[R-G] [BillTottenWeblog] It's Finished

[Bill Totten]

by John Lanchester

London Review of Books (May 28 2009)


It's a moment of confusion and loathing that most of us have
experienced. You're in a shop. It's time to pay. You reach for your
purse or wallet and take out your last note. Something about it doesn't
feel quite right. It's the wrong shape or the wrong colour and the
design is odd too and the note just doesn't seem right and ... By now
you've realised: oh shit! It's the dreaded Scottish banknote!
Tentatively, shyly - or briskly, brazenly, according to character - you
proffer the note. One of three things then happens. If you're lucky, the
tradesperson takes the note without demur. Unusual, but it does
sometimes happen. If you're less lucky, he or she takes the note with
all the good grace of someone accepting delivery of a four-week-dead
haddock. If you're less lucky still, he or she will flatly refuse your
money. And here's the really annoying part: he or she would be well
within his or her rights, because Scottish banknotes are not legal
tender. 'Legal tender' is defined as any financial instrument which
cannot be refused in settlement of a debt. Bank of England notes are
legal tender in England and Wales, and Bank of England coins are legal
tender throughout the UK, but no paper currency is. The bizarre fact of
the matter is that Scottish banknotes are promissory notes, with the
same legal status as cheques and debit cards.

These feared and despised instruments, whose history has long been of
interest to economists, come in three varieties from three issuing
banks: the Bank of Scotland, the Royal Bank of Scotland and the
Clydesdale Bank. Small countries with big ambitions but few natural
resources need ingenious banking systems. The history of the
Netherlands, Venice, Florence and Scotland show this - and so does the
tragic recent story of Iceland. 'In the 17th century, when English and
European commerce was expanding by leaps and bounds', James Buchan wrote
in Frozen Desire (2001), 'the best Scots minds felt acutely the shortage
of ... what we'd now call working capital; and Scots promoters were at
the forefront of banking schemes in both London and Edinburgh,
culminating in the foundation of the Bank of England in 1694 and the
Bank of Scotland in 1695'. The powers down south, however, came to think
- or pretended to think - that the Bank of Scotland was too close to the
Jacobites, and so in 1727 friends of prime minister Walpole set up the
Royal Bank of Scotland.

There was more to the new bank than Whiggish manoeuvring. During the
17th century, Scottish investors had noticed with envy the gigantic
profits being made in trade with Asia and Africa by the English charter
companies, especially the East India Company. They decided that they
wanted a piece of the action and in 1694 set up the Company of Scotland,
which in 1695 was granted a monopoly of Scottish trade with Africa, Asia
and the Americas. The Company then bet its shirt on a new colony in
Darien - that's Panama to us - and lost. {1} The resulting crash is
estimated to have wiped out a quarter of the liquid assets in the
country, and was a powerful force in impelling Scotland towards the 1707
Act of Union with its larger and better capitalised neighbour to the
south. The Act of Union offered compensation to shareholders who had
been cleaned out by the collapse of the Company; a body called the
Equivalent Society was set up to look after their interests. It was the
Equivalent Society, renamed the Equivalent Company, which a couple of
decades later decided to move into banking, and was incorporated as the
Royal Bank of Scotland. In other words, RBS had its origins in a failed
speculation, a bail-out, and a financial crash so big it helped destroy
Scotland's status as a separate nation.

Fast-forward 300 years, and RBS is today, by the size of its assets, not
just a big bank, and not just one of the biggest companies in Europe.
The Royal Bank of Scotland, by asset size, is the biggest company in the
world. If I had to pick a single fact which summed up the cultural gap
between the City of London and the rest of the country, it would be that
one. I have yet to meet a single person not employed in financial
services who was aware of it; I wasn't aware of it myself. I think if I
had been, there are two questions I would have wanted answered: how did
that happen? And is it a good thing?

Unfortunately, the second one is easy to answer. During the weekend of
11-12 October last year, the point when the British banking system
teetered on the edge of collapse ('the only time in my career', a senior
banker told me, 'when I've felt genuinely frightened'), RBS was in
receipt of an emergency injection of government cash, to the tune of GBP
20 billion. This left us, the taxpayers, owning about sixty per cent of
the collapsing bank. On 26 February this year, RBS gave a preliminary
announcement of its annual results. The bank had lost GBP 24 billion,
the largest loss in British corporate history, and required yet more
government money to stay solvent. The new government money, GBP 25.5
billion, took the taxpayer's share of the bank to around 95 per cent. In
addition, RBS put GBP 302 billion of its assets into the government's
Asset Protection Scheme, a sort of insurance plan under which the
government, in return for a fee, promises to underwrite future losses
from the toxic assets (these assets used to be worth GBP 325 billion but
their value has already been written down).

A figure of GBP 50 billion has been widely touted as the eventual cost
of this scheme to the government - not the overall cost of it, just the
part of it belonging to RBS. That figure is guesswork, since the whole
problem is that nobody knows what these assets are worth. In the same
week that news came out, it emerged that the former chief executive of
RBS, Sir Fred Goodwin, had, at the time of the October bail-out, asked
for and received a doubling of his pension pot before he would agree to
leave the bank. This took his pension pot to GBP 16 million, which will
pay out GBP 693,000 annually for life. Why did the government go to such
lengths to secure Sir Fred's acceptance of his own departure, rather
than just sacking him? Why did they agree to the doubling of his pension
pot? We don't know, but it's almost certainly because, when the deal was
done, everyone was so preoccupied by the question of whether the British
banks would stay solvent that Sir Fred's pension was the last thing on
anybody's mind. Anybody's, that is, except Sir Fred's.

He's an easy man to dislike. Even his face, pinched and complacent, is
easy to dislike. In a wider perspective, however, the pension question
is something of a non-story. We are exposed to such gigantic losses
through the financial crisis that it doesn't really matter if Sir Fred
spends the rest of his life bathing in Cristal at our expense. The
question of his pension has become a synecdoche for the more general
issue of City bonuses, which to the City are a normal fact of life but
to outsiders are the emblem of the City's greed and amoral
exceptionalism. It's interesting to observe how completely the banking
industry fails to hear its own tone of voice on this subject. By City
standards, Sir Fred's pension is not outlandishly large; bonuses are so
much a part of City culture - on average, they make up sixty per cent of
an investment banker's pay - that they are often guaranteed by contract,
and even when they aren't they are part of an employee's 'reasonable
expectation' in terms of pay, and are therefore protected by law. To
outsiders, it doesn't make sense to have a 'guaranteed bonus': if your
bonus is guaranteed, it isn't a bonus, it's a salary. In the interests
of preserving their trade's reputation, it's bankers who should be
leading the attack on Sir Fred's clearly indefensible pension; instead,
they're chirruping about the evils of 'banker bashing'.

To sum up: so far taxpayers have spent GBP 45.5 billion in directly
bailing out RBS (for wonks, that's GBP 15 billion in equity and GBP 5
billion in preference shares last October, followed by GBP 25.5 billion
in capital instruments this February), plus another GBP 50 billion for
the toxic assets in the protection scheme (though as I've said, that's a
plucked-out figure which could go as high as GBP 302 billion if the
assets are worthless). Call it GBP 95.5 billion. Oh, and another GBP 16
million to keep the person responsible in Dom Perignon and Charvet
shirts for the rest of his life. Still, let's look on the bright side:
at least we have an unequivocal answer to our question about whether it
was a good thing that RBS got to be the biggest company in the world.

The question of how it got to that point is easy to answer at the macro
level. RBS grew through takeovers. These are commonplace in the
financial service industries, though it should be noticed that takeovers
and mergers often have the effect, in the long term, of destroying
value. Company A, worth GBP 10 billion, takes over company B, worth GBP
5 billion, some time passes, and you end up with a new company worth not
A + B = GBP 15 billion, but A + B = GBP 12 billion. You have magically
made GBP 3 billion go away. That's destroying value, and many takeovers
and mergers in time end up doing exactly that. Perhaps the definitive
example was that of the car companies Daimler-Benz and Chrysler. The
German company took over the American firm in 1998 at a cost of $36
billion, promising all sorts of exciting synergies and possibilities for
growth. These turned out not to exist, and Daimler-Benz ended up selling
Chrysler in 2007 in a complicated deal which involved a net cash outflow
of 500 million Euros - an amazing turnaround and a heroically effective
destruction of value. In fact, when you look into the question, you soon
conclude that non-capitalists and anti-capitalists should throw street
parties every time the words 'merger' or 'takeover' are used. Why do
they go on happening? Mainly because it is the mission of most companies
to grow, and takeovers are one of the quickest and most spectacular ways
of doing that.

