October 2, 2008 | posted by Michael Baxter in Banking | comments (1) |

You know what it’s is like arguing with a child.  You say,  ‘yes, you must,’  and then the child replies  ‘no, no, no.’  So you say,  ‘yes, yes, yes, yes,’  and the  ‘no’s  get louder and more frequent,  and then you end up threatening to take toys away from the child. Eventually,  after a cool off period,  in which the child is sent to bed,  you get your own way,  or at least,  sometimes you do.

Last night,  senators voted to accept the Paulson plan.  This time they voted 74 to 25 in favour of the plan.  Here is the curious bit,  the plan wasn’t changed by that much,  the only really significant change is that it has got more expensive.  And yet,  somehow it is thought this time it will get through.  Friday night is when we will know,  that is when the House of Representatives votes.  Last time it was 228 to 205 votes against.

 The consequences if the plan was voted down would be disastrous for the markets of course,   a negative vote would lead to massive falls on stock markets across the world.

So these are the changes to the Paulson plan,  and this is what is wrong with them.

First off,  the maximum guarantee for money on deposit is being increased.  Now,  you can have up to $250,000 on deposit in the US,  and if the bank goes bust,  your money is still protected.

Secondly,  there are going to be changes in tax breaks for US companies and individuals using renewable energy.  Just re-read that.  The Paulson plan mark 2,  designed to save the global economy from a catastrophic banking meltdown,  will include tax incentives to invest in renewable energy.  Now there is nothing wrong with the idea per se of tax incentives to use renewables,  but it is not exactly relevant,  is it ?  So the child won’t go get off the swing at the playground and you offer to buy her a milk shake if she does.

The plan will also see one year’s worth of extra relief from what’s called the Alternative Minimum Tax.  This scheme was supposed to tax higher income earners more heavily,  but due to inflation was hitting more people than originally intended.

The new plan is also supposed to put curbs on executive pay.

But really,  it is just tweaking.  This is a plan that was supposed to save the universe, and its modifications are really not significant.  Well,  they are significant in one way.  The original plan was 4 pages in length,  the revised plan 451 pages.  So,  at least US lawmakers are getting more reading matter for their money.

George Dubya is doing his best and has been getting on the blower, ringing Republican members of the House of Representatives,  and the salesmen reckons he has already got four more votes.  No doubt,  he has got some hot leads too.

One snag is that while both Republicans and Democrats are against the plan,  they are largely against it for different reasons.  So changes designed to appease some, may antagonize others.

Yet here is the odd thing.  The biggest worry with the first plan was that it was so expensive - $700bn.  The new plan will be more expensive.

But the fundamental problem is this.  It is still the wrong plan.  The Paulson plan still amounts to little more than a bigger version of all those others plans that were implemented to save banks in the early 1980s and 1990s.  View those previous plans from a longer-term point of view,  and it appears they have not been successful at all,  because surely the roots of this crisis lie in the solutions to the last crisis.

To work effectively,  capitalism needs failure.  You need to get rid of the dross,  and let poorly run businesses fail.

The snag is,  that a wholesale failure of the global banking system would lead to a major economic depression with all the horrendous social consequences of that.

The right plan, would be one that sees government money used to recapitalise banks,  in exchange for equity.  The equity would come at a massively discounted price,  it should do,  you always get bankrupt stock at rock bottom prices.  The shares will also be available to the public, and sovereign wealth funds.  This plan would be the right plan because firstly it deals with the fundamental problem of solvency.

It would also be the right plan  because it punishes the owners of the banks,  and thereby makes it likely the same mistakes won’t be repeated in a hurry.

It is also the right plan because it means tax payers will enjoy a share in the recovery of the banks,  when this happens.

The reason why this eminently superior plan is not being considered is because it smacks of socialism.  But that is really missing the point. Socialism is when companies are nationalised,  because it is felt that the state should own business because it is socially just, and because the free markets can’t be trusted.  

Rather, the plan described above would just be temporary,  designed to reduce the social costs of capitalism working efficiently. Capitalism says investors in a business should be rewarded.  Because the Paulson plan does not reward tax payers with equity,  it is in fact the antithesis of capitalism.

