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)