This is partly a question of accounting. In the stock market, all money
is not created equal. The price of a share is determined by what people
think it's worth - obviously. But what people think it's worth is in
turn decided by what they think the company's prospects are. Take the
example of companies A and B mentioned above. Both of them make widgets.
Company A is a fast-growing internet-based firm, eWidget, which is
promising to take over the world market in widgets by riding the new
trend for firms and customers to order their widgets online. Last year
its earnings were GBP 200 million. The company's pitch to the stock
market runs something like this: the global market for widgets is GBP 1
trillion. In time, say ten years, it is clear that thirty per cent of
widgets will be ordered over the internet. Our ambition is to win ten
per cent of that market. (The trick is to keep these projected and
made-up figures sounding sensible and achievable: don't claim that the
net will be all the market, and that you'll get all of that business.
State a huge number for the total market, and claim to be after a
sensible fraction of it.) So your sensible and achievable goal is for
eWidget to have ten per cent of thirty per cent of GBP 1 trillion, in
other words GBP 30 billion a year. Wow! It's clear that eWidget has a
big, big future, and if you get in on it now by buying a piece of the
company - that is by buying shares - you will, in time, make out like a
bandit. As a result, eWidget's shares trade at a high price in relation
to the company's present earnings: at the already mentioned market
capitalisation of GBP 10 billion, that means the shares cost fifty times
the company's earnings. The P/E ratio, as it's called, is 50/1. That is
high, and it can only be justified by steeply rising future growth.

Company B is Goodwidget Ltd. This is a well-run old firm with members of
the original founding family still in charge. It has grown at ten per
cent a year for decades, and its business model is the same one it had
during those years, one of steady incremental growth through the
old-fashioned method of making a better widget than its competitors. The
stock market takes one look at its figures and reacts with a colossal,
neck-ricking yawn. There is no glamorous upside here and no reason to
believe in any growth beyond the kind that Goodwidget has proved it can
achieve. Thus, although Goodwidget actually sells more widgets and makes
more money than eWidget - it made GBP 500 million last year - because it
seems to have less potential for growth, its shares are, in terms of
their earnings, cheaper. The shares are priced at ten times their
earnings, giving the company a market capitalisation of GBP 5 billion.
Goodwidget, despite earning more than twice as much as eWidget, is worth
only half as much on the stock market. All money is not created equal.
The money earned by Goodwidget is worth much less than the money earned
by eWidget. This is one of those points of stock-market logic which
seems surreal, nonsensical and wholly counterintuitive to civilians, but
which to market participants is as familiar as beans on toast. (An
example: when AOL took over Time Warner, the old media company supplied
seventy per cent of the profit-stream, but ended up with 45 per cent of
the merged firm, because AOL's market cap was so much bigger. How
successfully did that play out? Well, at the time of the merger, the new
combined company's market capitalisation was $350 billion. Today it's
$28.8 billion. That's $321.2 billion in value gone with the wind. I say
again, for anti-capitalists, merger = fiesta.)

Now let's consider what happens if eWidget takes over Goodwidget. They
bid GBP 5 billion for the old-school company, and their offer is
accepted. (In practice, by the way, they would offer more than that,
since the whole point of takeovers is that the buyer sees more value in
the target company than the market does: he sees a way of making more
money than is already being made. But let's keep this example simple.)
The new company is worth GBP 10 billion plus GBP 5 billion, yes? No -
and this, from the stock market's point of view, is the beautiful part.
Goodwidget's GBP 500 million of earnings are now added to the total
revenue of eWidget, so the merged firm is earning GBP 700 million a
year. Remember that eWidget is valued at fifty times its earnings (so
that GBP 700 million of earnings implies a market capitalisation of GBP
35 billion), which means that eWidget shares are about to more than
treble in price. That in turn completely justifies the confidence of the
shareholders who bought a piece of this exciting, sexy, go-go
21st-century widget-maker. The successful takeover has magically sent
the share-price rocketing; the company has grown. It isn't what's known
as 'organic' growth, of course, the kind which comes from selling more
of your stuff to more people, but so what? Although most takeovers and
mergers end by destroying value, the market loves them anyway.

Back to RBS. The bank fought off three takeover/mergers in the 1970s and
1980s - one each from Lloyds, Standard Chartered and HSBC - before
growing stronger and launching takeovers of its own. The first was of
Citizens Financial Group, which has grown (through the takeover of
Charter One Bank) to be the eighth largest bank in America. The biggie,
however, was the battle to take over the high street behemoth NatWest in
1999. RBS's opponent in that battle was its old enemy, the Bank of
Scotland; the older bank's plan had been to part-fund their acquisition
by selling off various components of NatWest such as Coutts and the
Ulster Bank. (Coutts is the posh bank, concentrating exclusively on high
net-worth customers, which only recently began issuing cheque cards.
Before that, any shop or service provider who didn't understand what a
Coutts account meant was demonstrably too lower-class to deserve
patronage from Coutts clients such as the queen and Wayne Rooney.) RBS
by contrast planned to keep the subsidiaries together as part of a new
company, the Royal Bank of Scotland Group. RBS won the fight, and became
the second biggest UK bank after HSBC. Fred Goodwin was something of a
hero in the banking world. Philip Delves Broughton, a former Telegraph
journalist who went to Harvard to do an MBA and wrote a funny,
depressing book about it, What They Teach You at Harvard Business School
(2008), reports that in 2003 the school made RBS the subject of one of
its famous case studies. The study was called 'The Royal Bank of
Scotland: Masters of Integration' and began with a quote from the man we
now know as Fred the Shred or the World's Worst Banker: 'Hard work,
focus, discipline and concentrating on what our customers need. It's
quite a simple formula really, but we've just been very, very consistent
with it.' Right. By now RBS, or the RBS Group, was a truly huge company,
embracing the banking interests already mentioned plus a large range of
insurance products, known to the UK consumer under various brand names
such as Direct Line, Churchill and Privilege.

>From this springboard - which included a ten per cent share in the Bank
of China, the world's fifth biggest bank - RBS launched yet another
takeover bid, this time for the Dutch bank ABN Amro. The French
philosopher Rene Girard talks about something called 'mimetic desire',
which basically means copying our idea of what we want from someone else
who wanted it first. We're all familiar with the phenomenon in everyday
life, but RBS seems to have had a corporate version of mimetic desire.
Barclays had launched a high-profile takeover bid for ABN Amro, a
long-established bank whose earnings and share price had recently
stagnated. (ABN stands for Algemene Bank Nederland, the inheritors of a
business which had originally been one of the Dutch charter companies,
the Nederlandsche Handel-Maatschappij or Dutch Trading Company - not so
different from RBS's legacy as the Company of Scotland.) RBS, seeing
Barclays putting the moves on ABN Amro, decided to make some moves of
its own, and after a complicated fight, ended up winning ABN Amro, as
part of a consortium of bidders with the Belgo-Dutch bank Fortis and the
Spanish Banco Santander. The consortium bid 71 billion Euros, as opposed
to Barclays's 66 billion Euros - and this notwithstanding the fact that
ABN had sold off its American subsidiary LaSalle, which was one of RBS's
reasons for being interested in the deal in the first place. (The action
of selling off LaSalle was part of what's known in the city as a 'poison
pill' defence, undertaking an action intended to make you toxic to a
potential predator.)

The consortium's plan was to split ABN Amro up, with RBS getting the
Anglo-American and wholesale parts of the business, Fortis the
Belgo-Dutch, and Banco Santander the South American. It wasn't in
principle a ridiculous scheme, but the problem was the price. Most of
what has been written about the financial crisis is pure hindsight, but
not this: many observers thought that the winning consortium had
overpaid. The consortium won their takeover on 10 October 2007; by April
2008, RBS was going to the markets to raise more capital, to cover
losses from the deal; by July 2008, Fortis had lost two-thirds of its
value and its CEO, Jean-Paul Votron, had resigned; on 28 September,
Fortis was part-nationalised by the Dutch, Belgian and Luxembourgeois
governments. We've already read what happened to RBS. So within months,
the ABN Amro takeover destroyed RBS and Fortis and what was left of ABN
Amro itself. Along with the AOL-Time Warner merger and the
Daimler-Chrysler merger, the ABN Amro takeover is one of the biggest
flops in corporate history.

All of this makes RBS's corporate report for 2007, published just weeks
before the bank had to go back to the markets for more capital, a
document of unusual interest. Northrop Frye somewhere defines 'irony' as
involving a state of affairs in which words have a different meaning
from their apparent sense. This can be achieved by the audience's
knowing something the speaker doesn't: so the speaker is saying one
thing but we are understanding another. The RBS corporate report is like
that. (So are their slogans: 'Make it happen'. Make what happen? A GBP
100 billion tab for the taxpayer?) The section on corporate citizenship
at the beginning is particularly good value. The firm is involved in
plans to increase general levels of financial education. 'When people
have been educated about money and how to work with financial services
firms they are more likely to make the right decisions and to avoid
difficulties'. That's true, but you can also just rob post offices. 'RBS
is a responsible company. We carry out rigorous research so that we can
be confident we know the issues that are most important to our
stakeholders and we take practical steps to respond to what they tell
us. Then occasionally, we blow all that shit off, fire up some crystal
meth, and throw money around with such crazed abandon that it helps
destroy the public finances of the world's fifth biggest economy.' See
if you can guess which of those sentences is not in the report.

