Another day another lethal financial derivative

Collateralised Debt Obligation (CDOs) and Credit Default Swap (CDS) are old hat. Say hello to the Exchange Traded Fund (ETF).

The EFT  is a fund which supposedly concentrates on a discrete area of economic activity such as a the trading of a commodity, a  particular  area of business, for example, banks, or a  particular country’s stock exchange index, for example, the FT 100.  Nothing wrong with that you might say.  Let me introduce you to its cousin the Synthetic ETF (SEFT). Suppose it is ostensibly an ETF concentrating on Japan ,  but contains  no Japanese shares. Instead it invests in  shares in Chile. That is an SEFT.

This sounds like an arrangement more suited to Alice in Wonderland than rational investment. The natural response would be to ask why on earth would  anyone set up such a fantastic investment vehicle? Well, it could entice the unwary and inexperienced investor into investing in funds they imagined were much sounder than they actually are. It also allows those holding unattractive hard-to-sell shares  to bundle them up in an SEFT and so disguised  shift them off the books.

The EFT fun does not end there. Holdings  in ETFs are  being shorted in massive numbers .  Short selling is the borrowing of shares for a fee for a period, say six months, selling them immediately  in the hope that their price will fall by the end of the borrowing period at which point they can be bought for less than they were sold for,  returned to the person or organisation from which the shares were borrowed with the difference between the selling and buying price representing the profit for those shorting. If the price rises they make a loss not a profit.  Just describing it makes it sound like a spiv’s delight. In fact it is worse than that because a share may be shorted by any number of people,  so at any one time short positions exceeding the total shares in existence  for a particular business or investment fund.  This means multiple people have a claim to the same share.  This could produce a situation where something akin to a bank to a run on a bank is possible.

The SEFT may be a new boy on the dodgy investment block, but  the CDO and CDS have not become extinct.  CDOs began in a quiet way  with those holding debt  bundling together a  few mortgages  or other debts such as those arising from credit cards, calling them a CDO and selling them to a third party.  Nothing too alarming at first, but the business rapidly ballooned so that vast amounts of debt of greatly varying quality were  bundled together  and traded freely so that the process became ever more complex and opaque the further the debt moved from the initial lender and borrower and the individual CDOs were divided into various layers  (tranches) of risk so that if the cash from the assets covered by a CDO were insufficient to pay all the investors those in the higher risk tranches suffered losses before those i9n the lower rick tranches.  Much more dangerous.

Much more dangerous became an open invitation to disaster when the rating agencies such as Moody’s and Standard and Poor  gave CDOs sparkling credit ratings, quite often AAA marks, almost regardless of the quality of the debt they contained.   Both the CDO issuers and the rating agencies had a vested interest in keeping the CDO balls in the air. The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO;  credit rating agencies  receives fees from CDO issuers  for their service in providing a rating for  CDOs.

To put the cherry on the investment disaster, along came the CDS. This was in its original form simply an insurance against the repayment of the debt held by owners of a CDO not being met.  No harm so far. Then came Naked  Credit Default Swaps  (NCDS)  where the thing insured by the CDS is not held by the owner of the thing insured. This gives the  holder of the NCDS incentive to cause the default of that which is insured by the NCDS because they do not own the thing which is insured but can still get the insurance if, for example, a mortgage fails to be paid.   It is akin to the situation of someone being able to insure a house they did not own and then burning it down and being able to collect the insurance.

The fact that banks and their ilk are still behaving in this reckless fashion shows that either politicians have learnt nothing since the  economic crisis began or are too scared of  or too complicit with bankers to put a stop to their criminally reckless behaviour.

 

All British banks are “too big to fail”

The media is alive with politicians, bankers and economic commentators saying British banks must be broken up so they are not “too big to fail”.  The Governor  of the bank of England  Mervyn  Kingof England Mervyn King was at it last week (htttp://www.thisislondon.co.uk/standard/article-23927727-well-let-banks-fail-says-mervyn-king.do) and the new chief executive of Barclays, Bob Diamond, has had his say today. (http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8365101/Barclays-chief-Bob-Diamond-says-let-banks-fail.html)

The idea is a literal nonsense statement. To begin with the whole of economic history shows that a run on any bank above the size of a local bank with one or two branches is likely to spread the contagion to other banks. Indeed, even runs on small banks can have a snowball effect bringing ever larger banks to default as the nexus of borrowing and lending unravels. This is what happened in the USA during the Great Depression when their highly fragmented banking system saw the phenomenal number of approximately 9,000 banks fail before the America’s entry into the second World War in 1941 finally broke the economic spell with the sudden need for vast amounts of servicemen and war-related materials driving down unemployment.

