only want to buy what he can pick up and select. A grocer may not want to tie up his cash in something so far off into the future.

What is needed is someone in the middle. Someone willing to guarantee a price for those oranges now, take them in the future and then sell them on when they are needed. This is where the speculator steps in and provides a vital service.

Ahh… the evil speculator, now there is a ripe target!

How can somebody who produces nothing, does not employ physical labour, and does not reorganise the factors of production, be in any way productive in society? Off with their heads!

Speculator: one who speculates on abstruse or uncertain matters

The key is uncertainty. The future is not known; if it was, then the central planners might stand a better chance. But the future peculiarities of individual desires and wants can never be known, so there are always highly uncertain outcomes inherent in planning for the future. The world is too complicated to simplify into maths or bureaucratic diktats. The risks are too great and the mistakes too expensive. What we need is a mechanism to attempt to put a price on future outcomes. We need to “crowd-source” the answer to the problem of resource allocation. And, that’s what speculation is…

I risk my own shirt to take on risks that others do not want. I’m proud to say I speculate. I speculate that I will be able to find another buyer for those risks at a future point in time, and then I charge a fee for my services.

Some say that this is making money from nothing, but I say I provide a service to the world in smoothing out the jagged pointy edges. If things go wrong, I will have to pay the price personally.

The act of speculation is important in the signals it sends out. If prices rise, it signals a shortage which stimulates extra production to satiate demand. Or if the speculator successfully sells short some shares, the falling price will send out a signal that not all is well with that company.

Let me quickly clear a couple of things up …

Markets are not efficient

This is a stupid, indefensible idea peddled by neo-classicist eggheads. Information is often wrong and therefore people err. Mistakes are made, but I contend that the mistakes made by crowds are much smaller than when Government gets its grubby hands on a ‘problem’.

Markets work in waves and ripples and patterns, not aggregates, averages and efficiencies

Early adopters get rewarded the most; late arrivers are penalised. The crowd sometimes gets carried away, and prices rise too much or fall in an unwarranted way, but by and large, when not unduly influenced by power, markets are a remarkably efficient way of making a myriad mind-numbing decisions that all hang together. Markets are smart in the way a regulator can never be.

Short Sellers

Secondly, I want to sing the praises of those great unsung heroes of stock markets: the short sellers.

Selling short is the process of selling something you do not own, in order to profit from a fall in prices, then buying it back at a lower price.

Short selling is a dangerous game. You are hated by all and sundry. Governments, regulators, corporate bosses, and fat cats. Everyone, it seems. You are always at risk of being targeted for a ‘short squeeze’. But short selling is vital for two reasons:

1) Buyers need a seller to buy from.

If you want to buy some shares – who do you think it is that will sell them to you?

It’s not usually an investment fund, or a pensioner, or your mate. It’s the ‘market’, and it is more than likely that the person you bought them from will not own them, but will scrabble around for the rest of the day trying to find them a penny cheaper. Can you be bothered to do that?

The stupidity of banning short selling is that it stops the market working – meaning that movements are likely to be bigger, and the falls greater.

2) Short sellers are the policemen of the markets – a much better (and more fearsome) regulator than the FSA.

Without short sellers, Enron and WorldCom would have got away with their fraud for a lot longer. It is a tragedy that the short sellers of banks were not bigger and better armed during the run up to the sub-prime crisis.

Don’t get me wrong, short sellers were there, playing their lonely game, but they were just too small in face of the great money/banking juggernaut carelessly careening away. Stronger short selling might have seen off the sub-prime fiasco earlier and with less pain.

As a society, we should desperately be encouraging short sellers in situations like this. Big business needs to respect the short seller – it keeps them honest. When prices are rising in a rampant fashion, usually no good comes of this. This is when we need the short seller to tame the wild beast.

Speculators do a much better job of sifting through the morass of conflicting signals to fish out the price for the best allocation of resources in a way that Sir Humphrey, sitting in an ivory tower in Whitehall, could only dream about.

So, traders and speculators are vital for a productive and fully-functioning capitalist economy. In a pure and free economy, they are a force for efficiency and part of the crowd-sourced resource allocation system.