It is as if socialism has become a naughty word - and anything that in any way bears any resemblance with that word is bad.  It is like a asking a parent what sex their child is,  and then another child who overhears the conversation sniggers because they heard the ‘s’ word.

The reason why the right plan is not being considered,  is down to semantics, and for that reason,  US Congress are making a big mistake.

October 2, 2008 | posted by Michael Baxter in Banking | comments (0) |

If you don’t think madness is rife on Wall Street, consider this.

A heated debate is raging on Wall Street over the way accountants do things.  This may not seem that serious to you,  and yet it cuts right to the heart to the matter of the credit crunch and banking bail outs.

When companies value their assets they are supposed to use something called  “mark-to-market.”  So,  if one company is forced to sell its assets as part of a fire-sale,  then all companies with similar assets  are forced to revalue them,  in accordance with this fire-sale price.

It all boils down to mortgage securities.  Their value is plunging,  because those banks that need the money desperately are being forced to sell on the cheap.  Therefore,  all banks with these types of mortgage securities have to make write-downs,  creating losses, and then creating a banking crisis.

So, all we need to do to end this financial crisis,  is let banks put a more sensible value on their mortgage securities.

But here is the snag with this idea.  Who is to say what the right value is for these assets ?

The only way you can determine the value of assets is through market valuation.  Those who want to remove this rule are somehow suggesting the markets are wrong,  and they are right.

But it is curious,  isn’t it ?  When these securities were rising in value, you didn’t hear many complaints then.

The key, though lies with transparency.  There has to be a method for valuing assets that has some basis in reality.  A move towards some other method of valuing these assets has the makings of the next Worldcom and Enron controversy.

October 1, 2008 | posted by Michael Baxter in Banking | comments (0) |

So the spivs are getting the blame again.  Several days after the government banned short-selling,  speculators are being blamed for causing another crash in the HBOS share price.

Those very same newspapers that talked up house prices shamelessly,  are,  from the warmth of their glass houses,  throwing stones at the people they claim are responsible for this crisis.

The HBOS share price went into free fall,  creating a question mark over the merger with Lloyds TSB,  and it’s all the fault of the spivs,  apparently.

This is the problem.  Lloyds TSB is offering 0.833 shares for every HBOS share,  but,  of course,  its shareholders have to agree to the deal.  But since the offer was made,  the HBOS share prices has tanked.

Never fear,  Brown is here.  Gordon Brown,  who was undoubtedly the best chancellor in the UK ever had during the ten year period from 1997 to 2007,  is going to come to the rescue.

“I am confident that the Lloyds TSB takeover of HBOS will go ahead.”

Yet, he also said this was a  “matter for shareholders not a matter for Government.”

So what a kafuffle.  If you are a shareholder in Lloyds TSB,  don’t be surprised if you get a phone call from a rather ponderous sounding Scotsman,  trying to persuade you to vote yes.  Or Maybe,  Gordon should take leaf out of the Lib Dems books, and arrange a recorded phone call.

September 30, 2008 | posted by Michael Baxter in Banking | comments (2) |

So,  when the history books describing this time are written will they really look back at yesterday’s decision by Congress as the pivotal moment?  Will the decisions of those 228 Law makers really send the global economy into a 1930s style depression?  Was this really a one off opportunity to fix the problem?

Last night,  EU Commissioner Peter Mandelson was interviewed on BBC2 Newsnight.  He said  “I feel they’ve taken leave of their senses and I hope that in Europe we will not see politicians and parliamentarians replicating the sort of irresponsibility and political partisanship that we have seen in Washington.”

And yet,  consider this.  The Paulson plan had many flaws.  There are strong arguments to suggest it was the wrong plan.  Some say,  well,  at least it was a plan.  Any plan is better than no plan.

But is that right ?

