That was the week that was – and it’s still not over

That was quite a week in financial markets. The US Administration has been trying everything to get the money markets and the market in credits to work again. They decided that they could draw a distinction between financial institutions that were too crucial to allow to go into Administration – Fannie. Freddie and AIG – and those that should be put through bankruptcy or creditor protection to force them to restructure and revalue their assets – Lehman and maybe others to follow.

I guess it was worth trying. Unfortunately, the markets reacted very badly to the collapse of Lehman. Instead of market participants learning the lessons of past excess and coming to sensible judgements about risk, it invited two reactions. Firstly, everyone looked around to find out which large company might be the next to go down. Secondly, everyone decided to play it ultra safe, and only buy government backed securities, for fear of making a mistake.

It is another example of how important the work and words of the regulators are, and how they can have perverse consequences. The US had taken action to control short selling, but that didn’t stop big falls in shares of financial institutions. People who owned the shares decided to get out, seeing how a large and important institution like Lehmans could tumble in just a few days of reappraisal of their worth.

Now in the UK we have a ban for a few months on short selling shares in financial institutions. The general response of the press has been to say “shutting the stable door after the horse has bolted”. That is a false response. The experience elsewhere shows that banning short selling does not bolt the stable door. Doing it in one market still allows it in others, whilst the share movements in recent weeks where shares in some financial institutions have collapsed have been caused primarily by the owners of the shares wanting to get out. I speak as someone who never short sold a share all the time I was a professional investment manager, partly because your potential loss if you get it wrong is unlimited.

At the heart of the problems in the banking markets is fear of what the assets of each financial institution are truly worth. Normally markets are quite capable of putting a price on anything – that is all they do and they are usually quite good at it. Today market professionals who created large quantities of cleverly structured paper based on traditional mortgages or loans seem no longer able to come to a rational view of what it is worth. They no longer trust each other, and no longer want to hold all this paper they made a lot of money creating. As a result, instead of trading packages of mortgages or loans between themselves, one needing the money and the other prepared to take the risk to earn a better return, they will only buy bits of paper secured against the government revenues of a major country. Short term loans to government are now very highly prized, whilst loans to anyone else attract a low value.

It is curious that no new consensus emerges from the wreck of the mortgage securitisation movement about how to value all these loans in the new conditions. Packages of mortgages which were valued at 100 pence in the pound 14 months ago must be worth something today. It is true that people now think more of those taking out the mortgages will be unable to pay the interest, and true that in more cases when the home is repossessed to repay the mortgage there will be a shortfall because the house price has fallen. Even allowing for all that, most of these mortgage packages will still be worth considerable sums of money., especially the senior packages that were designed to avoid the worst of those two risks. The high risk packages may well be worthless, but people who bought them should have understood that could occur.

Meanwhile on both sides of the Atlantic the authorities have been involved as midwives to great new merged corporations that they think will withstand the difficult times better. We learn that Lloyds will merge with HBOS, and that famous Wall Street investment bank names are in talks to merge with deposit taking institutions to widen their capital base. The UK authorities who had been asleep at the wheel throughout 2007, allowing the run on the Rock to develop, are now awake to at least some of the dangers.

Yesterday the main Central banks of the world tried to jump start the markets with a huge injection of extra liquidity. $180 billion was made available. If all that remained was a liquidity problem it should have done the job. All it did was prevent the main share markets falling further. There was no sustained surge in shares prices. It was probably that disappointing response which decided the US authorities to try one more big move. They have now said they will take action to sort out the market in mortgage debt.

We await details of how this might work. For the sake of the US taxpayer, let us hope the people designing the scheme judge the right balance between toughness on those who made bad decisions to own all these packages of mortgages in the first place, and realistic valuation so it unblocks the market. In the longer term there should be money to be made for the taxpayer. The taxpayer can borrow short term money very cheaply, as the banks only want to lend to governments at the moment. There are many packages of mortgage loans and other loans on offer at what taxpayers will hope prove to be giveaway prices. A patient owner could hold them until the markets have come to their senses and are able to value them more realistically, or if necessary own them until all the loans in the portfolio have matured and most repaid. The US government clearly now sees itself as a credible buyer with the capability to get some extra value out of what it buys. This is an operation for professionals with very big pockets only.

I wish them well with it, as the good health of the world banking system currently depends on their actions. If they do it in order to make money for the taxpayer it might work. If they do it to offer subsidies to a banking industry which has got it hopelessly wrong it will stretch the taxpayer too far and create a new problem further down the track. Judging price and security will be most important. Pay too much for the loans and they will lose. Fail to offer enough for them, and it will not restart the markets. During this drama market players are ignoring the deteriorating numbers in government finance. That could become a story later , when the share prices of financial stocks no longer hog the headlines.

