The market rout continues

How I wish I could just write today that things in financial markets are calm. I would like to have woken up to better times, to spend the day without having to test out my views yet again on the state of the banks and the world economy.

Instead, this morning comes news of a large sell off of shares in Australia, Japan and other Asian centres, following the collapse of US share prices yesterday. The world’s investors are gripped by fear of recession, and are rushing into cash to protect what remains of their savings.

Listening to stockbrokers this week, they have said that their clients have been ringing up in larger numbers to express worries about their bank deposits. They have apparently been calmer about their shares. It is curious. People have been worrying about the wrong thing.

Since the credit crunch first hit in the summer of 2007 no-one has lost a penny by holding a deposit in a UK bank. Any deposit taking institution that has got into difficulties has been helped or rescued one way or another. The guarantee level has also been raised to £50,000 for each customer with any particular banking group. Meanwhile people have lost large sums through holding shares. Some have held their own shares directly. Many more have held them through investment funds and above all through their pension funds.

Usually it is right to get less pessimistic about shares as markets fall. The normal criticism of the public(not always fair) by the professional investors is that the public tends to get carried away with enthusiasm for shares near the top, and gets carried away with pessimism near the bottom. This time, according to stockbrokers, more people have been looking for buying opportunities as the markets fall.

The problem this time is that the markets have not fallen a sensible amount and then started to rally. On the contrary. The markets fell more gently and slowly for the first year, and now seem to be in freefall. How can we explain this?

Let’s take the UK share market. A little while ago it had fallen by about a fifth. You might say that means shares are 20% cheaper. If you think they will still pay the same dividends and still make good profits, that is attractive.

Unfortunately the market is now realising that if we enter a nasty recession, far from being a fifth cheaper, some shares may be dearer. If profits fall a lot, and if some dividends have to be slashed, individual shares may not have fallen enough to offset these adverse changes. If confidence is restored quickly some shares might now look very cheap, but others are in companies which still face difficult trading conditions ahead whatever happens to banking confidence.

The UK economy has been especially dependent on the success of financial, business and professional services. This sector is being badly battered, so it weakens the whole market. Are the banks really short of capital? How much money will they have available to pay dividends? Will they need to seek more money from their shareholders? Recent events have caused uncertainties about some companies.

In the first half of the year the companies quoted in London that are involved in mining and commodities did well. Commodity prices were still soaring, so the shares in these companies reflected the improved prospects for profits and dividends that followed from this source. In the second half of the year commodity prices have mainly fallen dramatically, so the share prices of such companies have to adjust to the worse outlook.

Some companies are still responsible for pension funds. To the extent that these pension funds are invested in shares and property, the companies concerned now have to face up to bigger losses in these funds.

This week people using share markets around the world are asking themselves How bad will this downturn be? They are concluding that it is going to be worse than they at first thought. They suddenly think profits and dividends will be lower than their previous idea, so they see a need to sell some more of their shares. Recessions hit profits hard. When profits reduce, businesses have less cash to pay the bills. If they are also finding the bank manager unhelpful when they want an extra loan to tide them over, there is more likelihood of bankruptcies.

There are now two problems superimposed on each other. There is the banking crisis, and there is the coming recession. They reinforce each other in a downwards spiral. If the banking crisis gets worse, the banks will lend even less money to people and companies to buy things. Businesses will then sell fewer things, and will need more borrowing to tide them over. Banks will be unable or unwilling to lend all that is needed. Companies will lay workers off, cut bonuses, and overall real incomes will fall.

Not so long ago we were all told that the Paulson plan to buy up problematic packages of loans from the US banks would be our salvation. A huge $700 billion was voted through Congress and Senate to do this. The banking markets still remain frozen but the money is still to be spent. This week the UK government has come up with an even larger package – $850 billion to provide liquidity and new capital for the UK based banks.

The US decided to tackle the problem by trying to relieve banks of some of their difficult loans, and by establishing a market value for all the others to show the banks were capable of trading with each other. The UK decided to offer cash and guarantees to banks so they could be reassured that each bank in the system was solvent and liquid, so again they can trade with each other. Much has been written about which of these routes is best or right. As the collapse of confidence is now global let’s hope both work. Each has more chance of working because of the other.

What should the authorities do next? At the G7 Euroland could offer a scheme to complement the US and UK ones. To the extent that the collapse of confidence is now a global problem, it requires similar responses from all the main centres. They could respond to the growing fear of recession and cut interest rates again on a concerted basis. There is no need to keep interest rates high to fight inflation, when we are staring deflation in the face. They could agree in confidence to return home and call in all their senior bank chiefs privately to tell them it is now up to them to start trusting each other and dealing with each other to help save the system.

