Wednesday, September 26, 2007

Another Financial Collapse

Northern Rock

The fall-out from the Northern Rock episode contains some signal lessons for both the Treasury and the FSA. Whether they will be heeded, of course, is a matter of mere conjecture, so should they need spelling out, I shall do my best to elucidate.

The first lesson is that whatever losses are caused to the financial sector by financial crime and money laundering, even when counted together, they are as mere pin-pricks, when compared to the losses which can be caused, even by one institution, if it decides to go and play in markets and with financial products it doesn’t really understand.

The second lesson is that focussing ones’ regulatory attention for too long on an unproven risk, takes one’s attention away from the real threats. Lead by a Government whose slavish adherence to US-inspired fantasies of global criminal conspiracies has left it wallowing in a form of quasi-religious zeal in its reported determination to go after the Napoleons of Crime and the terrorist godfathers, we have been forced to focus on the perceived dangers to the financial sector from an unquantifiable number of the dangerous class, and we have taken our eye off the antics of the usual suspects in the financial sector, the market practitioners themselves.

Despite the absence of any meaningful statistics or empirical evidence to back up their wild assertions, repeated Treasury and Home Office Ministers have lamely trotted out the old law enforcement shibboleths of the risks from criminals, and have connived in a wholesale reconstruction of our laws, and the withdrawal of whole areas of civil liberties, all in the name of combating a phantom army of crooks, terrorists and wise-guys, whose number or activities no one can determine .

And all the time, the activities of the regulated sector pose, as they have always posed, the biggest risk to the financial stability of the entire British financial services arena.

It is really rather simple actually.

I have lived through an era when it was very hard to get a mortgage, and if you wanted one, you had to have a track record of prudent savings in one of the old Building Societies, savings which would enable you to demonstrate that you were the right sort of investor that the lenders wanted to lend to.

If you wanted a loan, you had to have a very good reason, and you had to have collateral with which to back your request. Banks and financial institutions did not advance money to every Tom, Dick and Harry, because it was perceived to be too risky, and might place too great a strain on the capital adequacy of the institution.

Then interest rates began to decline, and as they fell lower and lower, it became much harder for lending institutions to make any money from simple interest alone, because it was at a very low number, and in any event, there were beginning to be lots of other competitors out there waiting to offer services, if the traditional institutions declined.

Banks had also learned a very interesting fact, which made the relaxation of their lending policies even easier. Some clever statisticians worked out that in the UK at least 88% of people always paid back their debts! It seems that the thought of being made bankrupt still possessed a real stigma for a great number of citizens, and ensured that they would repay their debts in full.

Suddenly, a whole new vista of lending possibilities opened up. Instead of worrying whether individuals were worth lending to, it now made sense to get them into as much debt as possible, as quickly as possible. You see another thing that the statisticians discovered was that a large number of people tended to stay with the first banking institution they started with, no matter how badly or inconsiderately the bank treated them. Moving an account was just too much trouble, and the vast majority of people would put up with bad treatment as long as they could get some form of banking service.

So the banks began to engineer all sorts of new lending possibilities. Credit cards for students, no problems. Loans, why not? Guaranteed overdraft facilities, of course! Interest repayment holidays, certainly! Anything to get clients into debt, debts that incurred higher rates of interest, secure in the knowledge that over the long term, those debts would be paid in 88% of cases, and at enhanced rates of interest.

In fact, it got so lucrative a business that the banks soon started to look round for other sectors to lend to. The possibilities were endless, and the banks pushed their lending teams hard to get the cash out onto the street. Unpaid debts, not to worry! County Court judgements, let’s see how we can help! maxed-out credit cards, let us lend you even more money just to pay them off! They were now lending vast sums of money to people you wouldn’t trust to take your dog for a walk, in the hope that he would be brought home again in one piece!

Then another wise-guy came up with a clever idea. When lending money to punters (sorry, valued clients), why not encourage them to think long-term. Why not interest them in a single premium insurance policy which if they were ever to suddenly experience a set-back, their debts would still be paid by the insurance policies?

This one was really clever, because the banks then loaned the money to pay for the single premium as well, while ensuring that the terms and conditions of the insurance were so carefully constructed that the likelihood of ever successfully utilising the policy was almost illusory! The banks then leveraged those insurance policies with another insurer!

If the punter then did default on the loan, the bank would be able to claim on the policy. It all seemed like money for old rope!