Britain’s present position is different from that of the USA in 1929. None of her banks are really small for even the smallest building societies which converted to banks in the past twenty-five are far removed from a local bank with half a dozen or fewer branches. Not only that, but the ten largest banks control 90% of the UK banking market (http://www.economicshelp.org/blog/uk-economy/top-10-british-banks/). This produces two difficulties: the danger of a wholesale collapse of confidence in banks is greatly amplified because of their size and the damage done by a failure of any of them would be both great and immediate. For example, suppose Barclays was simply allowed to fail. It is inconceivable that the failure would not lead to a run on all the UK banks.

Those saying banks should be reduced in size so they are not “too big to fail” have a further hurdle to pass beyond that of the lessons of economic history. The internationalisation of banks makes the idea of governments forcing banks to become “small enough to fail” impractical. For example, how would a government force an international bank to split off its British banking from the international business? Unless this could be done, the contagion might well start overseas and spread to the British banking end. The same general objection applies to the idea of splitting retail from investment banking. If an international bank refuses to do it there would be little a British government could do because they could not afford to say do this or cease trading in Britain. But even if the international problem could be miraculously overcome, it is difficult to see how the UK parts of banks such as Barclays could be split into different parts small enough to be “allowed to fail”. Divide Barclays into ten separate companies and each part would still be large.

It is also difficult to envisage a situation whereby a British government would cease to guarantee deposits up to a sizeable or withdraw entirely from its position as lender of the last resort. The continuation of those two engagements would amount to a great deal of moral hazard remaining.

Most fundamentally, whatever system was put in place; whatever political commitments were given, if a run did begin on a British bank it is most improbable that a government faced with the reality of such a failure, with the threat of contagion spreading to other banks, would fail to step in. The only way to stop the bankers running riot again is to nationalise the banks. Fail to do that and we are likely to have a re-run of the present disaster in the not too far distant future because already the banks and their ilk are behaving , as far as present circumstances allow, much as they did before the failure of Lehman Bros in 2008, dreaming up new types of complicated derivatives, paying themselves grotesque amounts of money and laughing at those outside their magic insiders’ circle.

Why have the bankers escaped punishment?

 The fragility of the belief in laissez faire economics can be seen by the readiness of almost all of the supposedly  big bad free marketeers  to rush for the support of the State when things go wrong. As the Government almost invariably steps in when it is a bank going bust, being a  banker  is a one way bet:  the bank makes money you get the vast remuneration: the bank fails the taxpayer steps in and you do not  suffer any punishment such as summary dismissal, the removal of limited liability if you are a director or  criminal proceedings, but are dismissed with a massive pay-off at worst and continue to be   employed on the same outrageous remuneration terms as  you were before the taxpayer had to bail out the banks.

 There is existing law which could be applied to culpable bank directors but never is.  Section 174 of the 2006 Companies Act details the duties of the directors as follows :

 (1) A director of a company must exercise reasonable care, skill and

diligence.

(2) This means the care, skill and diligence that would be exercised by a

reasonably diligent person with—

(a) the general knowledge, skill and experience that may reasonably be

expected of a person carrying out the functions carried out by the director

in relation to the company, and

(b) the general knowledge, skill and experience that the director has.

 How can the directors of RBS, HBOS, Lloyds TSB and Northern Rock be said to have met these requirements? Lloyds TSB have even admitted that inadequate due diligence was done before the takeover of HBOS.

There is also the question of general competence. The alarming truth is that  the executive directors of banks almost certainly did not understand the complex financial packages being devised by their investment arms which led to the crisis.  On 10 February 2009 the recently removed executive directors of the RBS and the HBOS appeared before the Commons Treasury Select Committee: Sir Fred Goodwin  (ex-RBS chief executive) and Sir Tom McKillop (ex-RBS Chairman),e Andy Hornby  (ex-HBOS chief executive) and Lord Steveson of Conandsham  (ex-HBOS  Chairman).

During their examination by the committee, each of the four directors on show was asked to detail their formal banking qualifications. All four had to admit that they had none. I am generally an enemy of credentialitis, but in this case technical qualifications are necessary to ensure that the directors understand the very complex financial instruments being used and  the exotic accounting practices employed  by large corporations. If failure to understand such things does not amount to gross negligence what does?

The  Companies Act allows shareholders, subject to the agreement of a court,  to sue directors for  negligence, default, breach of duty or breach of trust. No attempt has been made to removed their limited liability to allow this to happen. Nor, as far as I can discover,  has any attempt has been made to get bank directors banned from holding directorships in the future.   Why have the institutional shareholders not started such legal action to remove limited liability from directors so they can be sued?  Why has no politician raised the possibility of banning ex-bank directors from being directors in the future? The only plausible reason is the  tacit class interest encompassing  politicians, bankers and large institutional investors, the  last being the  only  non-governmental  people generally  with the financial muscle to fund  actions to remove the limited liability of directors. There is a simple legal way to stop them enjoying the fruits of their ill-gotten gains:  remove their limited liability and ban them from holding directorships for life.