The UK scheme has three components. I have praised the two that entail lending more money to the banks and offering guarantees. This is the bulk of the money. I accept the government’s pledge that they will take proper security for the taxpayer, that the taxpayer will earn fees and interest for the service, and that the money will be repaid in full.

The smallest pot of money is the pot to provide new preference share capital. I hope the main banks will decide that they do not need to use this. Some will be able to say they have quite enough capital without raising new. Others may say they think it would be a good idea to raise extra capital to demonstrate how prudent they intend to be, but they can and will raise it from a combination of existing shareholders and new shareholders other than the UK government. It might help if the regulator reminded everyone that all the banks it supervises more than meet their capital requirements, and reminded us all how it set those capital requirements to take account of possible stresses in the system.

If any bank does want to access the government’s fund there are important issues of accountability to taxpayers which need to be resolved. Taxpayers would not take kindly to their money helping pay large bonuses to senior executives and directors or even to large dividends to existing shareholders. If a bank is in need of taxpayer share capital, it will have to lead a much more puritan existence than it has been used to if it is to pass democratic muster.There also need to be clear protections for the taxpayer interest.

(Anyone needing investment advice should seek it from someone who understands their circumstances and is qualified to offer it – nothing above is intended to offer advice)

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25 Comments

  1. figurewizard
    Posted October 10, 2008 at 9:56 am | Permalink

    The problem with Euroland offering a similar rescue plan to complement those of the US and the UK is that in the present circumstances each member of that club is understandably now more concerned with its own national interest. There were huge imbalances even before the present crisis as evidenced by widely disparate rates on sovereign bonds with Germany's offering lower returns to others such as Spain and Italy. Therefore it could well be the case that quite apart from housing markets and stock exchanges the Euro itself may well become a victim. In fact I'm beginning to think that it is going to become inevitable.

  2. david
    Posted October 10, 2008 at 10:01 am | Permalink

    The Thatcher Revolution is now eating its own children.

    • David morris
      Posted October 10, 2008 at 11:04 am | Permalink

      How many more blogs are you going to post this on?

    • Stuart Fairney
      Posted October 10, 2008 at 1:40 pm | Permalink

      Didn't you know that someone somewhere would find a way to blame Mrs Thatcher who has been out of power for almost two decades ~ risible.

  3. Tony Makara
    Posted October 10, 2008 at 10:08 am | Permalink

    Its clear that the market has to take a hit and iron the bad debt out of the system. The situation isn't helped by the way investors have been switching from fiat to commodities and back again. The crisis is fundamentally one of confidence and whether 'the promise to pay' will be fulfilled. Once again this sets the focus on the medium of money itself, its very raison d'etre and how we can establish a monetary system that garners more than faith, but absolute confidence. This can only come by the establishment of a world currency to run along existing national currencies, an end to the chaos of floating exchange rates and a world central bank to set rates of interest and exchange around the world. The laissez faire system is based on an ideological belief that markets correct themselves, this is has created the problems of excess credit and the end of liquidity. The belief that the market can just bounce back, like a coiled spring. It is only when this blind faith has been destroyed that we can establish an economic order built to last.

    • Puncheon
      Posted October 10, 2008 at 4:05 pm | Permalink

      As I have asked elsewhere on here, what about gold?

      • Tony Makara
        Posted October 11, 2008 at 8:18 am | Permalink

        The Bretton Woods era, for the most part, provided the greatest period of stability and prosperity and if we focus on UK history in particular we find that most of our problems began once Sterling was floated. Since then we have struggled to corner export markets and been saddled with lumpen-unemployment. Gold certainly does remain a sound investment and the Russians are currently building up their gold reserves to record levels. As readers will know, the plastic chancellor sold off our golden legacy. It is certainly an interesting debate.

    • DWL
      Posted October 10, 2008 at 4:27 pm | Permalink

      Tony, we don't operate a laissez-faire system! In fact financial markets are astonishinglyy heavily regulated (see all the attention that has been given in recent days to capital adequacy directives, Basel II, etc etc. Arguably the reason why many banks have to be so big is to moderate the costs of compliance to the regulations. Ironically, the stringent regulation of the financial system has led to the unintended consequence that there are a few 'single points of failure' in the system.

      Then look at where the regulators have failed, etc in the failure to regulate CDOs properly.

      Markets are only human, and so at some point will fail and require intervention.