Most successful business people will tell you it is a mistake to make split second decisions. If you enter into a hire purchase agreement to buy a new TV,  you are given a seven days cool off period.  If you are buying a house,  the lawyers seem to do their best to slow the whole process down,  with their due diligence.  In business,  it sometimes feels as if lawyers call the shots – their  “moreovers”  and  ”whereupons”  can be irritating,  they can slow transactions down,  but most would agree they are essential.

Sometimes you may find yourself under pressure.   We are usually suspicious of take it or leave it deals.  Here is some advice for a would be buyer subjected to a high pressured sales techniques: walk away.  Anyone who tries to persuade you the deal won’t be available tomorrow is usually bluffing.

Now we are told we face financial Armageddon.  That it is 1929 all over again,  that yesterday’s no vote by the House of Representatives spells the end of prosperity.  That the US is a third world economy in the making.  And markets do their headless chicken impersonation.  Paulson wanted $700bn,  yesterday the US stocks markets had more than $1trillion knocked off their value,  therefore goes the argument,  Congress’s reticence has already cost more than the money Paulson wanted to spend. 

Yet,  you know that’s not true.  Markets rise and fall,  even the US government has only limited opportunities to spend $700bn.

Right now,  what is really called for is thought,  a considered response to the financial crisis.  Those who can keep their head while others panic,  should be the ones who set the pace.

Yesterday’s decisions by Congress does not spell disaster.  And this is why.

The first thing you need to bear in mind is this.  Congress acted the way it did,  yesterday because that is what the electorate wanted.  Your average US American was not impressed by the Paulson plan.  Bankers have lost the confidence of US citizens,  well they have lost the confidence of most citizens everywhere,  and this was a plan hatched by an ex banker.  Bankers failed to see this crisis coming,  and former chairmen of Goldman Sachs turned Treasury Secretary are no exception to this.

George Dubya’s loss of credibility in the US is almost as bad as the loss of credibility he suffered from in Europe a few years ago.  If George likes the plan,  it must be bad,  went the reasoning.  This point is perfectly illustrated by the comments from one US politician, comparing the argument that the Paulson plan will save the economy with claims that there were weapons of mass destruction in Iraq.

But,  set aside the emotive response,  there were major flaws with the Paulson plan.

Nouriel Roubini,  high profile Professor of economics at New York university pointed out that in an IMF study of 42 systemic banking crises,  only seven,  Mexico, Japan, Bolivia, Czech Republic,  Jamaica,  Malaysia,  and Paraguay,  saw the government purchase bad assets,  in the style of the proposed Paulson plan.  None of these seven Paulsonesque plans were especially successful.

By contrast,  the banking rescue that seems to have been the most successful – if you like the model rescue,  was seen in Scandinavia.  This saw no buyout of bad debts,  instead,  the governments in Sweden,  Norway,  and Finland,  injected capital into the banks,  and in return the governments acquired substantial equity.

Yesterday,  when it was assumed the plan would go through,  Capital Economics said  “The root of this crisis is not the lack of liquidity in that market,  it is the lack of capital in the banking system.  As it stands,  the Treasury’s plan to buy the illiquid assets on banks’ balance sheets will do almost nothing to prevent the destruction of bank capital and the resulting reduction in lending and economic activity.  We still expect the economy to endure a torrid recession over the next year,  forcing the Fed to slash interest rates to only 1.0 per cent.

“In using the government’s money to buy assets,  the Treasury will be working against the leverage on banks’ balance sheets.  What the Treasury should be doing is working with the leverage,  using its money to inject capital directly into the banking system.”

Mr Roubinu,  perhaps one of the biggest critics of the Paulson plan said  “the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification.  This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer - the common and preferred shareholders and even unsecured creditors of the banks.”

The big snag with the Paulson plan,  of course,  as was pointed out here yesterday,  is that it is based on the assumption that mortgage debt is undervalued.  The Treasury was in effect supposed to second guess the market,  buy assets on the cheap and sell them at the market price down the line.

But supposing Paulson estimate of the true value of debt was wrong.  His plan mounted to little more than asking tax payers to fund speculation.