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16 Comments

  1. Kit
    Posted September 19, 2008 at 8:53 am | Permalink

    “The US had taken action to ban short selling” – no quite. They only starting to enforced a 2005 law on naked short selling. For the moment you can still short sell in the US. The UK governments ban on short selling is just a political move – Brown is trying to shift blame from himself and has nothing to stabilising the stock market.
    Let us be clear HBOS failed because it could not borrow money not because of its share price.

  2. Tony Makara
    Posted September 19, 2008 at 9:21 am | Permalink

    Interesting that the diary was discussing all these matters well over a year ago, so readers are perhaps not surprised by recent events.

    http://www.johnredwoodsdiary.com/2007/08/31/freedom-of-movement-of-money/

    I’m all for competition generally, however in the field of financial services, perhaps a few mega banks will provide a more stable environment, so I’m not too horrified by the idea of the HBOS-Lloyds deal. The last week has taught us how easily confidence can be eroded and how quickly life in the city can impact on Joe Public. We all know the ban on short-selling won’t last and although I’ve long seen this practice as parasitic, it certainly isn’t the root cause in this latest crisis of capitalism. Perhaps the answers lie in the fact that there are too many lenders, too many vessels that can fail? Perhaps we need an era of mega banks to provide the fundamentals and the security needed for a reliable lending environment?

  3. Derek
    Posted September 19, 2008 at 9:54 am | Permalink

    What seems to have been largely overlooked by the media, in hysterics over short selling, is the fact that the actual share owners willingly loan the shares out to the short sellers. I’d bet that in many cases the owners will be large institutional UK pension and insurance funds, who profit from this practice. I’m not that keen on short selling though, it does often seem to be accompanied by a faint whiff of insider trading.

    I think it’s a bit optimistic that taxpayers will profit, even in the very long term, on the mortgage backed securities it ends up with. Any mortgages originated and securitised over the past three years must already be substantially underwater, assuming average loan-to-value ratios.

    I can’t really understand why mortgage backed securities can’t be carefully unpicked and credibly marked to market. Although, this assumes they are still the predominant problem, as claimed, and the contagion hasn’t in fact spread substantially to other areas of banking activity.

  4. Acorn
    Posted September 19, 2008 at 10:54 am | Permalink

    I was forgetting you are ex Rothschild Bank John and your post above makes sense to me. Down the road, when the dust clears, there will be significant value in a lot of these mortgage backed securities, but it will be a hell of a job to unpick them back to the original mortgage.

    With central banks issuing all this new paper, what is going to happen to the money supply? Will this not chase up global inflation? Will the Banks be required to have much higher fractional reserves in their vaults and in their accounts at the BoE?

    Meanwhile I will try and understand what an “exchange traded fund” (ETF) is; these apparently will takeover the job while the “short sellers” are in the sin bin.

    Redwood for Chancellor OK.

    reply: It is unlikely to be inflationary, because the government money is being issued to try to make up for the collapse of private credit

    • Andrew Forbes
      Posted September 19, 2008 at 2:55 pm | Permalink

      I’ll 2nd that nomination of Redwood for Chancellor.

    • Acorn
      Posted September 19, 2008 at 6:31 pm | Permalink

      Watching the market today, I was starting to feel better about the world’s finances. Then I was sent this link.

      It seems the problem is much much bigger than I imagined. It appears that there is a “ten trillion dollar opportunity” out there for anyone who has any cash to spare. Some of the text in this link is nearly understandable.

      http://www.highyieldblog.com/

  5. adam
    Posted September 19, 2008 at 1:01 pm | Permalink

    I dont know whats going on but i do know the government and media have not got a clue.
    I dont see a problem with short selling, if someone wants to buy and someone wants to sell where is the problem with that. I dont like it one bit. I am not convinced short selling is guilty of anything.
    When we have a man in charge who, with his whole team, cant work out N.Rock’s balance sheet, what hope is there.

  6. Bazman
    Posted September 19, 2008 at 3:57 pm | Permalink

    Sounds like pyramid selling, (words left out) at worst. At best, a bit like the American car dealerships who claim that they can get credit and thus a car for anyone. The car is so old and worthless that any lose by non payers is just absorbed by the car dealer and the finance companies. Keeps everyone in a job and America on the road.
    Unfortunately the amounts of money where significant and Homer Simpson was buying from Cowboy Bob.
    Madge: Did you spend our life savings on a motor home?
    Homer: Of course not. I spent our life savings on the down payment of a motor home!
    They end up stranded in the woods.
    There will be of course fortunes to be made from the wreckage in cheap shares, fees to advisor’s/consultants/dealers and cheap property. Much of it paid for by the taxpayer if we stop pretending.
    ‘It never rains on the rich’ remains true as ever and it looks like there is some humidity on the way for me.