      To talk about having 'absolute confidence' in a currency is hocus pocus. There will always be an exceptionally small chance of something going very badly wrong (read Taleb's 'Black Swan', the book de jour apparently). Floating exchange rates in fact manage this risk, by allowing investors in foreign currencies to express their relative confidence in different currencies and in so doing efficiently provide information about weaknesses in currencies. The same goes for shares.

      All this talk of world central banks, world currencies, and a new economic order will not help. They will be run by politicians, who will regulate. Seeing how regulation has a large part in this mess, you now propose extending this regime to the entire world! I would rather trust my prosperity to the market than to politicians and regulators. Your proposal stinks of Dirigisme and Socialism.

  4. Bernhard
    Posted October 10, 2008 at 10:52 am | Permalink

    Thank you for this informative and easy-to-read analysis. I'm sure many of us who don't work in the city are keen to learn the basics and this post and the previous one on bank capital really helped my understanding.

  5. Rugfish
    Posted October 10, 2008 at 12:57 pm | Permalink

    New Front bench required immediately –

    David Davis – Michael Fallon – Bill Cash and John Redwood NOW please !

    Euro policy agenda number 38 –

    We've got a committee working on delivering serious proposals based on sound economic principles to the British people at the forthcoming election, and that report will be what we base our policy on as to what we ask the people to VOTE for.

    It will be chaired by Ian Duncan Smith !!

    At the moment it looks likely we'd be wanting to rejoin EFTA and stick the Federalisation of our country up the Euro bum at the next election which we will WIN because we are the only party which cares enough about protecting our democracy, unlike Labour and the Liberals who want to sell us away.

    Come on people – New direction and new focus is required to take back the political ball, back to where it belongs – The people and our party !!!

    We must show "LEADERSHIP" .

  6. APL
    Posted October 10, 2008 at 1:33 pm | Permalink

    JR: "Not so long ago we were all told that the Paulson plan to buy up problematic packages of loans from the US banks would be our salvation. A huge $700 billion was voted through Congress and Senate to do this. The banking markets still remain frozen but the money is still to be spent."

    Problem with Paulsons plan, addressing the issue of effectiveness rather than constitutionallity or legality, was and is that the plan does not address the underlying problem – Where are the losses in the banking system – who has them and what are the magnitude of the losses. Rather the plan tried to cover up the liabilities by squirting cash at the problem.

    Almost everyone knows that Benanke is nicknamed Helicopter Ben because several years ago now, he made a speech saying there was no problem the Fed couldn't address by printing more money.

    Ben Benanke and Paulson have for some time been dropping US$ from the sky, we can see how futile and counterproductive that policy has been.

  7. Webloyalty
    Posted October 10, 2008 at 2:45 pm | Permalink

    The markets are pretty bad today. Are we talking about a 10% down turn daily? Usually, the 'bears rule' stays for a longer time. Unfortunately, this is across the world! Let us hope this will subside quickly.

    – David.

  8. Acorn
    Posted October 10, 2008 at 2:49 pm | Permalink

    Please answer all questions, show your working. Turn over your paper and start now. Time allowed is as long as it takes for the FTSE 100 to drop 9%.

    1 Co-ordinated, global base rate drop, no effect, 3 M LIBOR spread has actually gone up. Central bank base rates now irrelevant, as is MPC.

    2 No bank is going to loan money to an entity that will be destroyed in the coming recession, regardless of how much cash [sorry, I mean liquidity], you stuff in it.

    3 Our government debt will shift up from £600 billion to at least £1100 billion. It will actually be about £1800 billion, but government accounting will massage this number down for voter consumption. Unfortunately, they will not be able to hide it from the Treasury bond and currency markets.

    4 The ONS will have to find new ways of inflating the GDP number. That laptop you bought recently for half the price of the last one you got, will be counted at double what you payed for it for GDP purposes. (It does twice as many things so it is obviously worth twice as much to you)

    5 Inflation will be recorded at some unbelievably low figure; because, ONS will assume you are now buying Tesco Value beans instead of the brand leader.

    6 We will bring home our troops to quell Public Sector strikes. The government will find a clause in the Terrorism Act to use on the trade unions. Probably the same one they used on Icelandic banks.

  9. Tim Worstall
    Posted October 10, 2008 at 4:36 pm | Permalink

    "This can only come by the establishment of a world currency to run along existing national currencies, an end to the chaos of floating exchange rates and a world central bank to set rates of interest and exchange around the world."

    Bwahahahahaha.

    Mr. Makara, you really do tell some good ones. For a moment there you had me going, thinking that you were serious.