But unfortunately, we do not have free markets

The sub-prime fiasco has shown us that markets, especially financial markets, are anything but pure. Markets are distorted by power, and it’s important to turn your swivel gun onto the source of that power….

The one thing you should always know about busts is that you can’t stop the pain at that point: it’s too late, the damage has already been done. The boom may have felt good at the time, but those tequila slammers at 2am always seem like fun. Remember the feeling in the morning. Trying to alleviate the hangover by more of the same is the action of an alcoholic. It’s the boom when assets are wildly misallocated, and that’s where we should focus.

The sub-prime crisis started with government, was promoted by government agencies, and was taken to the dizzying heights of stupidity by a banking system fuelled with masses of cheap money, produced by central banks that panicked after the previous cheap money bubble went pop in 2001.

The bankers perceived an inexhaustible supply of cash that could be lent at a profit to people who had no chance of paying back. The Mexican strawberry picker given a $750,000 loan to buy a house he could never afford to repay. A cleaner running a buy-to-let portfolio of 4 houses, with zero down payment.

What’s the problem with banks, after all, it’s a free world?

Banks are not run by kindly old bespectacled men, carefully lending money to young families to give them their first break. Remember It’s a Wonderful Life with Jimmy Stewart – the friendly banker looking after good ol’ townsfolk? Scrub it from your mind.

Banks are vast hedge funds, with vast trading floors of speculators, all doing “God’s” work, as some idiot once said.

One UK clearing bank has been described as a huge smart hedge fund, with a mediocre provincial bank bolted onto its underside. That’s probably true for all of them.

A few starters on banks:

1) They are licensed by the government. I cannot start up a bank – neither can you, unless you go through the various hoops, fires, and barriers erected in front of you. You need mountains of capital. They make it difficult to join their club.

2) They operate under a specially loosened set of accounting rules.

Normally, companies are required by accounting rules and law to make sure they provide for their liabilities as they fall due. If you order a load of gear on credit, you have to show that you have the ability to pay for it – and pretty rapidly. Companies are expected to make their creditors ‘whole’

Look at the accounts of Vodafone and in their balance sheet they have to provide for ‘current liabilities’ and ‘long term liabilities’, but not so for a bank. Banks get away with a broad ‘liabilities’ section, with no attempt at sorting near term risks from long terms assets. It doesn’t matter whether they owe money tomorrow and are due to cover it in 5 years time.

3) Banks thrive on red tape, loopholes, fuzzy wording and obfuscation

For instance, 75% of people in this country believe that when they place their hard-earned money in a current account, it remains their money. It most emphatically is not. You hand your money over, and you get a promise. Well, I say promise, but the bank goes to great lengths to hide this fact. You are given a statement, which shows your money proudly sitting there, waiting for you – all safe and sound.

Except it’s not.

It is being lent out to Dubai World! Or passed onto the trading floor, and being pushed into Alphabetti Spaghetti Derivative Hooplas, funnelled into their massive casino operation.

Even though you might spend it tomorrow, the bank will not have your money. If you want it, they have to get it from somebody else’s account, or go onto the money markets and borrow it.

4) A bank is an operation designed to make profits from money that is not their own.

When you put your Tesco’s money into a bank, you are investing in a hedge fund, except you don’t get any of the profits. If it all goes wrong, as it did in 2008, then the taxpayer pays for all the losses.

Even in the good times, the taxpayer insures deposits (explicitly or implicitly), leaving the banks free to gamble away. Does this seem like free market capitalism to you?

What is the problem with this, after all, it’s a free world?

Well, it’s not. As I said before, banks operate with privilege and monopoly rights, with taxpayer backing. And we can add a final potion into the mix: incentive and liability

The sub-prime crisis cost Wall Street and the City trillions, or rather it is costing taxpayers that much. If I lose money, I remortgage my house; otherwise I don’t come back.

When Goldman Sachs put all its eggs in the AIG basket, they should have received a bloody nose – at the very least. Yet uncle Sam paid them out 100c on the $ and Goldman scored a slam dunk. God’s work, eh? A miracle indeed.

A trader called Howie Huber recorded the single biggest loss ever at a bank. He cost Morgan Stanley over 10 billion dollars, but he got to keep the 24 million dollar bonus he earned the year before.