As for criminal charges, I wonder if something could not be done under the laws relating to fraud. There must come a point where  recklessness behaviour becomes fraud because the director knows they are taking chances which will most probably not come off.  For the future we need a law of reckless endangerment which would make any director who endangered a bank or allied institution through their criminally reckless behaviour to be punished by the criminal law.

 The culpable bankers should be punished both from common decency and to deter others in the future. Those who are saying “we must move on” are  arguing a nonsense. Let’s try that argument with a few other scenarios: X murdered Y but there is no point in recriminations: we must move forward; X stole £50 million from his employer but that was in the past: we must move on.  Doesn’t really work does it? The argument politicians and bankers both employ promiscuously that to concentrate on bankers’ pay is to distract from the real issue of what is to be done about the economy is simply special pleading: reforming  bankers’ pay is part of dealing with the economic mess because if they have the same incentives to misbehave in the future and no penalty is paid by those who have misbehaved in the past there will be no reason not to misbehave once more. . 

Far from being punished, bankers who have left the banks they have helped ruin have received   gigantic pay-offs to reward them for their incompetence. The  case best known to the public is that of Sir Fred Goodwin of RBS who originally was to receive an immediately payable pension of more than £700,000 per annum,(since reduced to a more modest £400,000 odd )  but he does not stand alone. To take a couple of other examples, according to the Telegraph  (27 Feb 2009) “Eric Daniels, the chief executive of Lloyds Bank, which has accepted tens of billions of pounds from the Government, could receive almost £10 million in pay, perks and bonuses this year”,  while Adam Applegarth, the chief executive of Northern Rock when it failed,  a bank so badly damaged  that it is now wholly owned by the British taxpayer, reportedly   trousered  £760.000 (Northern Rock boss to get £760,000 payoff Telegraph Tony Undercastle 31/03/2008).

 Nor is it only bankers who have been so lucky. viz:   “Clive Briault, the official in charge of supervising Northern Rock when it collapsed, received a payoff of almost £530,000 after parting ways with the Financial Services Authority, it emerged yesterday. The payoff took Mr Briault’s total remuneration for the year to almost £884,000. FSA chief executive Hectors Sants collected cash, bonuses and other benefits totalling £662,000, compared with the £652,577 received by his predecessor John Tiner, despite the FSA’s own critical report into regulatory failings that culminated in the Northern Rock fiasco. “ (£530,000 farewell for FSA official who watched over Northern Rock  Peter Taylor  Telegraph 01/07/2008).

 As for politicians. not a single person  responsible for the mess has taken any responsibility. The person most at fault is of course Gordon Brown, who in more then ten years as chancellor debauched the British economy through massively expanded public spending and his role as cheerleader-in-chief  for the excesses of the financial sector.

Since the development of this economic crisis the Government has been advocating what they  represent as a  Keynsian solution.  The problem is that they  are only giving us half of  Keynes,. There  are two parts to his theory: the prudence of government in reducing public debt in good economic times and the use of public money to boost aggregate consumption in bad economic times. In fact, even that does not do Keynes justice,  because he advocated public spending to boost demand only as a very last resort after time had shown that the self-righting corrective of the market had failed. Gordon Brown as Chancellor neglected the prudent part of Keynes with the consequence that we arrived at the credit crunch is unprepared to carry out the second part of Keynes.

As for the independent  economic “experts” who supported laissez faire , have they suffered from  their failure to predict what was happening? Not a bit of it. They still occupy their posts in the media, think tanks, private consultancies  and academia, drawing their pay and pontificating as if their misjudgement and misunderstanding of economics  had never happened.

There is no excuse for the failure to predict the financial collapse.  It was  of course impossible to predict the detail of the crash but it really wasn’t that difficult to see what was coming in general terms. Some of us, myself included, picked the disaster before it happened, in my case in July 2007 before  even Northern Rock had collapsed. My decision to make such a prediction came when the housing bubble which was driving the economic boom became so extreme that first time buyers  on average earnings could not afford to buy a property in most parts of  Britain, despite mortgages of five and six times earnings and up to 125% of the value of the property being on offer. As first time buyers support the entire housing market, that could only have one result: a severe fall in  house prices which in turn would topple the boom into bust.  It was not, as they say, rocket science.   