Joking apart, the RBS Group corporate report is a document of historic
importance. This was the last bulletin from the bank before it blew up:
a process that began within days of its publication - the accounts were
signed on 27 February 2008, and on 22 April RBS announced that it was
attempting to raise GBP 12 billion of capital in the form of newly
issued shares, to cover its losses from the acquisition of ABN Amro. The
consequences of the bank's unravelling will be with us for a long time,
in the most basic way: we will be paying for it. Not metaphorically, but
literally: instead of schools and medicines and roads and libraries,
huge chunks of public money will go to RBS's balance sheet. So it's
worth taking a close look at that balance sheet, and before we do so,
it's worth thinking for a moment about what a balance sheet actually is.
If the Titanic is the most abused metaphor in the world - in the words
of the Onion parody headline for 1912, 'World's Largest Metaphor Hits
Iceberg' - the balance sheet runs it a close second.

We don't know who invented balance sheets; they seem to have been in use
in Venice as early as the 13th century. But we do know who noted down
the method behind them, and in the process invented modern accounting,
which relies on four financial statements to provide a full picture of
any given business: the balance sheet, the income statement, the
cash-flow statement, and the statement of retained earnings. The man who
noted down the method for gathering and recording the relevant
information was Luca Pacioli, a Franciscan monk and friend of both Piero
della Francesca and Leonardo da Vinci, whose assistant he was for many
years. Pacioli wrote Summa de Arithmetica, the book which laid out the
method of double-entry bookkeeping which is still in use in more or less
every business in the world. (He also wrote about magic, in the sense of
conjuring. I'd like to think he would have enjoyed the old joke about
accountants: 'What's two plus two?' 'What would you like it to be?')
There's something amazing about the fact that a method used in Venice in
the 13th century and written down by a Tuscan in the 15th should still
be in daily use in every financial enterprise in the developed world.

Of the four financial statements, the balance sheet is the one which
provides a glimpse into a moment in time. The others show processes,
flows of money; the balance sheet is a snapshot. A balance sheet is
divided into assets and liabilities. Assets are things which belong to
you, liabilities are things which belong to other people. Here's what an
individual's balance sheet might look like:

Assets (GDP)
70,000    Share of house owned by me 	
10,000    Deposits in bank 	
10,000    Car 	
15,000    Stuff I own 	
05,000    Money people owe me 	
40,000    Pension 	
150,000  Total

Liabilities (GDP)
130,000  Share of house owned by bank
02,000    Credit card debt
02,000    Car loan
06,000    Unpaid debt on stuff I own
140,000  Total
10,000    Equity

150,000  Total Liabilities and Equity (GBP)


You'll notice there is something mysterious on there called 'equity'.
This is the magic ingredient which means that a balance sheet always
balances: it is added to your liabilities so that they match your
assets. The fact that it appears with the liabilities might make equity
seem sinister, but it isn't: it's a good thing. It's the amount by which
you are in the clear; it's the amount by which your assets exceed your
liabilities. Your equity is your safety margin; it is your net worth, it
is the thing which keeps you in business.

Now imagine for a moment that you are a business. Instead of just being
plain you, you are now You Ltd. You set out to sell shares in yourself.
The part of you that you sell shares in is the equity. The buyer isn't
taking over the assets and liabilities, but the equity. Say I bought ten
per cent of your equity, as set out in the balance sheet above, at a
price of GBP 1000 (an accurate price, since that's exactly what it's
worth today). In a year's time, say you've paid back GBP 10,000 of your
mortgage, your house price has gone up by half, you're being paid better
at work and so you've another GBP 10,000 in the bank - golly, your
assets are now GBP 270,000, your liabilities are GBP 130,000 and your
equity is now GBP 140,000. My one-tenth share of your equity is now
worth GBP 14,000. Cool. I could sell my share in your equity and make a
nice profit, or I could just sit on it, betting that you would do even
better in the future. On the other, scarier hand, you could have had a
lousy year: your house price might have crashed (in fact, using UK
average figures, your house price has crashed, by GBP 50,000), you have
been put on part-time work so your salary has halved and wiped out your
savings, your debtors have gone bankrupt and your car has lost fifty per
cent of its value, so your assets have gone down by GBP 70,000. Your
liabilities, on the other hand, are the same. There's a problem: your
liabilities now exceed your assets, by a cool GBP 60,000. In plain
English, you're broke. In the language of accountancy, you are
insolvent. You have met one of the two criteria for insolvency: your
liabilities are greater than your assets. The other criterion is
inability to meet your debts as they fall due. In British law, meeting
either criterion makes you insolvent. It is a criminal offence to trade
while insolvent.

There may be a get-out, however. Are you really insolvent? I've made
things clear-cut for the purposes of this example, but you could argue -
and in comparable cases people do argue - that your problem is not so
much insolvency as illiquidity. Liquidity is the ability to turn assets
into something that can be bought or sold. With a depressed housing
market, the problem with your house could easily be not so much its
value, as the fact that you can't sell it, because nobody is buying
property at the moment. Or rather you can sell it, but you have to do so
for an artificially depressed, crazy-cheap price: a 'fire sale' price.
When the market returns to normal functioning, you will be able to sell
your house for its true value; so you aren't really insolvent, you're
just caught in a 'liquidity trap'. In practice, all you would do, in the
above example - as long as you weren't really You Ltd, in which case you
might well be under a legal obligation to go into receivership - would
be to simply ignore the question and keep going. You'd hope to be able
to pay bills as they fell due, and hang on for grim life until your
house price recovered. As we speak, hundreds of thousands of people
across the UK - across the world - are doing precisely that.

The same principles apply to company balance sheets. They look a lot
more complicated, but the underlying factors are the same. At business
schools, they play a game - sorry, 'undertake an exercise' - in which
students are given balance sheets and asked to determine what type of
business the company is in. Sums are in millions of pounds. So what's
the business whose balance sheet is shown here?

See table at http://www.lrb.co.uk/v31/n10/lanc01_.html

There are clues in the fact that 'Deposits by banks' and 'Customer
accounts' are listed in the column for liabilities. 'Loans and advances'
are a main category of asset. Our hypothetical business student would be
able to work out in pretty short order that this business is a bank.
Which one? A clue is the figure for 'Total assets': GBP
1,900,519,000,000 - GBP 1.9 trillion. Since the entire GDP of the United
Kingdom is GBP 1.762 trillion, this is a freakishly large bank - oh, all
right, I'll stop being coy, it's our old friend the Royal Bank of
Scotland, aka the biggest company in the world. It seems weird at first
glance, and indeed at second glance, that bank balance sheets list
customer deposits as liabilities, but it makes sense if you think about
it, since a liability is at heart something that belongs to somebody
else, and the customers' deposits belong to the customers. This was
something that my father, who worked for a bank, used often to say to
me: don't forget that if you have money in a bank account, you're
lending the bank money.

Banks themselves certainly don't forget it. Actually, that's not true.
They forget it all the time in their actual dealings with their
customer/creditors - us. They act as if it's their money and they are
doing us a favour by letting it sit in their bank earning interest. Take
a look at the balance sheet, however, and at the page after page of
corporate reports and footnotes which accompany it, and it's a different
story. High levels of deposits mean high levels of liabilities; and high
levels of liabilities oblige a bank to have high levels of assets. Since
banks are mainly in the business of lending money, high levels of assets
mean high levels of loans. That means that a bank's main assets are
other people's debts. This is another distinctive feature of bank
balance sheets, the fact that its principal assets are other people's
debts to it.

The balance sheets of other businesses look very different. They're
smaller, for a start: only banks are this bloated with assets and
liabilities. That's natural, since the business model of banking,
involving lots of money coming in and sitting in accounts, balanced by
lots of lending, is always going to involve lots of money on the balance
sheet and relatively small amounts of equity. A company with a quicker
turnover will look very different. Apple Computer, for instance, in 2008
had $39.6 billion in assets, $18.5 billion in liabilities and $21.1
billion in equity; compare that to RBS's GBP 1900 billion, GBP 1809
billion and GBP 91 billion. Apple's assets are a fiftieth the size of
RBS's, but its equity is only a sixth the size. In that sense, Apple is
a safer business than RBS; it has a larger safety cushion, a
proportionately bigger margin for error. {2} Of course, it might be that
it has a bigger margin for error because it is an inherently riskier
business. Banking should be much more solid than
computers/gadgets/music, but the fact that banks will always have
elephantine balance sheets, in proportion to their equity, means they
have a tendency to be a little less secure than they look at first
glance. That's one of the many reasons banks are, in their corporate
body-language, so keen to look as imposing and rock-like as they
possibly can.