This is what we know.  The global finance sector is in crisis.  The last few days has seen two of the largest US banks go down – Washington Mutual and Wachovia,  (Wachovia did not go bust as such,  it was bought by Citigroup at a rock bottom price.)  In Belgium,  within hours of the nationalisation of Fortis,  news broke that the Belgium bank Dexia SA,  the world’s largest lender to local authorities was on the verge of collapse.  In Iceland,  Glitnir,  the islands third largest bank has been nationalised.

But the underlying problem behind all of this is the collapse in house prices - around the world.  The house prices crash was not caused by the credit crunch,  the relationship is the other way round.  Implicit to the Paulson plan is assumption that house prices will stop falling – then go up,  which in turn will get the US tax payers off the hook.

But this may not be the right thing for the long-term.

The best possible solution is for all governments,  US,  UK,  and Eurozone,  to inject banks with capital - and in return acquire substantial equity.  When things recover, maybe in several years time,  government shares should then be sold.   The rejection of the Paulson plan was the right thing, because a better plan was needed, and if that takes a bit more time, then so be it.  

September 30, 2008 | posted by Michael Baxter in Banking | comments (0) |

There are some unhappy bunnies at Building Societies,  at the moment.  The Financial Services Compensation Scheme means that banks and building societies have to bail out depositors when one of the fellow banks and building societies goes bust.  That’s what happened to Bradford and Bingley this weekend. 

The government stepped in of course,  and put its money into the pot,  on the understanding it would be refunded in due course.  But,  its action came at a price.  Our venerable financial institutions have to pay the government around £450 million a year in interest payments,  and that has left our Building Societies hopping mad.

The BBC quoted Adrian Coles,  director general of the Building Societies Association as saying,  ”It is galling that those institutions that behaved prudently in the housing market upswing are now being called upon to pay some of the bills of those institutions that were far less prudent.”

It has been estimated that the UK’s 59 building societies will have to chip in £89 million a year,  and they don’t think it is fair.

You can understand where they are coming from.  Bradford and Bingley was irresponsible,  why should those who played it safe lose out ?

But consider this.  Bradford and Bingley failed because it backed the activity that stood at the centre of the UK’s own property bubble,  the buy-to-let madness.

Where were the Building Societies warnings?  Bradford and Bingley may have been the one to focus especially hard on this market,  but warnings from banks and building Societies were virtually non existent.  As such they are all slightly culpable for this disaster.  And they should all pay a part of the price.

September 29, 2008 | posted by Michael Baxter in Banking | comments (0) |

It’s a funny thing.  When Northern Rock went down,  it was as if the sky had fallen in. When it was finally nationalised,  you could barely see the faces of Messrs Darling and Brown,  so encased were they in egg.  The bank run on Northern Rock occurred when the US Treasury secretary was in Britain.  ”What must he think?” asked the press.  Henry Paulson,  the highly respected former boss of Goldman Sachs,  no less,  must have thought he had come to the wrong country,  and that he had arrived in some third world nation, not the land that boasts the so called finance capital of the world, or so went comment at the time.

Then this morning it was déjà vu.  Bradford and Bingley went the way of Northern Rock. Is Hank gazing across the pond,  wondering about the collapse of Blighty?  Does this leave our European partners laughing over their Croissants?  Well no.  Hank is too busy worrying about that pain in his knee,  which must surely have developed after be begged Nancy Pelosi,  Speaker of the House of Representatives for help.

US bankers won’t be laughing at our ineptitude,  instead they will be fretting over the demise of Washington Mutual,  the biggest US bank to ever fail.

As for our cousins across the channel,  it appears that at least in the three countries that make up Benelux,  they would be delighted to swap our problem for theirs.  They would be more than happy to take Bradford and Bingley off us,  if we took the giant bank Fortis off them.

And so it came to pass,  that during the midst of the great financial crisis of 2008 to 2009, (or should that read 2008 to 2010?)  Bradford and Bingley was nationalised.  But, on this occasion, the British government got very clever.

This is the challenge.  You want to avoid a meltdown in the finance sector,  but you want to punish banks for their mistakes,  otherwise,  they will never learn their lesson.  With the collapse of Bradford and Bingley,  it appears they have managed to pull it off.