Dick Fuld at Lehmans faced some devastatingly hard questions from some horrible congressmen, but retired a very rich man.

It was the taxpayer who paid the price. Private profits and socialised losses – emphatically NOT what I’d call free market competition.

Now I don’t mean that we should round these guys up and shoot them, or even take their bonuses back – they signed contracts, and we respect the rule of law, and contracts. It’s the basis of our freedom and we risk tyranny if we selectively choose to violate these rights.

We have to recognise that bank traders get a free option. You can bet it all on red or black: win, you get a bonus. Lose, you may lose your job – but then probably use your ‘reputation’ to walk into another one.

The system is wrong, and something must be done about it.

In terms of dealing with the crisis we have to understand that damage is done before we are aware of it. In the sub-prime crisis, it was done in those happy days of 110% mortgages, up front discounted rates, and more freshly printed money than you know what to do with. We were killing our economy with cheap money love.

When gravity asserted itself, and the inevitable bust came we faced a simple choice: take the pain, or hide it.

In 1982, 100 Keynesian economists wrote a letter to the times saying that the government’s economic policies were suicide. It’s a bit of a coincidence, then, that that was the exact moment the real economy started to grow. Time and again, history shows us that if we take our medicine early, we get through the illness quicker.

Or we could take the Japanese/Keynesian approach, and hide it with fiscal aggregate kabalah nonsense. And lose twenty years in the process

But banks.. what should we do with them?

Some suggestions:

1. Firstly, banks should not speculate with your beer money – unless you understand this, and you explicitly sign it off.

2. Banks should be audited as strictly and as thoroughly as normal companies are – no favours.

3. Banks should legally have to provide for liabilities as they fall due – as every other company should.

4. Banks should offer accounts that are 100% reserved. That is where your money is kept safe, not used to speculate – and it remains your property.

5. Speculation should be undertaken by hedge funds and specialist trading groups, not by deposit-taking institutions, or by the likes of Barclays, that can borrow money from the Bank of England at 0.5% and walk over to the craps table.

6. Anybody, or company, that offers fiduciary advice should face 100% liability in case it goes wrong.

And most importantly,

7. Any person paid more than a certain amount by a bank, should be liable when things go wrong.

The contract that Dick Fuld signed should have meant he lost his house when he crashed Lehman’s. Howie Huber should now be serving Big Macs. And Lloyd Blankfein should be a little more circumspect when talking rubbish about doing God’s work.

God is watching you mate… be careful.

Economics

The corporate virtue of bankers

By Jamie Whyte, on 16 February 11

Senior bankers make a lot of money and take a lot of risk. This combination strikes most commentators and politicians as revealing sad failures of personal morality and corporate governance, failures that must be rectified by the regulation of bankers’ pay. They are confused.

The principle challenge of corporate governance is to align the managers’ interests with the owners’. A simple way is to make managers owners too, by paying their bonuses in company shares. Yet this is an imperfect solution, because it fails to give managers the same “risk appetites” as other shareholders.

Few of a company’s shareholders are investors in that company alone; most hold a diversified portfolio of stocks. Provided these stocks are not perfectly correlated, the volatility of the portfolio’s value is lower than the average of each stock’s volatility. When held in such a portfolio, the optimal volatility of each individual stock is higher than it would be if held on its own.

The risks of company managers, by contrast, are concentrated in the firm they work for. Not only are they partly paid in its shares but, if the company fails, they lose their incomes. A company’s managers are therefore more risk averse than its owners, even when their bonuses are paid in shares.

This fact helps to explain the high salaries, huge bonuses, “golden parachutes” and other elements of “fat cat” compensation that outrage the popular press. They are designed to relieve corporate executives of their natural caution and bring their risk appetites up to the level of the other shareholders’. Contrary to popular opinion, it is low paid and risk-averse bank managers that would represent a failure of corporate governance.

But surely, some will protest, the financial crisis shows that bankers took too much risk. It does not. Shareholders of a limited liability company enjoy an asymmetric exposure to its performance. If it does well, there is no limit to how much their equity can appreciate. If the company fails, however, the most they can lose is what their shares cost to buy. This means that shareholders benefit from risk.