    • Tony Makara
      Posted October 11, 2008 at 8:01 am | Permalink

      Mr Worstall, perhaps if you debated the issues instead of trying to score cheap jibes people might take you more seriously. A world currency is an inevitability and I hope to see it established in my lifetime.

      • Tim Worstall
        Posted October 11, 2008 at 6:09 pm | Permalink

        OK, I'll be serious. A world currency by definition means a world interest rate. Just as with the euro, a single currency means a single interest rate in the euro area (note that I mean a single base rate, a single macroeconomic stance, not that each and every borrower gets money at the same rate).

        As you might have noticed this has caused some problems recently. Spain has a trade deficit of 10% of GDP, had a huge housing boom and now a huge housing slump. The Irish economy had an interest rate much too low for its own good for many years and similarly had a boom and a slump. Other countries (say, perhaps Italy, certainly Germany for a couple of years) had, in the same time period, interest rates that were too high for their domestic economies, thus stifling growth.

        As an economist would put it, the eurozone is not an optimal currency area. And if that small number of countries isn't such an optimal area then there's no way at all that the entire world is.

        In fact, there are many who would argue that the events of the 1980s showed us that not even the UK is an optimal currency area.

        The reason I simply laughed is because these points are blindingly obvious to anyone with even a passing acquaintance with the facts. I assumed you were joking precisely because I assumed you knew such things.

        That you now seem to insist that it was a serious suggestion isn't perhaps the wisest of moves on your part. You've revealed that you simply have no idea what you're talking about.

        Better to be thought to be joshing than that, eh?

      • mikestallard
        Posted October 11, 2008 at 6:21 pm | Permalink

        Isn't a world currency already here?
        We call it the "Dollar".

  10. Keith
    Posted October 10, 2008 at 5:00 pm | Permalink

    John, all you had to say was that Gordon is barking mad. That would have said all there is to say.

  11. James
    Posted October 10, 2008 at 5:10 pm | Permalink

    I'm wondering why you have made no mention of the Icelandic problem. It has certainly surprised me that Councils have so much in reserves. Why are we paying such huge amounts to our local councils in Council Tax when they have all these moneys floating around many institutions earning interest.
    Surely their brief is to provide local services for local people and not to act as professional investors?
    Obviously have reserves, but not on this grand scale.
    Why hasn't this money been used for social housing projects.
    Now it seems £1 billion may well have been as good as flushed down the toilet.

  12. mikestallard
    Posted October 10, 2008 at 5:43 pm | Permalink

    I totally agree with Bernhard – well done for a really lucid explanation!
    A footnote:
    If you believe in old fashioned traditional virtues, then you must ask why are the banks still offering huge bonuses (Telegraph today: £3 billion)? Why should people on low incomes pay for these? Have these bankers no sense at all?
    Another one:
    In the Spectator Charles Moore, who is sane and who has a good track record, mentions that there is a serious danger of whole states going under. Iceland may be the first domino. The Euro is shaking. The UK went bust the last time Labour was in power. Why not again?
    If you are right about our being £1.3 trillion in debt before the crisis struck, we can assume that we are now about £2.3 trillion in debt. This is three times the government's annual income at the moment, and then some.
    I am very glad that I myself am not in that position.
    Aren't you?

  13. Tim
    Posted October 10, 2008 at 8:18 pm | Permalink

    I would be interested to hear John's thoughts on the Icelandic banking situation and how the regulator allowed them to take deposits in the UK when they had such an unfunded deposit protection mechanism.

  14. Richard
    Posted October 10, 2008 at 9:23 pm | Permalink

    There do seem to be some jolly good deals about though – I didn't realize that dealers have machines that automatically sell shares when a given value is achieved – that seems folly. As per usual it would appear that OAP's are the most exposed – my brother's father in law has gone ostrich. I guess we're all going to have to act differently in the future – mini funds hedged all over the system – could be an opportunity I guess but confidence & expectations can be brutal.

    Cheers John

  15. Fidelio
    Posted October 11, 2008 at 12:04 am | Permalink

    Thank you Mr Redwood. The very best of tutorials!

  16. R.Rowan
    Posted October 11, 2008 at 1:33 pm | Permalink

    Has George Osborne caught the mc cavity syndrome where is the opposition.Promising to be supportive before knowing what is proposed seems to have left the front bench in a quandary,its time someone got a grip and started knocking Brown for his failures which have exacerbated the current situation.

    • mikestallard
      Posted October 12, 2008 at 8:43 pm | Permalink

      You are so right; this is becoming as embarrassing as the time when he promised to spend as much as the Labour in the first two years of Tory government!

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    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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