LRB · John Lanchester: It’s Finished - About

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.

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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.

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. 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’.

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(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.)

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This is a well-run old firm with members of the original founding family still in charge. It has grown at 10 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 £500 million last year – because it seems to have less potential for growth, its shares are, in terms of their earnings, cheaper.

Highlighted by rochenko

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.

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The new company is worth £10 billion plus £5 billion, yes? No – and this, from the stock market’s point of view, is the beautiful part. Goodwidget’s £500 million of earnings are now added to the total revenue of eWidget, so the merged firm is earning £700 million a year. Remember that eWidget is valued at 50 times its earnings (so that £700 million of earnings implies a market capitalisation of £35 billion), which means that eWidget shares are about to more than treble in price.

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‘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.

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Debt securities 276,427 127,251

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Derivatives 332,060 118,112

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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.

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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.

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Banking does not just involve the management of risk; banking is the management of risk.

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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.

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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?

Group Company

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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.

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

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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’.

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Already in 2006 some analysts were citing the firm as the world’s third biggest player in sub-prime mortgages

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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.

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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 7 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.

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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.

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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 Société Générale, 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.

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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.

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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.

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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

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If the global economic crisis can be reduced to one single phenomenon, it is this: the fact that nobody knows which banks are solvent

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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

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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 t0o-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.

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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.

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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

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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

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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.

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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

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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.

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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.

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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.

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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 30 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.

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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.

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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.

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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 40-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.

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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 20 to 30 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.

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In 1976, Britain went broke running an annual deficit – the gap between tax revenues and government spending – of 6 per cent of GDP. Next year that figure is going to hit 12.4 per cent. A bad omen.

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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 10 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.

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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.

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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.

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LRB · John Lanchester: It’s Finished

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