A simplified example will make this clear. Imagine you are a shareholder of a firm with a leverage ratio of 10:1. If the assets devalue by 10 per cent, you lose all your equity. However, if their value increases by 10 per cent, you double your money. If the probability of each outcome is 0.5, your equity is worth 1 (=2×0.5+0×0.5). Suppose the firm now increases its risk by taking its leverage to 50:1. If the assets increase in value by 10 per cent, then your equity is worth 6. If the assets decline in value by 10 per cent, then your equity is again worth nothing. The expected value of your equity is now 3. The extra risk has made you better off.

Why then do companies not increase their risk ad infinitum? The answer is that they are prevented from doing so by their creditors. Because a firm’s creditors do not participate in its profits, they gain nothing from its extra risk taking. On the contrary, the more risk the firm takes, the less likely its creditors will be repaid and, hence, the greater the “risk premium” they will charge for their lending. It is the increasing cost of borrowing that constrains corporate leverage and other risk taking.

This market mechanism breaks down, however, when the corporates concerned are banks, because lending to banks is made (almost) risk free by government guarantees. These guarantees are explicit in the case of “retail deposits” and unstated but dependable in the case of “wholesale” bank creditors.

Since 1988, 28 of the world’s largest 100 financial institutions have failed. This equates to a 1.3 per cent annual probability of default. Nevertheless, the top 100 banks have enjoyed an average credit rating of A+, which corresponds to a 0.05 per cent annual probability of default. This apparent anomaly is easily explained by the fact that in only two of these 28 cases of bank failure did the national government allow creditors to suffer losses.

By eliminating the normal “risk premium” on bank debt, government guarantees subsidize bank risk-taking. A bank that took so little risk that it was no more likely to default than the government could borrow at the same low rate of interest even without the guarantee. Its managers would effectively be rejecting the government’s offer of a subsidy. By contrast, the greater the risks taken by a bank, the greater the subsidy it extracts from the government guarantee.

If the virtue of senior bankers’ is still not clear, imagine two tobacco companies, Holy Weed and Noxious Weed, both eligible for government subsidies of tobacco production. Whereas the CEO of Noxious Weed accepts the subsidy, Holy Weed’s CEO rejects it. Who has been irresponsible?

Perhaps the CEO of Holy Weed has performed a public service, but that is irrelevant. He is not a public servant. He is responsible not for public welfare but for the welfare of his firm’s shareholders. Rejecting a subsidy would be a dereliction of that duty, since it would drive down the value of Holy Weed shares.

Similarly, a senior bank manager who refused to take government subsidized risks would be derelict in his duty to his shareholders. It should surprise no one that banks whose senior executives had the greatest shareholdings also took the greatest risks. The bankers who “brought the economy to its knees” were only doing their job.

Economics

The violation of Mr Smith

By James Tyler, on 15 February 11

Forty years ago today, Britain moved to decimal currency. A 1971 penny was worth the equivalent of today’s 10p. In recognition of this dramatic debasement, and its devastating effects, we are bringing forward this classic article, originally published in December 2009.

Mr Smith works hard, plans carefully, and saves what he can, putting his money into a building society. He pays his credit card bills off each month, and tries to overpay his mortgage when he can.

Mr Smith got a 3% pay rise last year – inflation was only 2% – so he felt good about that. But… he doesn’t feel any wealthier.

Year after year, the government had said that the economy was growing strongly, but still, things seemed harder for his family and him. Train ticket prices up again. Heating bills rocketed when the price of oil went up, but never seemed to come down. He swears a loaf of bread and a pint of milk were much cheaper in years gone by.

When he changes his cash for Euros, he realises that his holiday in France is now unbearably expensive. His tax rates didn’t go up, but still, after all his bills were paid, he seemed to have less and less spare cash than he remembers a few years ago.

There are Mr Smiths everywhere. Careful folk, who plan, save for a rainy day and have a sense of personal responsibility.

Smith is the target.

It is Mr Smith who is going to pay for the banking crisis.

His saved wealth will pay the national debt.

His prudence will bail out Gordon Brown’s profligacy.

His forgone holiday will pay the banker’s bonuses.

His careful spending will pay for the vast number of quangos.

His financial planning will bail out the failed NHS computer project, over-budget military programs and ID cards.