Here is the clever bit.  On Saturday it was concluded Bradford and Bingley was no longer viable.  Under the Financial Services Compensation Scheme,  most of Bradford and Bingley’s mortgage debt became the responsibility of the UK banking industry.  But, of course, the banking industry can’t afford to take on this mortgage debt.  So, the government is to take it on, under the understanding that if it the debt goes bad,  and not re-paid,  then British banks have got to pay the cost.

So,  in effect,  the government has said to the banks,  look,  this is your problem,  but we will very kindly take it on for you.  If it goes bad,  you have got to pay for it,  but there’s time here.  It won’t go bad for a while,  so you have got time to sort yourselves out.  Oh, and by the way,  we are charging you £500mn a year for doing this.

So,  is the taxpayer in danger?  Well, not really.  The British government has taken on £20bn of Bradford and Bingley mortgage debt.  The banks have only got to cover the first £15bn of this.  So,  if bad debts creep up to over 75 per cent of the total,  the British tax payers will have to fork out,  but frankly if this happened,  things will be so dire,  that this debt will be the least of our problems.

Once again,  the Spanish bank Santander has come out of it all rather well.  The bank already owns Abbey and Alliance and Leicester,  of course.  Now it is taking Bradford and Bingley’s 20bn worth of savings,  and 197 branches.  It is paying £600 million for its troubles.

By the way,  assuming no branches are closed down,  the Santander network in the UK will consist of 1,156 branches.  Clearly Santander is emerging as a major player on the High Street, but still lags behind the big four.  Lloyds TSB has 1,900 branches and HBOS 1,100,  so Santander in the UK will still have a much smaller presence than a Lloyds TSB HBOS combo.    Then again, as Monty Python might have said “Nobody expects the Spanish Acquisition!”

Contrast this with the problems at Fortis.  You may recall,  Fortis was one of the three banks, ( RBS being another ),  that bought out ABN Amro last year.  Well, now the bank is being nationalised.  And this time three governments have had to work together.  The treasuries from Netherlands,  Belgium and Luxembourg will between them fork out £9bn to shore up the bank,  and take it into a three way government ownership.  The bank will be forced to sell its slice of ABN Amro,  though it is not clear who will buy it.

And so the banking crisis rolls on.  Is there an end in sight?  To answer that,  we must turn out attention back to the US,  Hank Paulson,  and the rest of the gang.

September 29, 2008 | posted by Michael Baxter in Banking | comments (1) |

Here is an idea for solving the economic crisis.  Liquidate.  Maybe we should liquidate labour,  liquidate stocks,  liquidate the farmers,  liquidate real estate.  This will in turn purge the rottenness out of the system.

Ummm,  controversial advice.  Here is another idea.  If we do all these things,  high costs of living and high living will come down.  People will work harder,  live a more moral life. Values will be adjusted,  and enterprising people will pick up the wrecks from less competent people.

Well, that was the suggestion that Andrew Mellon of the US Treasury had in 1929 for solving the crisis in that era.

Until a week or so ago,  commentators were drawing similarities between Mr Mellon and today’s Treasury Secretary Henry Paulson.  Like Paulson,  Mellon was a very rich man indeed.  Paulson is a former banker,  Mellon, was a highly successful investor.  And when Lehman Brothers went down,  many concluded Paulson just wanted to let the full and vicious force of capitalism do its worst.

It is not like that now,  of course.  Now Henry Paulson has become a great nationaliser,  a socialist applying policies that arch protectionists in Europe today, or in the UK back in the 1950s, would have been proud of.

The Paulson plan has now been accepted by Congress.  Sure it been tweaked – pay is to come under the microscope,  and banks which benefit from the Paulson plan,  and which pay out salaries in excess of $500,000,  will have certain tax breaks removed.

The thing you need to understand about the Paulson plan,  though,  is this.  It is based on the idea that mortgage securities have been undervalued by the markets.  So the Treasury takes on these cheap assets,  thereby removing a lot of toxic waste from the bank’s balance sheets,  then in due course,  when these securities return to more appropriate value,  the government can sell them,  recouping,  most of its money - who knows,  even make a profit.