Apple's accounts are all about how many computers and phones and songs
the company will sell, since its financial health depends on that. (I
say 'songs' - Apple's iTunes is the biggest music retailer in both the
UK and US.) RBS's accounts are all about its loans, since the financial
health of the company depends on the quality of those loans. It follows
from that that RBS's accounts are all about loan risk, since the
profitability of the loans depends on how likely they are to be repaid.
For that reason the nature of the assets - the loans - are all
important; and risk is not some marginal factor but the core of a bank's
business. Risk is always an important issue for any company, but for a
bank, it isn't just important, it's their whole business. Banking does
not just involve the management of risk; banking is the management of risk.

The RBS accounts were signed on 27 February 2008. On 22 April, the bank
went back to the markets to seek GBP 12 billion in new capital, to
repair its balance sheet. The later unravelling of this very balance
sheet, as I've already said, has us on the hook to the tune of GBP 100
billion and maybe more. By rights, by logic, and by everything that's
holy, it should therefore be possible to see, somewhere in the accounts
and the balance sheet, some clue to what went wrong - especially given
that whatever went wrong must have already gone wrong, to hit the
company so hard less than two months later. The reader who thinks that
is quickly disillusioned. Instead we get this: 'It is the Group's policy
to maintain a strong capital base, to expand it as appropriate and to
utilise it efficiently throughout its activities to optimise the return
to shareholders while maintaining a prudent relationship between the
capital base and the underlying risks of the business'.

Where on the balance sheet are the gigantic bets that went bad? Where
are all the toxic assets? The losses were so huge that one shouldn't
have to look for them in this way - in fact it's bizarre to be doing so,
minutely parsing the accounts for evidence of a gigantic disaster. It's
a little like being Sherlock Holmes, crouched over and peering through
his magnifying glass, looking for a smoking crater the size of
Birmingham. Eventually you come across this glimmer of a clue:
'Derivatives, assets and liabilities increased reflecting the
acquisition of ABN Amro, growth in trading volumes and the effects of
interest and exchange rate movements amidst current market conditions'.
Looking at the balance sheet, we see that derivatives have indeed become
a much, much bigger part of it, to the tune of GBP 337 billion of
assets, as opposed to GBP 116 billion the year before. Is that where it
all went wrong? When you read the report's words about derivatives, it
makes them sound as if they were used to hedge risks: 'Companies in the
Group transact derivatives as principal either as a trading activity or
to manage balance sheet foreign exchange, interest rate and credit
risk'. Nothing there about the famous sub-prime mortgage derivatives
which have blown up the global banking system. When we go looking for
sub-prime elsewhere in the report, we find this:

The Group has a leading position in structuring, distributing and
trading asset-backed securities (ABS). These activities include buying
mortgage-backed securities, including securities backed by US sub-prime
mortgages, and repackaging them into collateralised debt obligations
(CDOs) for subsequent sale to investors. The Group retains exposure to
some of the super senior tranches of these CDOs which are all carried at
fair value.

At 31 December 2007 the Group's exposure to these super senior tranches,
net of hedges and write-downs, totalled GBP 2.6 billion to high grade
CDOs, which include commercial loan collateral as well as prime and
sub-prime mortgage collateral, and GBP 1.3 billion to mezzanine CDOs,
which are based primarily on residential mortgage collateral. Both
categories of CDO have high attachment points. {3} There was also GBP
1.2 billion of exposure to sub-prime mortgages through a trading
inventory of mortgage-backed securities and CDOs and GBP 100 million
through securitisation residuals.

Right. So they have a 'leading position' in this stuff. It consists of
GBP 2.6 billion in allegedly high grade CDOs, GBP 1.3 billion in the
next grade down, and another GBP 1.2 billion of diverse exposure to
sub-prime, for a total of GBP 5.1 billion. Granted, GBP 5.1 billion will
buy you quite a few Mars bars; but again, how did we get from there to a
GBP 100 billion black hole? Might the weasel word be 'include' -
meaning, there's more of this stuff but we're not discussing it here?

According to the Daily Telegraph, the answer is simple: the bank had
much bigger exposure to the sub-prime market than it admitted.

During a board meeting in the summer of 2006, Sir Fred was asked by
fellow directors whether the bank had any plans to move into the
sub-prime market. He told the board that the bank would not move into
sub-prime and that, as a result, 'RBS is better placed than our
competitors'. In the foreword to RBS's 2006 annual report, published in
April 2007, Sir Fred wrote: 'Sound control of risk is fundamental to the
Group's business ... Central to this is our long-standing aversion to
sub-prime lending, wherever we do business'.

On the principle that people deny something only when there's something
to deny, this remark might be the biggest single clue anywhere in the
RBS accounts as to the risks the bank was running. RBS turned out to
have quite a lot of exposure to sub-prime risk, and to be steadily
acquiring more. On the 2007 balance sheet, it appears to be under 'Debt
securities'. When we look at the relevant footnote, we find that this
category includes GBP 68.302 billion of mortgage-backed securities, up
from GBP 32.19 billion the previous year. Aha! Already in 2006 some
analysts were citing the firm as the world's third biggest player in
sub-prime mortgages. In her new book, Fool's Gold (2009), Gillian Tett,
the heroine who covered capital markets for the Financial Times and who
predicted the crisis, has RBS 'aggressively' growing its exposure to
Collateralised Debt Obligations during this period {4}. In 2007, its
American subsidiary Greenwich Capital bought a chunk of sub-prime
mortgages from New Century Financial, one of the biggest players in the
market, which was, not coincidentally, facing bankruptcy; RBS lent
another sub-prime player, Fremont General, $1 billion; yet another
American subsidiary of RBS, the aforementioned Citizens Bank, was buying
up US sub-prime risk, 'allegedly without seeking approval from the RBS
board'. The Telegraph goes on to say: 'It is claimed that it was not
until the summer of 2007, as Northern Rock was facing meltdown, that Sir
Fred told the board that RBS had, in fact, built up a substantial
sub-prime exposure'. A spokesman for RBS said:

"The reality is that, like many others, RBS was heavily exposed to
problems in sub-prime markets via its own operations and those inherited
from ABN Amro. This is despite the fact that we did not engage directly
in sub-prime issuing. The Board was in possession of full information
and the details provided to the market in all financial reporting
reflected the Group's honestly held opinion at the time."

The experience of reading a publicly held company's accounts is not
supposed to resemble a first encounter with late Mallarme. But
unfortunately, it all too often does - particularly in the case of the
banks. I defy anyone to study RBS's reports and accounts and to acquire
from them a full sense of the risks the bank was taking. It is exactly
as Warren Buffett wrote in 2004: 'No matter how financially
sophisticated you are, you can't possibly learn from reading the
disclosure documents of a derivatives-intensive company what risks lurk
in its positions. Indeed, the more you know about derivatives, the less
you will feel you can learn from the disclosures normally proffered you.'

I'm not claiming that the accounts are deliberately obfuscatory, but I
am saying that there is no way one can acquire a full understanding of
what was going on from reading them. The lack of transparency is severe.
And this was just RBS, whose arrangements weren't especially baroque by
the standards of the City and Wall Street. RBS had no involvement in the
Structured Investment Vehicles - SIVs - whose main purpose is to keep
things off the balance sheet. SIVs involved borrowing short in order to
lend long, the same dazzlingly successful financial model that
underpinned Northern Rock; I use the past tense in reference to SIVs
because none of them is still in business. They have all blown up - they
were hugely involved in lending to and investing in the sub-prime market
- and as a result have had to be taken onto the balance sheet of their
parent banks. SIVs were invented by Citibank in 1988. Citibank's SIVs
were all taken back onto the balance sheet of Citigroup, the holding
company, last year, and partly as a result Citigroup, by revenue the
biggest bank in the world, lost $32 billion dollars. On 23 November 2008
the bank received $20 billion from the US government, with an agreement
that it would stand as guarantor for another $306 billion of the bank's
loans. On 27 February this year the US government announced that it was
swapping its $25 billion in emergency aid for a 36 per cent share in the
bank. So the people who brought us the SIV have now been the subject of
two of the biggest bail-outs in history. Now consider the Lehman
Brothers' balance sheet. In their 2007 accounts, under the heading 'off
balance sheet arrangements', they had derivative contracts with a face
value of $738 billion. According to them, this represented an actual
value of $36.8 billion. Pocket change by comparison, but still, as it
turned out, big enough to destroy the bank.