The cost of the current banking failure

The extent of the obligations which the taxpayer has taken on is impossible to  calculate with any precision for two reasons. First,  it is not known how much of the money pushed into British banks  (RBS, HBOS, Northern Rock, Bradford and Bingley)  will be recouped when and if they are sold.  Second, the extent  to which  the  loans guaranteed by the taxpayer (both for the banks which are now part owned by the taxpayer and those which are still technically impendent like HBSC and Barclays)  are subject to default is not known.  That the  “experts” are groping in the dark can be seen from the fact that the Governor of the Bank of England has refused to even estimate how much money will have to be put into the banks. (Mervyn King: ‘Impossible to say’ how much capital needed to shore up banking system By James Kirkup, Telegraph 26 Feb 2009)

There is also the possibility  that if  the Lloyds Group  is successfully sued by institutional shareholders on the grounds that  they were misled by the management before the takeover of HBOS by Lloyds TSB or because of Lloyds TSB e failure to do due diligence  before completing the deal,  then the taxpayer might have to foot at further colossal bill, especially if the company is still part-state owned when a suit is successful.

The partly state owned banks are in theory to be sold reasonably quickly, probably  within the next five years, but  that assumes they will be in a state which will attract buyers and the world economy will have recovered enough in that time to create circumstances in which plausible buyers  will come forward.  There is a further fly in the ointment. The EU competition commissioner has already insisted that subsidiary parts of  RBS and Lloyds are sold off, with the added proviso that they must not be sold to buyers who would then have too large a market share in Britain. If that ruling is extended to the sale of the main bank assets it would create very grave difficulties because no British bank would be able to make such a purchase and the number of foreign banks able to do so would be very limited. That could result in the banks being broken up clumsily just for the sake of reducing size rather than for good commercial reasons or sold for a song.

In addition to the problem of finding buyers,  there is a very real possibility that  nothing like the full extent of  sub-prime debt has  been admitted to by the banks, whatever their ownership status, and only a fool would bank on both Britain and the world’s economy recovering fully within five years. The fact that RBS  had to be bailed out  again with mind-boggling sums so soon after the first gigantic cash injection is strong indicator of  the massive hidden bad debt still lurking within banks.

The hard figures for taxpayer’s cash being spent to prop up the banks are mind boggling. To date  RBS has received £45.5 billion – with another £8 billion earmarked if it is needed. Of that approximately £27 billion has already disappeared through the toxic debt trapdoor (as at November 2009). .  Through a series of complicated loans and repayments,   Lloyds Banking Group has received £14.7 billion net. Northern Rock received £27 billion in September 2007, although this has been reduced as the less toxic mortgages have been   redeemed  (Daily Telegraph High Risk gambling in record bank bailout 4 11 2009).

As for estimates of future obligations, even the government anticipate a  long term cost to the taxpayer of the bailout to be £20-50 billion,  but it could rise to  over £1 trillion if all the government insurance and other guarantees are called in – the amount underwritten in the governments Asset Protection Scheme  currently stands at £282 billion (ibib). In  July 2009 the IMF estimated the cost of  British taxpayer support for the banks to that date as £1,227 billion (IMF puts UK banking bail-outs at £1,227bn Telegraph 31 Jul 2009 Edmund Conway).

Then there is the  national debt. The Office for National Statistics (ONS) projects a  national debt of £792 billion by the end of the 2009/10 financial year  with another possible £1.5 trillion being added before the crisis is over. (Independent 5 11 2009 1.5 trillion  could be added to national debt). This would leave Britain with a national debt of  £2.3 trillion, substantially more than current GDP which is around £1.5 trillion. Before Northern Rock was nationalised, the National Debt was officially less than £600 billion. ( It should also be borne in mind that the National Debt is substantially larger than the current official figure because Brown’s Enron-style accounting has kept the true cost of PPP and PFI off the books, most of the ongoing debt not being included in the National Debt.)

In addition to the direct costs of this banking fiasco, there are the vast sums of money, loss of expertise and human misery caused  by a severe recession to be set against the politicians and bankers’ account.  There is now, as there has always been,  a signal failure amongst the laissez faire believers to acknowledge the true  economic costs of their  religion in terms of lost wages, lost tax, higher benefit payments and increased  anti-social behaviour when people are put out of work. A prime example of such  behaviour  was that of Margaret Thatcher when she  exulted in the destruction of  Britain’s heavy engineering and extractive industries without seemingly having any concern about the structural unemployment she was causing or its human and economic costs. .

There obviously have to be limits to  public service employment,  but it is clearly better, for both moral and economic reasons,  having people employed in useful – and I stress the useful – public service than unemployed, provided their wages can be met without radically destabilising the economy.  At least that provides people with purposeful lives and the public with something for their taxes.  Moreover where enterprises such as coal mining and the railways  and the  energy utilities are in public hands strategically important economic capacity is being maintained. Nor is it simply a case of defending public service provision for important private industries can be defended through protectionist measures. This mixture of public and private protection of employment opportunities could be further bolstered by a refusal to permit further mass immigration.