The key though,  are the two words,  “who knows”.  Sure,  the government may make a profit - but actually,  when you really drill down into the plan,  Paulson is asking the US Treasury to speculate.  He is saying the markets have got it wrong,  I know better.

It is strange,  isn’t it ?  When markets are booming, and people fear a crash,  authorities say you can’t second guess the markets.  How do we know that shares,  or house prices have climbed too high ?

It seems markets only get it wrong when they crash,  and not when they boom.

Maybe,  though,  there is a deeper problem right now,  a problem the Paulson plan is not addressing.  To find out why,  consider the musings of the man who was possibly the greatest economist the UK ever produced,  and also,  by the way,  quite possibly the brainiest Briton during the entire course of the 20th century.

Keynes had a thing or two to say about a financial crisis like this one,  and maybe now is the time to consider his ponderings.

September 26, 2008 | posted by Michael Baxter in Banking | comments (0) |

The Hank Paulson plan is quite possibly the most important business plan ever written. It seems it will get tweaked, it may even get tweaked quite a bit, but it will get through.

At the time of writing, it appears all is recrimination. Republicans are blaming Democrats, Democrats are blaming Republicans. Hank Paulson is at once a hero and a villain. Bankers have become evil incarnate, and even America’s poor, with their subprime loans and trailer homes, are getting the blame.

But eventually the blame game will end, and it will dawn on senators that unless some kind of Paulsonesque plan gets through, and gets through quick, the US economy will face catastrophe, and even US politicians will finally see their urgency and need for that, even the ones who double up as hockey mums.

But just because a Paulson-type plan is vital for saving the global economy, it doesn’t mean it is a good plan, it is just the best plan anyone can come up with.

But it does have major flaws: some we are stuck with, some are more serious, some, well, watch them unravel.

When the South Sea Bubble craze was at its height, one business plan famously had the following description: “For carrying-on an undertaking of great advantage but no-one to know what it is!!”

The Paulson plan, by contrast, was written in 21st century speak, but it kind of said the same thing: “Decisions by the Secretary pursuant to this Act are non-reviewable and may not be reviewed by any court of law or any administrative agency.” And oh, by the way, Paulson doesn’t know yet how the money will be spent.

Okay, so US taxpayers, and in a way, the rest of the developed world, have got to trust Hank. So, let’s put our faith in Mr Paulson, he is after all a former chairman of Goldman Sachs, he knows his onions. The likes of George Dubya are just out of their depth, so are most senators. In a way, Paulson is to US politicians what Vince Cable is to Liberal Democrats.

But the snags are these:

First of all, wasn’t it bankers who created the whole mess in the first place? Do you really want an ex-banker to sort it out?

Secondly, Hank will be starting a new job soon; do you really want to charge someone with the responsibility of bailing out banks, when that same person may be looking for a job at one of those banks next year?

Thirdly, isn’t the problem too much pay and too much reward for failure? Isn’t it the problem that bankers have been bailed out every time there is a catastrophe, from Third World debt, the savings and loans disaster, to Tiger economy debt, the Russian crisis, Long Term Capital Management? Isn’t it the problem that banks keep getting it wrong, because they never learn from their mistakes?

Well, all of those arguments may be right, but maybe there is an even deeper problem too. And the problem this time is not so much bankers, politicians, or even economists, this time the guilty part comes in the most innocuous of forms. When you were at school, did you ever know anyone who was brilliant at maths – really brilliant? Not A-grade at Further Level Maths type brilliant, but capable of getting a maths degree at 12 sort of brilliant.

Mathematicians have been running Wall Street.

But this is the snag with mathematicians, they may be good with calculus, or whatever it is that geniuses concern themselves with, but they still make the same old human errors that afflicts us all.

The author, Nassim Taleb put it well in his book The Black Swan. There are two countries in this world, Mediocristan and Extremistan.