RBS, I repeat, had no involvement in SIVs or off balance sheet
investments. Its accounts are models of clarity and translucency
compared with some of its competitors. And yet you still can't tell from
them what the hell was going on. A big part of the assets listed on
their balance sheet turned out not to be worth anything. We have to
conclude from this that with the banks in their current condition, it
isn't possible to tell from their public accounts what the real
condition of their business is. Call that problem one. There is another
problem, however, and it is this which compounds the difficulty with
banking accounts and makes it a critical one for the British economy.
That problem is the sheer size of the big banks. They are, by near
universal consent, too big to fail. The one time a big bank has been
allowed to go under - Lehman's, in September last year - it almost
destroyed the global banking system, with consequences that are still
being felt, and will continue to be felt for a long time. Without
confident lending from banks to banks and from banks to businesses and
individuals - without the proper functioning of the credit system - the
global economy comes to an abrupt screeching halt. When a bank goes
under, it destroys that confidence. So a big bank can't be allowed to go
under. Call that problem two. Put problem one and problem two together,
and we have the current situation, in which the big banks are completely
untransparent but also too big to fail. That is a catastrophic formula.
We (the taxpaying we) have no choice but to keep them in business, and
yet no real idea what's going on inside them.


Sometimes, when you eat chilli-hot food, the first few mouthfuls tell
you nothing other than that the food contains chilli. It takes a moment
or two to detect the presence of other flavours. Bank bail-outs and
collapses are a bit like that. At first you think they're all the same -
that's the chilli - then you notice that the spicing is in fact subtly
different. RBS might be considered a complex dish like the Mexican mole,
a chilli-and-chocolate stew with a huge variety of textures and flavours
that leaves you uncertain what you're eating. The failure of HBOS is
more straightforward, more like a bog-standard high-street curry. The
Halifax was a former mutual society which became Britain's biggest
mortgage lender. In 2001, it merged with the Bank of Scotland to form
HBOS, a new bank to rival the 'Big Four' on the British high street. The
company set out to dominate the mortgage market in the UK, and did so.
And that's the problem: not fancy derivatives and sub-prime loans from
the US, not indecipherable off balance sheet SIVs, just plain old
mortgages which customers can't afford to repay. Only seven per cent of
HBOS's troubled assets are the fancy-pants imported sub-prime variety.
The rest are all home-grown, created during the UK housing bubble. In
2007, HBOS had GBP 28 million of mortgage arrears and repossessions on
its books. In 2008, that figure became GBP 1.13 billion. HBOS says it is
making allowance for eighteen per cent of its mortgage loans to go into
default. These weren't for the most part the super-risky 125 per cent
loans which helped destroy Northern Rock, just ordinary mortgages on
ordinary, wildly overvalued British homes, which have at the time of
writing fallen in value by about twenty per cent, and have an
unquantified amount still to fall. (My evidence-free personal view is
that they won't stop before they've fallen thirty per cent, and because
markets tend to overshoot in both directions, may well fall further.)
HBOS's share price began to drop last summer when the City became
nervous about its reliance on UK mortgages. There were denials that the
firm was in crisis, which is always a terrible sign. In September 2008,
the Big Four bank Lloyds bought HBOS, after its boss, Victor Blank -
this is the part you couldn't make up - bumped into Gordon Brown at a
drinks party and got him to give an assurance that a takeover would not
be referred to the monopolies commission.

Most of us have had a few drinks at a party and done something
embarrassing, usually along the lines of "I've always fancied you isn't
it time we did something about it", but let's take comfort in the
following truth: none of us has ever done anything as embarrassing as
buying HBOS. The idea was to make Lloyds-HBOS into a giant, dominating
the British high street. The reality? Well, on 1 September 2008, a
couple of weeks before the news of the HBOS takeover, Lloyds was a much
admired bank with a strong capital base (everybody thought) trading at
303p a share; today, 14 May, it trades at 88p a share and is around 65
per cent owned by the British taxpayer, following a bail-out in October
2008 (GBP 17 billion) and then another bail-out in March this year (cost
as yet unknown), after it became clear just how badly the HBOS merger
had affected Lloyds's balance sheet. So the failure of HBOS has dragged
Lloyds down and in turn dragged down the taxpayer, and is another thing
we will be paying for for years and perhaps decades to come. HBOS was
TBTF - Too Big To Fail - and Lloyds, which was bigger, was also
obviously TBTF. The combined Lloyds-HBOS is TBTF in spades.

The alert reader will have noticed that I haven't been precise about
exactly how much of RBS and Lloyds-HBOS we-the-taxpayer now own. That's
because we don't yet know. This overlaps with the question of what is
meant by the all-encompassing word 'bail-out'. The term is a portmanteau
one, and it involves several different kinds of cash injection from the
government to the afflicted banks. ('Afflicted' probably isn't the right
word. 'Self-afflicted'?) The government's money has been given in return
for various different kinds of shareholding and stake, involving
distinctions between 'ordinary' and 'preference' shares, exquisitely
boring distinctions which I don't propose to explore in detail. Because
RBS doesn't yet know how much of the available capital it's going to
need, we don't yet know how much of the bank we are going to end up
owning. The amount could go as high as 95 per cent. In addition, the
government has created the aforementioned Asset Protection Scheme, as a
sort of dump for the assets that are causing all the trouble. The way it
works is that banks can put assets into the scheme, and the government
will insure them against a crash in their value. The scheme has one of
those 'attachment points', in that the first chunk of the loss is borne
by the bank: in the case of RBS, the first GBP 19.5 billion of losses is
borne by the bank. Then the Asset Protection Scheme kicks in, and the
government bears ninety per cent of the rest of the losses. RBS has put
GBP 302 billion of assets into the scheme. In return for this service,
the government is charging a fee of GBP 6.5 billion. In addition, RBS
has to promise not to use tax credits from its losses to weasel out of
paying tax; it also has to promise to keep up lending to UK homeowners
and businesses, to the tune of GBP 25 billion over the next twelve
months. The equivalent numbers for Lloyds are GBP 260 billion in the
Asset Protection Scheme, with an attachment point of GBP 25 billion
before the scheme kicks in. The fee is GBP 15.6 billion, and the bank
promises to lend GBP 14 billion over the next year to the great British
public. How much of the bank we end up owning depends on a complicated
arrangement which swaps kinds of share for other kinds of share, and is
capped at 65 per cent.

Put simply, this is an insurance scheme. The government is insuring the
banks against losses on their assets. There's nothing unusual about such
schemes: they're a standard feature of the banking world. In fact, they
are one of the sources of the current crisis. In the commercial world, a
deal in which one financial institution insures another against
defaults, in return for a fee, is called a credit default swap, or CDS.
In effect, the UK government has undertaken a CDS with our imploded banks.

As chance would have it, it was CDSs that destroyed the third of our
chilli-hot financial companies, the American insurance group AIG. That
feeling you get when you've eaten something, and a few minutes later you
think, oh-oh, I think that my dinner just said that was a case not of
adieu but au revoir? That would be AIG. This is a gigantic insurance
company, worth $200 billion at its peak and definitively TBTF.
Entertainingly for fans of financial acronyms, AIG was done in by CDSs
on CDOs. That's to say, it took part in credit default swaps on
collateralised debt obligations, the pools of sub-prime mortgages whose
dramatic collapse in value last year was the proximate cause of the
financial crisis. When Lehman's imploded last September, done in by its
exposure to CDOs, there was a panicked scramble to see who else was
carrying similar risk. When it turned out that AIG was, and, worse, that
it was valuing those assets at much higher prices than Lehman's had,
investors freaked and the company's credit rating collapsed. That meant
that it had to post more collateral to cover its share of risks; because
credit markets had tightened up, it couldn't borrow the money it needed;
and because it was TBTF, the US government stepped in with a bail-out on
16 September, worth $85 billion, in return for 79.9 per cent of the
company. (The bail-out - I've said they come in different varieties -
was in the form of a 24-month credit facility. To adopt an analogy with
personal finances, this meant AIG could draw on the government's bank
account.) On 8 October, AIG was given another $37.8 billion in credit.
Enough, already? No. On 10 November the US Treasury pumped another $40
billion into the company by buying freshly issued stock created for the
purpose (this being yet another variety of bail-out - somebody should
write a Bankster Bail-out Cookbook). Finally enough, already? Don't be
stupid. On 1 March 2009 the Treasury gave the company another $30
billion and restructured the terms of its loan to make repayments of
government money less arduous. The next day the company announced a loss
for the quarter - not the year, the quarter - of $62 billion, the worst
corporate results in history. Finally enough, already already? Not
necessarily. According to the US Treasury statement accompanying the
fourth bail-out: 'Given the systemic risk AIG continues to pose and the
fragility of markets today, the potential cost to the economy and the
taxpayer of government inaction would be extremely high'. To stabilise
AIG would 'take time and possibly further government support'. That's
what Too Big To Fail means. Cost of US government assistance to AIG thus
far: $173 billion. You could put it like this: AIG + CDS + CDO + TBTF =
$173,000,000,000.

