July 22, 2008 | posted by Michael Baxter in Banking |

If you want to know why we have booms and busts then you can do a lot worse than look at that familiar ape -like creature called us. We overreact. When markets boom we jump on, and a kind of mass exuberance exaggerates the boom. When markets tumble, we go the other way.

In his book, Age of Turbulence, Alan Greenspan put it this way: “History is replete with waves of self-reinforcing enthusiasm and despair, innate human characteristics not subject to learning curves.”

Sometimes people emerge with sufficient vision to spot the madness for what it is. Joe Kennedy, father of the late president, famously sold his stock on the eve of the 1929 crash after a cab driver asked for his advice on what stocks to buy. In doing that he proved his shrewd mind.

Sir Isaac Newton was not so astute. He may have been one of the cleverest men ever to have come out of Britain, but he forgot his own laws, and lost a fortune as a result.

When the South Sea Bubble was in full swing, Sir Isaac had one of his sitting under the apple tree moments. “This market has risen too high, it’s bound to fall,” he reasoned. So he sold out. Then he had a change of heart, bought back just before the market imploded. He lost £20,000, a fortune for those days, and is reported to have said, “I can calculate the motions of heavenly bodies, but not the madness of people.”

Yet sometimes the madmen can prove to be quite wise.

When shares in Northern Rock tumbled, many thought they saw a buying opportunity and leapt back in. But, as you know, things just got worse. It was a similar story with Bear Stearns, and more recently it happened with the collapsed US bank IndyMac. Sometimes a seemingly mad sell off can be based on good logic.

So judging madness from intuition can be quite difficult. Which just goes to show it is probably impossible to call top and bottom. And it is impossible to judge investment decisions right each time, but the key lies in being broadly right. Buy when it appears markets have hit bottom, and if they carry on falling, well, in a few years’ time your decision will still probably look quite clever.

So, have bank stocks been oversold?

One would have thought that Dresdner Kleinwort and Morgan Stanley were switched on to be able to identify true value. Presumably they had a good reason to underwrite the HBOS rights issue last April; they clearly thought the rights issue share price was as safe as, well, as safe as houses.

Yet, in the three months or so that followed, the share price halved, and the two underwriters were left nursing their commitment. Did they mess up? Or are they left holding shares that may prove to be very valuable in a couple of years’ time? After all, with another £4bn in the coffers, one assumes HBOS is well placed to exploit the opportunity that is opening up.

As for Barclays, its efforts to raise money at a time of such troubles left overseas investors thinking they had spotted an opportunity. And now the Qatar Investment Authority has a 6 per cent stake in the bank, another Qatari investment vehicle a further 2 per cent stake and the Japanese bank Sumitomo Mitsui a 2.1 per cent shareholding.

For years Britain was on the receiving end of cheap credit from abroad. Cheap credit that helped fund a massive deficit in our current account. But now it is a different story. Britain is going cheap. In the longer term this may well lead to big dividend flows out of Britain that could lead to structural weakness in the pound.

But maybe we should look to private equity for a hint as to how close we are to bottom.

Recently, TPG couldn’t get away from Bradford and Bingley’s fund-raising efforts fast enough. But according to this morning’s FT, private equity outfit Blackstone is looking to buy buy-to-let mortgage specialist Paragon.

Blackstone had the sense to float on the New York Stock Exchange last year before the credit crunch crisis erupted. It also received a healthy dollop of funds from China too, but this was before the great crash in asset values, so it got a nice price for its stock. So, presumably, it’s got a lot of dough in the coffers.

So there is no shortage of shrewd investors who reckon banking shares have fallen too far. They may well be right, but when madness gets a grip it can take a long time before correct valuations become clear. They may yet have a long wait before banking shares reach anything like the highs seen a year or so ago.

It’s a promising sign that Blackstone has seen potential in a mortgage lender, but don’t expect this to represent the end of the financial shocks. When markets are correcting it can take a long time before we finally rid ourselves of the need for an asylum.