  7. mikestallard
    Posted September 19, 2008 at 4:35 pm | Permalink

    As an Historian, I try to take a very simplistic and long term view of life.
    How does this fit with the present crisis?
    Before the Big Bang, an Englishman’s word was his bond. People shook hands and meant it. If you cheated, you were out of the club. The catch was that you had to have gone either to a good school or to have been an officer in the Armed Forces and have the right accent. “A good egg”.
    After Big Bang, the Americans moved in and people began working on computers which, I learn, can do three transactions in the space of one eye blink.
    Honesty and being a gentleman who was trustworthy became quaint relics of Empire. (Telegraph cartoon – “Alex”?)
    But what were these transactions?
    Sub Prime Mortgages very often (perhaps inspired by do goody (words left out) busybodies in the government?) And, of course, as they were “transactions”, nobody either knew or cared what they were so long as they could sell them.
    It all got (deliberately?) very complicated indeed.
    Now even the governments have got together to put Humpty back together again.

    Myself, I cannot see how things can improve. If the city is just shuffling worthless pieces of paper – along with some serious transactions – and nobody has the faintest clue what they are doing, how can they?

    And, by the way, isn’t the whole idea of a hedge fund to escape regulation by the City? I wonder who is checking up on them? You need a greyhound to catch a hare.

  8. StevenL
    Posted September 19, 2008 at 5:05 pm | Permalink

    It’s not all doom and gloom with this financial crisis, I’ve actually found it all very educational.

    A few years ago I had a part time job in the banking sector, taking applications for credit cards and performing balance transfers on activation calls. This was in early 2004 and it struck me then just how much debt was out there and how unlikely it was that it could all ever be repaid.

    I’ve also worked in the public sector and done some work on debt advice. People with no income would regularly be seeking help with many thousands of pounds debts they had accumulated. It always struck me through the boom years that the banks must have been overvaluing this mountain of debt, and that the housing market was going bananas.

    I didn’t have the faintest clue what would happen though. Before the financial press started discussing the state of the US property market on the run up the first front-page shock of the credit crunch last year I didn’t even know what the LIBOR was, let alone a MBS, a CDO, and SUV, a CDS, a CFD or the rest of it.

    As a direct upshot of all this I’ve started reading the financial news, bought books on the subject and even dipped my toe in the water, made a few small derivatives bets and had my fingers burned just enough to teach me a thing or two about different ways of managing my money and risk.

    So in a way I think the credit crunch is not only an inevitable thing, but also a cloud with a silver lining.

  9. APL
    Posted September 19, 2008 at 5:55 pm | Permalink

    JR: “Now in the UK we have a ban for a few months on short selling shares in financial institutions.

    There has been a rally in the market today, some are saying it is because of the wise move on the part of that financial genius Gordon Brown.

    Well, how about this to give you nightmares?

    Shorts are getting out of their positions for fear of legal sanction. That seems to me to mean they now have to buy stock to cover their short position, hence the rally. They may well have lost money – because they have had to unwind their positions premeturely. OK so what you say, shorts are evil.

    So now shorting is illegal. Next week, perhaps next month, when the reality of the financial stocks dawns, the drift downwards will start and gather momentum. You know what – there will be no short covering rally. No one will be buying stock to cover their short positions, everyone will be scrambling to sell.

    Imagine a boat in rough seas with the passengers and crew standing on one side.

    Effectively, our financial ‘genius’ Gordon Brown has removed the mechanism in the market that would normally have stopped a plunge to the bottom.

    Personally, I think he is insane.

  10. figurewizard
    Posted September 19, 2008 at 7:01 pm | Permalink

    The week has ended with the FTSE up 9% on the day and the stars of the show were the banks. However it is entirely possible that those who had taken short positions on their shares were faced with huge losses once Bush announced his nationalisation of all of his country’s dodgy mortgages and were therefore desperate to get their hands on stock before it sailed into the stratosphere. That was Friday then – We shall see what kind of a grip Bush and Brown have, come the close of business next Monday.

  11. Adrian Peirson
    Posted September 20, 2008 at 2:35 am | Permalink

    It is unlikely to be inflationary ?

    can that really be true ?

    Either Govt is simply Printing more money, thereby devaluing existing money. IE Inflation.

    Or it is Saddling us with Bad Debts, which we have to pay back which itself is inflationary.

    Govt has a choice of Protecting the People or the Banks, why not simply say to the Banks, you got us into this mess.
    I am going to declare that as of today, all mortgage Debt is forgiven and the People can keep their homes.

    The Banks wont like it of course but Other Banks will take their place.

    Who should Govt protect, the Banks or the People.

    Since they have only lent us worthless fiat money or thin air credit any way, they have lost nothing anyway.

    PS.

    given that a £50 note costs around 1p to print why did Brown swap a large pile of Gold Bullion for a large Pile of unbacked, essentially worthless fiat money.

  12. Bazman
    Posted September 20, 2008 at 7:24 pm | Permalink

    It’s still not over. Anyone can see there is high prices, high house, low wages, and large debts in many forms. Something was going to happen and still is.

  13. Dusty
    Posted December 25, 2008 at 4:27 am | Permalink

    Nice! i`ll be stopping by from time to time 😉

  14. Erica Rose
    Posted June 4, 2009 at 3:14 pm | Permalink

    This was a great help to me so thanks for the advice!

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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