We had our entertaining but essentially distracting row over Sir Fred
'Knighted for Services to Banking' Goodwin's pension; in the US they had
their equivalent row over bonuses paid to senior AIG executives after
the bail-outs. The bonuses totalled $165 million and it doesn't take a
PR professional to see that March 2009, after the fourth AIG bail-out,
wasn't the ideal time to have announced them. Everyone on both sides of
American politics from Obama downwards joined in the storm of outrage,
which was followed by predictable bleating from the banksters. A
Republican senator invited the AIG executives to follow the 'Japanese
example' and either apologise or commit suicide. (More authentic to do
both, surely?) A Democratic senator threatened to tax the bonuses at 100
per cent. The New York Times published an AIG executive's open letter to
his boss, which said he was resigning because he hadn't been a
derivatives trader and his feelings were hurt. He seemed to be expecting
applause because he was giving away his own bonus of $742,006.40. Good
fun all round.

The story was a distraction from the real scandal about AIG, which is
what was happening to the other 99.9 per cent of the money the
government was pumping into the company. Since AIG wrote CDSs, which are
effectively insurance against losses, and since those losses had
occurred, why then the cash was going to companies that had lost money
in the credit crunch: companies such as Societe Generale, which received
$11.9 billion; Goldman Sachs, $12.9 billion; Merrill Lynch, $6.8
billion; Deutsche Bank, $11.8 billion; Barclays, $8.5 billion; BNP
Paribas, $4.9 billion. Nothing could better illustrate the way in which
this has be- come a systemic international crisis than the fact that the
US Treasury is transferring these gigantic sums to foreign banks,
because they feel they have no choice if they're to keep the financial
system functioning. But it's a hell of a pill for the US taxpayer to
have to swallow, a much bigger and more bitter pill than the one about
the bonuses. AIG is broke, essentially because it got its sums wrong
about the level of risk represented by CDSs. So it can't pay its
counterparties (that's the other side of the insurance deal, the
insurees). But the counterparties made the same mistake, since they took
out insurance with an insurer who, in the event of a structural crisis,
wouldn't be able to afford to pay them. So why are the insurees walking
away whistling with pockets full of US Treasury cash, while the US
taxpayer sits on a gigantic loss? Note that AIG's market capitalisation
- the total value of all its shares - was at its lowest less than a
billion dollars. Saving the company has cost many, many times more than
buying it would have. Why therefore has the Treasury saved it? Because
AIG is Too Big To Fail.

What links all these companies - and all the other companies and
institutions around the world which have been felled by the credit
crunch, from the Icelandic banks Glitnir and Landsbanki, the Belgian
bank Fortis, the Irish bank Anglo Irish, Northern Rock which started it
all, and all the other institutions that are currently in trouble - is
that gigantic holes have appeared on the left-hand side of their balance
sheets, where assets are listed. Those assets are for the most part
linked in one way or another to the collapse in property prices in the
US and elsewhere. They are often described as 'toxic assets', or more
euphemistically as troubled assets, and in fact that's how they're named
in the US scheme to buy them from the banks, by way of rebuilding the
banks' balance sheets: the Troubled Asset Relief Programme, TARP. This
is different from the British plan to insure toxic assets, which makes
the UK into a gigantic issuer of CDSs, in favour of its troubled banks.
But the term 'toxic assets' is misleading. It makes me think of Superman
intercepting a rocket-powered canister of vileness unleashed by some
villain and deflecting it into space. Toxicity, however, is not some
inherent property of these assets. The assets in question don't contain
some magic property of poisonous money-juice. What's poisonous about
them are their prices. As Stephanie Flanders has said, it would be more
accurate to call them 'toxic prices' - it would at least be an aid to
clearer thinking.

The definition is usually stated as follows: these are assets which
can't be accurately priced, and which therefore spread uncertainty and
insecurity throughout the financial system. But that isn't quite right.
It's true that some of the assets at the moment have no price because
there is no market for them, and it's a moot point whether or not there
ever will be a market again. But many of these assets do have prices -
there are buyers out there willing to acquire them. That makes sense.
Consider Lloyds-HBOS: it's obviously not true that every mortgage sold
in recent years by Halifax is a dud, spreading poison through the
company's balance sheet. That defies common sense. It's probably the
case that the bulk of the company's mortgages, perhaps the overwhelming
bulk of them, perhaps including the worrisome recent loans, are viable.
People's houses might not be worth what they paid for them, but in most
cases their owners are going to continue paying the mortgages anyway.
There must be many comparable examples out there, of highly
out-of-fashion mortgage-based investments which aren't as deeply in
trouble as the markets currently think. It might make sense, if you were
an experienced investor in those markets, to investigate the possibility
of buying some of these investments at a bargain price. The problem is
that these prices are, from the banks' point of view, too low. The
buyers are willing to acquire them at, say, twenty or thirty cents to
the dollar, so that an asset whose notional worth is $10 million - a
derivative tracing its value from sub-prime mortgages, for example -
might have someone willing to buy it for $2 or $3 million. For the bank,
that price is too low. It isn't too low in the sense that they quite
fancy the idea of a higher price; it's too low in the sense that, if
they accept the valuation, they have a gigantic hole on the left-hand
side of the balance sheet. Their assets aren't worth what they're
supposed to be, and the bank is no longer solvent.

I guarantee that at this very moment, somewhere in the world, somebody
at one of the big banks is sitting with his head in his hands, looking
at the company's balance sheet and sweating over this very problem. If
the global economic crisis can be reduced to one single phenomenon, it
is this: the fact that nobody knows which banks are solvent. Because
banks are crucial to the creation and operation of credit, a bank crisis
leads directly to a credit crunch. It's also the reason the huge amounts
of money being pumped into the banking sector by governments are tending
not to do the thing they are supposed to do, that is, restart lending to
businesses and consumers. That's because - and here we can have that
very rare thing, a brief moment of sympathy for the banksters - the
banks are being given two totally incompatible goals. One is to rebuild
their balance sheet and recapitalise themselves so they're no longer at
risk of going broke. The second is to keep lending money. They're being
told to save and to keep spending at the same time. It's not possible,
and in the circumstances it's no mystery why banks are using every penny
they can get, and calling in every loan they can: they're doing it in
order to 'deleverage' and rebuild their capital as fast as possible.

What the banks want to be able to do is what most of us would do in
comparable circumstances. Indeed, it's what a good few of us, myself
included, have done in the past, during previous busts in the property
market. You just wait. Those who are in the dreaded position of having
'negative equity' - that's 900,000 people in the UK, with many more due
to join them in the coming months - can sell and take a loss, if they
can afford to, or they can just wait. Carry on living, and wait for
prices to recover, and even if they don't, you still have somewhere to
live. That's what the banks would like to do about their toxic prices:
wait for them to become non-toxic. If they were forced to value their
assets today, for the price they could get today - a practice known as
'mark to market', which is supposedly enforced on most kinds of asset -
some of them would be insolvent. Since the current valuations would
irretrievably trash their balance sheets, they would prefer not to
accept them.



The trouble is that banks are not households. If banks sit on their
hands and wait for valuations to recover, the economy grinds to a halt.
The flow of money would stop and the recession would be even more severe
than it is already certain to be. That's because a situation in which
banks are insolvent but stay in business means that you have 'zombie
banks'. A zombie bank is a bank which is dead - insolvent - but has a
horrible pseudo-life because it is being allowed to keep trading by
(usually) an overindulgent government. Zombie banks are not
hypothetical: it was zombie banks, created by a too-cosy relationship
between banks and the state, which after 1989 turned the Japanese
economy from a wonder of the world to a comatose onlooker on global
growth. The economy can't recover until the zombies are killed.

It isn't hard to know how to slay the zombies. The only way to do it is
to hold a gun to the head of the various bankers - those various guys
sitting with their heads in their hands staring at balance sheets with
holes in them - and force them to admit what their assets are worth,
right now. Many of the banks will turn out to be insolvent. In that case
the bank is nationalised, or at the very least goes into administration
and receivership. Then, a number of options become available, one of the
principal ones being to break the bank up into the viable part of the
business, which will eventually be refloated back onto the market, and a
'bad bank' of dodgy assets which must be sold off (or arguably held
until the values recover) in whatever way makes the most possible money
for the taxpayer.

Nobody in power wants to do that. Nobody with power in the banking
system, and nobody with power in government. Both the British and the
American plans to help the banks are very, very, very expensive
variations on the theme of sticking their fingers in their ears and
loudly singing 'La la la, I'm not listening'. This is what's happened so
far. In Britain, on 8 October 2008, the government announced a GBP 500
billion rescue package. This had various components. One was GBP 200
billion for the Special Liquidity Scheme. This scheme had begun in April
2008 and the new announcement increased its size. It allows banks to
swap assets which can't be sold - pretty much the definition of a toxic
asset - in return for much more sellable (in other words, liquid)
nine-month government bonds. At the time of writing, this scheme has
been taken up by banks to a value of GBP 185 billion. The government
also created the Bank Recapitalisation Fund, to keep the banks in
business by buying their shares. An initial GBP 25 billion went into the
scheme, with another GBP 25 billion available if needed. It's this money
which has been used to bail out RBS and HBOS, as above. In addition, the
government offered up to GBP 250 billion in loan guarantees between the
banks. These were designed to take away the uncertainty in interbank
lending, the uncertainty whose cause was the existence of toxic assets
on each others' balance sheets. The government was offering to insure
these loans - in other words, the government was offering to become a
one-stop shop for credit default swaps.