In Mediocristan, not much ever happens. There are no surprises. To consider an example of what this country is like, consider a statistical survey to calculate average weight. The survey’s sample is, say, 999 strong. Then it is joined by one other person, but this person just happens to be the heaviest man in the world – how will the average weight be affected? Answer, actually, not that much, even if our fat man weights 100 stones, this will only mean the average weight will be increased by a couple of pounds.

In Extremistan, extreme things happen, and when they happen, the whole calculation is thrown out of kilter. When black swans were discovered in Australia, we had to re-think our definition of what a swan looked like. Or take another example, a statistical survey calculating average wealth. We have our 999 people, and have calculated their average wealth. Say the average comes out at £10,000. Then the list is joined by the word’s richest man, who, right now, is Warren Buffett. Our average person is now worth around £50 million. The extreme event, in this case the inclusion of the word’s richest man in the survey, has completely thrown out the result.

Now consider the world of high finance. Mathematicians make their assumptions based on prevailing conditions. They assume we more or less stay as we are. Risk does not change. We all behave in a certain way, and their view of how we behave is based on how we usually behave.

The mathematicians with their complex algorithms looked at the risk that the banks had insured, and reasoned that since it was insured, failure is highly unlikely. They looked at the laws of chance, and put a probability of systemic collapse at something so small that, by comparison, the one-in-fifty million odds that are supposed to reflect the probability that the Hadron Collider will throw up a black hole which will swallow the Earth, seem high.

In an article in this week’s New Scientist, the whole concept was explained well: “Models typically assume that market prices will continue to behave much as they have in the past, and that they are reasonably predictable,” says the article.

But, it then goes on to to quote William Perraudin, director of the Risk Management Laboratory at Imperial College London who says: “These models mostly overlook how bad news can affect banks’ ability to raise funds. The real risk,” he says, “turns out to be a cycle of drops.”

So, rumours gets out that a bank is in trouble, so others stop lending it money. The fact this bank can no longer borrow money creates problems for the bank, even if the original rumours were wrong. But this in turn can reduce the value of assets at the other banks, and the whole thing goes into a downward spiral.

What these mathematical models are singularly bad at doing is allowing for the fact that the various risks out there relate to each other. If one bank hits trouble, all the banks panic.

What is the probability that all Northern Rock customers will wake up one day and decide to withdraw their money from the bank? Answer: tiny. But the model fails to take into account that one person’s decision to withdraw money can affect someone else’s decision.

It was faulty logic like that that lay behind the Long Term Capital Management failure. That could have ended up as a major banking crisis – but Alan Greenspan gathered together leading banks and orchestrated a bail out. Disaster was avoided, but the lesson was not learnt.

Over the last few years, bankers thought they were living in Taleb’s Mediocristan. In fact, they were living in Extremistan.

Take as another example, the citizens of Pompei in Italy during the Roman Empire. No doubt it never occurred to them that one day the sky would quite literally rain fire, but it did. They too thought they lived in Mediocristan. The mistake the citizens of Pompei and Wall Street made is that they assumed their experience would never change.

In the case of Wall Street, events became self-reinforcing.

Mathematicians erred, and the result has been catastrophe.

The snag with the Paulson plan is this. It is not clear he has understood this. He is assuming that by throwing $700bn into the pot, everything will go back to normal.

But supposing Americans treat their home as if it is a home, rather than a cash cow. Supposing Americans learn to be more cautious with credit spending. Supposing bankers conclude risk has become too risky. With every financial disaster arrests follow. After the South Sea Bubble, the South Sea Company Directors were arrested. It happened again after 1929, it happened earlier this decade.

In Nazi Germany persecution of Jewish bankers turned to the Holocaust.

Right now, if they have any sense at all, bankers are completely changing their attitude to risk.

Who is to say that, post-Paulson plan, everything will be back to normal?

And that is the problem with his plan.

September 24, 2008 | posted by Michael Baxter in Banking | comments (0) |

In the beginning, Buffett said derivatives were financial weapons of mass destruction. Last year, the Sage of Omaha revealed his intentions to sell US denominated assets, and buy abroad. Earlier this month, Buffett is thought to have told the Berkshire Hathaway subsidiary, Kansas Bankers Surety Co, to pull bank deposit guaranty bonds, a kind of insurance policy for banks.