Finally the really clever derivatives chaps came back again with another idea. Why not take all these debts, which will be repaid at some date in the future, but parcel them all together, and then sell those debts in a securitised form to other investors. In this way, the bank can make another turn on its investment and minimise its risk on the debts.

Suddenly the market in credit derivatives became the only game in town. Packages of debts were re-packaged, sliced, diced, cut laterally, split lengthways, re-packaged, re-sold, and re-packaged again. The ability to calculate the financial return on these debts, which by now had become something akin to a form of bond, lay in the hands of the clever boys and girls with the Ph.Ds in astrophysics and quantum mathematics. The rest of the wise-guys merely sold them, again, and again and again, and cleaned up on the commissions and made their bonuses, and kept their sales-managers happy!

The problem was that by now, no-body knew where the risky debts, the more risky debts, or even where the debts defined as ‘toxic waste’ were, and even more important, when and how these debts would be repaid? Just as long as the market sentiment in the worth of these products remained strong, all well and good, but when the market started to look at these products through jaundiced eyes, then the whole edifice began to tremble, then to shake and finally, to wobble.

The problem is that no-one now really knows where or how much of the financial market may be exposed to these risks. We do know that a very large number of institutions have been engaged in what had been a very lucrative market, we know this because informed commentators have been warning about the lack of transparency involved in the credit derivatives markets, for a long time, and for just as long a time, the Regulators, who should have really been minding the shop, have been making vague noises about their concerns about the perceived risks involved.

It was all like playing a global game of pass the parcel, and just hoping and praying that you weren’t the one left holding the package when the music stopped!

Well, the music stopped in the US, when the realities of the level of speculative lending to the sub-prime market became too obvious to ignore any more. This has had a direct knock-on effect in the UK, and those who had followed the various commercial lending and borrowing practices engaged in by Northern Rock, pointed the finger at the institution as a prime target for concern.

The rest is all too awful to contemplate.

The realities of the outcome are to be measured in the length of the queues lining up outside Northern Rock offices demanding their money back. Even after the Bank of England, (rather rashly) guaranteed their continued existence, and even when the Government stepped in to assure investors that Northern Rock was secure, no-one among the investors was really listening.

The lessons to be learned from the fall-out of this event are salutary.

First of all, it demonstrated beyond peradventure that the good reputation of a financial institution is an insubstantial thing once the clients become worried about the security of their deposits.

Clients no longer have any loyalty for any financial institution because they have been treated so badly and with such total disregard for their interests in recent years. The banks have ridden roughshod over their client’s concerns and now they must pay the price when the going gets tough.

Clients are used to seeing their local branches close; never being able to speak to someone who can answer their questions; having to discuss their financial affairs with someone in Mumbai; being badgered to take out a myriad number of insurance products every time they put their head round a branch doorframe; and being ripped and gouged by their bank in costs, hidden charges and grotesque penalty fees.

When a client no longer has any loyalty to the institution with whom he banks, he will not hesitate to get his money out when the fickle finger of fate points in his bank’s direction.

Secondly, it should have proved to Gordon Brown and his financial whizz-kids in the Treasury that the greatest number of people no longer believe a word the Government says about anything. When the Bank of England put its support behind Northern Rock, it suddenly became the safest institution in the country. This has not stopped people from getting their savings out, and selling their shares.

Statements of government support became a meaningless echo, as a vast number rushed to divest themselves of their exposure to Northern Rock’s sinking reputation. The Government was not managing the crisis.

Any government whose word is worth as little as Gordon Brown’s has clearly proven to be, is a government with a credibility crisis, but then, as with the financial institutions, the ordinary man and woman in the UK has watched and listened while this Government has lied and twisted and squirmed and spun and lied again about so many issues, that no-one of any ordinary common sense believes a word they say!

So, let us hope that important lessons will be learned from this mess.

Traditional financial crime, money laundering and terrorism will never cause the same level of threat to a financial market that the abuse of one misplaced derivative product will achieve!

Regulators need to re-learn the lessons of previous times, and spend more time watching the activities of those who have most to gain from the propagation of these exotic products as a means of driving the debt/dependency culture; and act more decisively with regard for better and greater transparency in their application.

Both Government and the financial sector need to act swiftly and decisively to start re-building investor trust and confidence in the sector which we are told is so important to the future well-being of this country. Saving, thrift and self-reliance need to be encouraged; promoting debt and financial dependency is to be discouraged. Savers and investors have been screwed shamelessly by Threadneedle Street and Whitehall both for too long, and this is where the real financial crime has occurred