The distinctive feature of the UK scheme is the way the government took
stakes in the banks as a way of recapitalising them and helping them to
stay in business. In the US it was different. There, on 1 October 2008,
the Senate passed the Emergency Economic Stabilisation Act, based on the
plan floated by the then treasury secretary, Henry Paulson. This created
the Troubled Asset Relief Programme I've already mentioned, a $700
billion fund designed to buy the toxic assets from the banks. The
government would then be free to sit on them until they recovered some
value, and in the meantime could enjoy the income from the various
underlying streams of mortgage revenue - since these assets were of
course mortgage-backed securities based on the famous sub-prime
mortgages. This scheme varies from the British one in that it doesn't
have the government pumping cash into the banks to keep them solvent,
but instead has it taking the toxic assets away - deflecting them into
space a la Superman - and hoping that this will in and of itself cause
normality to break out in the banking sector. There was a not-so-subtle
difficulty with the plan, however: what price is the government to pay
for the toxic assets? How are the banks to be prevented from gouging
horribly unfair sums of money from the taxpayer? After all, the market
has broken down because the gap between what sellers are willing to
accept and buyers are willing to pay is so great that the two parties
can't do deals. So the government waltzes in and agrees to be the patsy,
overpaying for assets which the bank knows far more about than the
government does? It's not just buying a pig in a poke: it's buying a pig
in a poke at a price determined by the seller, at a time when there is
no market in pigs.

That problem proved unfixable. The banks and the government couldn't
agree prices for the assets to go into TARP. Instead, the government
found itself putting money directly into the banks in return for
shareholdings, in a less structured version of the British approach. So
far $250 billion has gone into the banks in this way; it's this money
which has underpinned the bail-outs to date, plus the extra $40 billion
into AIG. The current cost to the US taxpayer of TARP so far is
estimated at $356 billion. That got through about half the $700 billion
Congress had allocated to the bail-out. In February, the new treasury
secretary, Tim Geithner, announced the outline of his plan for the rest
of the money, and then on 23 March the detail of the plan came out. It
has three different components, all of which involve the creation of
public-private partnerships between the government and private
investors. One part of the plan matches private money with government
money, while also offering to lend up to 85 per cent of the private
stake. (We decide to buy something for GBP 100. I lend you GBP 92.50,
GBP 85 of it on loan, and you pay GBP 7.50.) Another part has the
government putting up a chunk of money to buy toxic assets, and offers a
line of credit to buy more assets, provided that private money goes in
too. This part of the plan is called the Term Asset-Backed Securities
Loan Facility or TALF (presumably TABSLF was viewed as unpronounceable -
but I can't be the only person to find in TALF a faint, embarrassing
shadow of the porny acronym MILF). This additional government money
comes in the form of a 'non-recourse loan' - that's to say, the
government can't ask for its money back, if the investment goes wrong.
The non-recourse loans can constitute up to 85 per cent of the total
investment. The private investors get all the upside if the price goes
up. This is a truly amazing sweetener to persuade private money - in
practice, if the plan works, that will be made up of hedge funds,
sovereign wealth funds and private equity groups - to get involved in
buying up the toxic assets. The idea, the hope, the longing, is that
this will create a market in the assets; and once a functioning market
is created, the thinking goes, the market will realise that these assets
are in fact undervalued, and the prices will recover, and bank balance
sheets will recover, and peace and order will break out and the
financial sector will be restored to health. It'll be like the last act
of Fidelio, except the people emerging from the cellars blinking with
joy will be bankers.

To the relevant bigshots of the financial sector - people Tim Geithner
knows well from his time as head of the New York Federal Reserve - this
plan represents a bold, sane, ingenious attempt to create a space for
the so-called assets to return to their rightful values. To many other
observers, it's not so different from dressing up in a costume and
dancing in a circle praying for the intervention of the Market Gods. The
plan embodies a desperate yearning for this to be a crisis of liquidity
rather than one of solvency, and hopes that by acting on that belief, it
will make it come true.

About twenty years ago I bumped into Alan Hollinghurst at a party at the
Poetry Society. He greeted me with the words, 'Hello. I'm going to
tremendous, Basil Fawltyish lengths to avoid being introduced to Sir
Stephen Spender', whose collected poems he had just given an unglowing
review. 'Tremendous, Basil Fawltyish lengths': that phrase stuck with
me. It comes to mind when I look at Anglo-Saxon attempts to address the
crises in their respective financial sectors. The UK and US plans are
different, as I've said, but at their heart they both show the
governments going to tremendous, Basil Fawltyish lengths in order to
avoid taking the troubled banks into public ownership. Our governments
are prepared to pay for them, but not to take them over.

There are four reasons for the reluctance to take over the banks, of
which the first isn't a real reason but a piece of political bullshit.

1. Because the government would be bad at it. This is the only reason
governments are willing to give in public, and it fails the most
elementary test of all: only a professional politician can say it with a
straight face. Bad at running the banks, compared to the bankers who
broke capitalism? Please. But this is the closest they can get to
admitting the first real reason, which is:

2. Because if the banks were taken over, then every decision they take
would come at a potential political cost to the government. Your
state-owned mortgage lender is threatening to repossess your house,
after you fell behind on the payments? Blame the government. Your firm
is laying off half its workforce because the bank won't roll over its
loan? Blame the government. This, of course, is in addition to all the
other economic things for which people are already blaming the
government. People are grumbling now, but to nothing like the extent
they would if the banks were directly owned by the state. Politicians
simply aren't willing to take on the responsibility for the banks' actions.

3. They also don't want to admit the extent to which we are all now
liable for the losses made by the banks. Guess what, though: it's too
late. The thirty per cent collapse in the value of sterling over the
last months is something which is only just beginning to be noticed by
the public at large; but it is unlikely to go away as quickly as it
arrived. The reason sterling has crashed is simple: the markets are
pricing in the fact that we the taxpayer are on the hook for the losses
made by our banks. The markets assume that we can't or won't default on
our government debts - that would mean we simply can't afford to pay
back the amount we're currently borrowing. They're probably right about
that. But Alistair Darling's desperately grim Budget made it clear just
how deep in the mire we are. As for how bad it is, and how quickly it's
gone bad, well: in March last year, at the time of the Budget, the
projected deficit for 2009-2010 was GBP 38 billion. By 24 November, the
projected deficit was GBP 118 billion. In the Budget on 22 April,
Darling admitted that the real figure is going to be GBP 175 billion.
The total projected borrowing for the next four years is GBP 606
billion. National debt will hit 79 per cent of GDP - the highest
peacetime figure ever. The economy is going to have its worst year since
1945. The debt is going to cost in the range of GBP 35 to GBP 47 billion
a year to service. That's just the debt alone; we're going to be
spending more on debt than we are on the entire transport budget.
Perhaps New Labour might consider changing its motto from 'Education,
education, education' to 'Debt, debt, debt'.

That means tax rises, a near total freeze on government spending,
swingeing public-sector job cuts, companies laying off every worker they
can to save costs, and a dramatic upward spike in unemployment. The one
easy thing the government will be able to do to help itself is to make
inflation go up - that helps, because it decreases the real cost of the
debt. An inflation rate of five per cent means that the debt goes down
in cost by five per cent every year, magically and just by itself. From
the point of view of a heavily indebted government, that's good news;
for other parts of the economy, for borrowers and for anyone holding
sterling, it's less good. To compound this already desperate picture, we
also have huge levels of personal debt, directly arising from our credit
bubble. The average British household owes 160 per cent of its annual
income. That makes us, individually and collectively, a lot like the
cartoon character who's run off the end of a cliff and hasn't realised
it yet. None of this is secret, and investors looking at the prospects
for sterling are making up their minds and bailing out. The
investor-pundit Jim Rogers, colleague of George Soros, is advising
anyone who will listen to 'sell any sterling you might have. It's
finished. I hate to say it, but I would not put any money in the UK.'
This isn't nice or polite, but it puts into the public domain what a lot
of international money men are saying in private. More to the point,
it's a policy on which they have already acted. This is the reason an
auction of government debt held in March failed. The debt was for
forty-year bonds paying out at a rate of 4.25 per cent, and the reason
it failed to sell everything on offer - the last time that happened was
in 2002 - is that the markets thought inflation likely to rise, making
the bonds a bad bet.