Buffett has played a blinder, the world’s richest man has been ahead of the curve all along. And now he is investing in Goldman Sachs.

Berkshire Hathaway, the company Buffett owns, is investing $5bn into the bank that used to be chaired by Hank Paulson.

He described the bank as an “exceptional institution.”

As for Goldman, well, it is a double plus.

First of all, it has got the endorsement of the world’s most respected investor. And secondly, what was that, oh yes, it has got another $5bn to play with.

Buffett said of the famous bank: “It has an unrivaled global franchise, a proven and deep management team and the intellectual and financial capital to continue its track record of outperformance.”

Goldman Sach’s fundraising doesn’t stop there. It is raising another $2.5bn from the sale of common stock – but, frankly, with that kind support from Buffett, the fundraising wil be a doddle.

Of course, for the first time since the 1930s Goldman Sachs can now operate as both an investment and commercial bank. This means it can go to the Fed for money – as and when needed; it can also get deposits from members of the public.

Earlier this week, Mitsubishi UFJ agreed to invest $8.4bn into the other investment bank, Morgan Stanley, but it is getting a 25 per cent stake for its troubles.

Maybe this endorsement from Buffett marks a significant turning point. When he reckons a bank’s stock has hit bottom, and the only way is up, well, you work the rest out.

September 22, 2008 | posted by Michael Baxter in Banking | comments (1) |

Ever since the Glass-Steagall Act of 1933 in the US there have been two types of banks: commercial and investment banks. It is in a way quite ironic, the US government set up a legal framework to keep the two types of banks separate as a part of its efforts to bring the great depression of the 1930s to an end.

Sixty-five years on, and it has been reversed. Last night, the US Treasury Secretary Henry Paulson revealed new rules allowing investment banks to operate as commercial banks too.

In that one move, the former chairman of Goldman Sachs appeared to provide a new hope for the two remaining investment banks in the US, Morgan Stanley and Goldman Sachs.

It means the duo will be able to take deposits from customers, that’s people such as you and me.

It means they will be able to get loans from the Fed. On a temporary basis they were afforded the ability to obtain loans after the collapse of Bear Stearns, but this was just a temporary facility. But, above all, it means the two banks will no longer be reliant on the money markets, now they will be able to secure their funding from the public.

You must spare some sympathy for Lehman Brothers and Merrill Lynch. If the new rules had been enacted sooner, Lehman may have survived and Merrill Lynch retained its independence. But that, in a way, is the point. It took the sad fate of these two banks to create an environment in which the new rules were considered acceptable.

Of course, commercial banks and investment banks have been able to exist under the same umbrella for some time. In 1999, the Gramm-Leach-Bliley Act repealed those provisions of the Glass-Steagall Act from owning other financial companies. In 2000, J.P. Morgan & Co. merged with Chase Manhattan Corp – and last week Merrill Lynch was bought by Bank of America. In the UK, banks do combine their activities with investment banking; consider, for example, Barclays Capital. And of course Barclays itself has bought up Lehman assets.

What is different this time around is that Goldman Sachs and Morgan Stanley will stay independent. Commercial and investment banking will be managed under the one roof.

Capitalism works when it is allowed to facilitate evolution. This morning, with the decision to let the two remaining US investment banks become commercial banks too, we saw evolution in the banking sector.

But evolution does not always work. To illustrate this, evolutionary biologists often cite the example of the male peacock. Its heavy tail weighs the bird down, making it less well adapted to survive. It is just that, or so it is theorized, the female of the species, through a mutation in the gene for determining sexual attractiveness, is rather partial to males with colourful tails. The more males with colourful tails breed with females who find this a turn on, the more the gene for creating colourful tails in males, and for making this attractive in females, is passed on.

Presumably the male peacock will eventually come unstuck.

In making Goldman Sachs and Morgan Stanley able to trade as commercial banks, let’s hope the US government has not created the wrong type of adaptation – and that the two banks won’t strut their feathers like peacocks, making the same old mistakes, all over again.