His sense of responsibility will end up funding the destruction meted out in Iraq and Afghanistan.

It won’t be the politicians or the bankers who pay for global warming – he will.

He knows he pays tax… but what is hard for him to comprehend is that there is another pernicious process draining his wealth and subverting his hard work towards paying for the misjudgement of others. Whether he likes it or not, he naively pays for the decisions made by the political class.

He has no choice. No option. He was never asked to vote for it. And for the most part, the act of theft is so subtle he doesn’t even know it is happening.

Why does he feel poorer?

Why is it that Mr Smith seemed to miss the ‘boom’, yet is hurting more in the bust? Why doesn’t life get easier for him? What is going on?

Inflation.

As technology produces things more cheaply, Mr Smith should have been able to reap the rewards – except that things don’t get cheaper for him. Society cheats him when the government opens the spigot of new money, washing this value away as the torrent of new money chases prices higher beyond his reach.

The winners are always those close to the gusher – the banks, financiers and politicians. These are the ones who get to spend the new money first, thus chase prices up before Mr Smith gets any sniff of what is happening.

To save or to invest?

Think about your personal circumstances. Every time your payslip comes in, you have a choice of how much to spend and how much to save. Every rational person knows that there is a balance to be struck between current enjoyment (consumption) and future enjoyment (savings – or deferred consumption).

This choice is exactly the same for society as a whole. As a country, we must decide how much to consume, and how much to defer consumption in order to allow our children and us to enjoy things in the future.

The choice for us all is simple. Defer consumption and invest for the future, or consume and enjoy now.

What is the process by which we save for the future? There are two ways.

Voluntary saving. If society needs to invest for the future, but people prefer to consume, then the savings rate – the profits paid on investments and/or the interest rate paid on deposits, rises until people choose to defer consumption and invest.
Forced saving. Government policy forces a decrease of the purchasing power of money via inflation of the money supply. The net effect is a transference of wealth from savers and fixed income groups towards net borrowers (itself included). It also creates an artificial pool of liquidity into which the government can sell its IOUs.

The evil of Forced Saving

The natural state of affairs in a free market, with a more consistent supply of money, is that general prices fall as technology advances. The prudent are rewarded, and borrowers have to carefully evaluate and moderate their flights of fancy, only investing borrowed funds carefully in sound projects.

When the value of money declines, savers find that their money buys less, whilst borrowers are happy to find that they can repay their debts with money of a decreased value. It’s like borrowing five books from the library and finding that you are only required to give four back!

By setting a target for rising prices and then pulling levers to increase the supply of money in the economy to achieve it, the government prevents the natural response of general prices to competition, increased efficiency and innovation: they stop prices from falling.

Entrepreneurs, innovators, inventors and new businesses exist because they believe that they can satisfy society’s wants better than they have been served before. They have ideas, innovations and take risks in order to provide goods that are cheaper than they otherwise would be. Businesses operating in a competitive environment always seek to reduce costs, be that one step more efficient and produce a cheaper or better widget. As group of people, entrepreneurs bring efficiency and innovation, and they make stuff cheaper.

The benefit to Mr Smith should be that his income goes further. As time progresses, technological innovation should mean he can buy more with the same cash. But that’s not what happens, as any pensioner knows. Saved money buys far less now than it did at the time it was saved.

Governments achieve rising prices by encouraging the supply of new money. This new money comes from the central bank via its control of the banking system. The first users of this new money are invariably politicians, finance capitalism and big business. These guys get to use the newly minted money first, and thus spend it first. This process bids up prices, leaving everyone else chasing behind, and poor old Mr Smith last in the queue.

What an evil system it is then, when government can control money in such a way as to give it a first user advantage that penalises all those in the general population whose wealth is being rapidly diluted. A process that systematically violates and loots pensions, savings, fixed incomes and the actions of prudent, and rewards the profligate, the speculative borrowers and above all, rewards the biggest borrower of all: Government.

Let’s be clear. The current system is a process that diverts the benefits of innovation and technological advancement that should accrue to the general population, and thrusts it towards the desired spending of the well connected and the political class.

We need to stop this continual violation of the little man. Mr Smith has to start realising what is happening to him.

That’s why I’m proud to support the efforts of the Cobden Centre.

The Cobden Centre

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