And the reason for that is that we in Britain are, to use a technical
economic term, screwed. Economies across the whole world are struggling.
Because nobody is spending money, even relatively blameless countries
such as Germany, with low levels of debt and workforces who actually
make things, are having a difficult time. Germany's economy is predicted
to contract by 5.4 per cent this year. A banker explained it like this:
'When your country's economy depends on people buying a car every three
years, and they decide that they'll only buy a car every five years,
you're fucked. Off a cliff.' So the German economy is fucked off a
cliff. But it will recover, when people start buying cars again, and
when it does, at least their underlying levels of debt are manageable.
Something similar goes for Spain, where the ending of the property boom
has caused a spike in unemployment to 17.4 per cent, almost doubling in
a year, or Ireland, which has contracted by a truly horrendous eight per
cent and where people have gone from owning private helicopters to
losing their homes in six months flat. All of these countries are in
deep trouble. But there are four things you don't want to have, going
into the current crisis. 1. You don't want to have had a boom based on a
property bubble. 2. You don't want to have a consumer credit bubble. 3.
You don't want to have an economy based on financial services. 4. You
don't want your government to have just gone on a massive spending
spree. We have all four of those things that you don't want.

It is possible that we are on course for the worst-case scenario. That
would involve all our big, TBTF banks turning out to be insolvent, with
the result that their balance sheets go onto the public debt. If that
were to happen, Britain itself could become insolvent. Countries do go
broke. A famous-to-economists example was Newfoundland, which in 1934
effectively went into administration and opted for direct rule from
Britain because it was broke - becoming in the process one of the only
colonies anywhere in the world ever to have voluntarily given up
independence. A modern-day equivalent is having to go to the IMF and ask
for money. It happened in 1976 and could happen again. The trigger would
be a general view in the markets that the government's tax receipts
weren't sufficient to meet its debt payments. That would cause a
'buyer's strike' in the bond market: nobody would want to buy UK
government bonds, so the government could no longer keep going back to
the markets for cash to pay its liabilities. That would leave the
government facing an immediate need for cash with no means of raising it
- and it's that which would send us prostrate to the IMF. Sterling would
be more or less worthless. Travel would be next to impossible, imports
would be unaffordable, interest rates would zoom up and stay up, there
would be cuts in all aspects of public sector spending, especially
employment. It would be brutal. Nobody thinks this scenario is likely,
but quite a few people are willing to admit that it is possible. In
1976, Britain went broke running an annual deficit - the gap between tax
revenues and government spending - of six per cent of GDP. Next year
that figure is going to hit 12.4 per cent. A bad omen.

Even if we fall short of the IMF option in favour of a run-of-the-mill
severe recession, the consequences for Britain are going to be horrific.
Roads and schools and hospitals will go unbuilt and unrepaired, medical
treatments will go unbought, nurses and policemen and council workers
will be laid off. Six hundred thousand jobs have been created in local
government in the last few years. Most of them will have to go. And then
the really gigantic argument will have to be had, over the public
service pensions which are paid for out of current tax receipts. I don't
know anyone who has studied this problem who thinks the government will
be able to afford them. Can you imagine the fights that are going to
happen? The political polarisation between public and private sector
employees, the savagery of the cuts, the bitterness of the arguments,
the furious sense of righteousness on both sides? It'll be Thatcher all
over again, and the current period of managerial non-politics will seem
as distant as the Butskellite consensus did in the 1980s.

All of this leads us to the fourth and deepest reason why the government
won't nationalise the banks. The deepest reason is:

4. Because it would be so embarrassing. Some of the embarrassment is
superficial: on the "not remembering somebody's name at a social
occasion" level. The Anglo-Saxon economies have had decades of boom
mixed with what now seem, in retrospect, smallish periods of downturn.
During that they/we have shamelessly lectured the rest of the world on
how they should be running their economies. We've gloated at the French
fear of debt, laughed at the Germans' 19th-century emphasis on
manufacturing, told the Japanese that they can't expect to get over
their 'lost decade' until they kill their zombie banks, and so on. It's
embarrassing to be in a worse condition than all of them.

There is, however, a deeper embarrassment, one which verges on a form of
psychological or ideological crisis. To nationalise major financial
institutions would mean that the Anglo-Saxon model of capitalism had
failed. The level of state intervention in the US and UK at this moment
is comparable to that of wartime. We have in effect had to declare war
to get us out of the hole created by our economic system. There is no
model or precedent for this, and no way to argue that it's all right
really, because under such-and-such a model of capitalism ... there is
no such model. It just isn't supposed to work like this, and there is no
road-map for what's happened.

It's for this reason that the thing the governments least want to do -
take over the banks - is something that needs to happen, not just for
economic reasons, but for ethical ones too. There needs to be a general
acceptance that the current model has failed. The brakes-off, deregulate
or die, privatise or stagnate, lunch is for wimps, greed is good, what's
good for the financial sector is good for the economy model; the sack
the bottom ten per cent, bonus-driven, if you can't measure it, it isn't
real model; the model that spread from the City to government and from
there through the whole culture, in which the idea of value has
gradually faded to be replaced by the idea of price. Thatcher began, and
Labour continued, the switch towards an economy which was reliant on
financial services at the expense of other areas of society. What was
equally damaging for Britain was the hegemony of economic, or
quasi-economic, thinking. The economic metaphor came to be applied to
every aspect of modern life, especially the areas where it simply didn't
belong. In fields such as education, equality of opportunity, health,
employees' rights, the social contract and culture, the first
conversation to happen should be about values; then you have the
conversation about costs. In Britain in the last twenty to thirty years
that has all been the wrong way round. There was a reverse takeover, in
which City values came to dominate the whole of British life.

It's becoming traditional at this point to argue that perhaps the
financial crisis will be good for us, because it will cause people to
rediscover other sources of value. I suspect this is wishful thinking,
or thinking about something which is quite a long way away, because it
doesn't consider just how angry people are going to get when they
realise the extent of the costs we are going to carry for the next few
decades. I think we will end up nationalising at least some of our big
banks because the electorate will be too angry to do anything that looks
in the smallest degree like letting them get away with it. Banks can't
change their behaviour, so we have to do it for them, and the only way
to do it is to take them over. We can't afford any more TBTF.

I get the strong impression, talking to people, that the penny hasn't
fully dropped. As the ultra-bleak condition of our finances becomes more
and more apparent people are going to ask increasingly angry questions
about how we got into this predicament. The drop in sterling, for
instance, means that prices for all sorts of goods will go up just as
oil and gas prices have spiked downwards. Combined with job losses - a
million people are forecast to lose their jobs this year, taking
unemployment back to Thatcherite levels - and tax rises, and inflation,
and the increasing realisation that the cost of the financial crisis is
going to be paid not over a few years but over a generation, we have a
perfect formula for a deep and growing anger. Expectations have risen a
lot, over the last three decades; that's going to have a big impact on
how furious people feel about the hard years ahead. The level of future
public spending cuts implied in Darling's recent budget - which included
the laughably optimistic idea that the economy will grow by 1.25 per
cent next year - is greater than the level of cuts implemented by
Thatcher. Remember, that's the optimistic version. If we're lucky, it
won't be any worse than Thatcherism.

Notes:

1 Neal Ascherson wrote about the Darien Scheme in the LRB of 3 January
2008: http://www.lrb.co.uk/v30/n01/asch01_.html

2 They go to some lengths to make sure it's that way, since Apple is, in
financial circles, notorious for sitting on huge amounts of cash. In the
balance sheet we're looking at, Apple had $24.49 billion in cash. That's
a colossal amount, as much as RBS, a company fifty times its size. This
cash, obviously, stays on the asset side of the balance sheet. You might
think that having lots of cash is a good thing, but in investment
circles it isn't loved: the logic is that if you have cash, you should
give that cash back to its ultimate owners, the shareholders. They might
have other things they want to do with it.

3 My footnote, not RBS's: an 'attachment point' is the same thing as the
excess in an insurance policy. It means the point at which the insurer
shells out. I quite like it as a corporate euphemism, embodying as it
does an image of the insured person desperately trying to attach himself
to the insurer, while implying that the insurer is keen for this not to
happen. Translated, 'high attachment points' means 'these crappy
mortgage-borrowers need to have lost a lot of money before they become
our problem'.

4 Fool's Gold will be reviewed in the LRB by Donald MacKenzie.

_____

John Lanchester's book about the financial crisis, Whoops, will be
published by the Penguin Press, once he's finished writing it.

Other articles by this contributor:

Cityphobia · The Crash

Warmer, Warmer · Global Warming, Global Hot Air

A Month on the Sofa · My Sporting Life

See you in court, pal · The Microsoft Trial

Bravo l'artiste · What is Murdoch after?

Unbelievable Blair · John Lanchester falls out with New Labour

Diary · Blogswarms

Other People's Capital · Conrad and Barbara Black
	
ISSN 0260-9592 Copyright (c) LRB Ltd, 1997-2009


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