Bank balance sheets become focus of scrutiny
Heard in London: Hedge fund economist: "Hey Bill I am worried that one of the major banks will go under by next year." Hedge fund manager: "Fred I am certain one of them is going to go under". Now hedge fund people move in a world of febrility, giant risk and hyperbole but this conversation happened, and recently (names changed, obviously).
If it's a plausible risk it explains why much of Gordon Brown/Alistair Darling's effort on the economic front was focused on patching up bank regulation and boosting liquidity. Far from "shutting the stable door after the Northern Rock has bolted", there may yet be the danger of another, more thoroughbred, horse kicking the stable door down and careering between Canary Wharf and Poultry smashing things up at all points in-between. We'll be looking at this on Newsnight sometime this week but, for now, here's a primer on what they're worried about...
1) The UK banking sector's shares have been hammered badly, causing them to go cap in hand to their existing shareholders for more capital. HBOS, plummeting today, is at £2.95 a share as I write and was £10 a share this time last year. The sector has lost around 70% of its mid-2007 value. In French they have the "mot de Cambronne"; in English we must reach for the "mot de Mottram" to describe such situations. (See here for an explanation).
2) They've been taken by surprise. Six months ago many bank bosses were insisting they did not need to go to the markets for more money; but now, through "rights issues", they have collectively raised about 21bn GBP. They needed to do this because the "capital adequacy" rules which govern banks say that their capital (represented by the value of their shares) has to be a certain percentage of the risk they are carrying on their books. That is why, this week, financial journalists and analysts will be scrutinising the balance sheets, not the profit and loss statements so much. Jill Treanor in the Guardian has more on this.
3) Capital adequacy rules are complex: unlike a straight "debt-to-equity" percentage, such as you use with your mortgage (say you have a 95k mortgage on a 100k house then you have 5% equity), the theory of capital adequacy allows banks and regulators to "weight" various types of debt according to risk. Right now the Basel II international regulation regime is having to be rewritten in real time because existing models are "not capturing" huge swings in the scale of risk. And the risks are increasing...
4) Soon UK banks could begin to be exposed to problems in the UK mortgage market: the subprime crisis began in the US of course, triggering a freeze-up of inter-bank lending across the globe. If UK house prices fall 20%, says Sandy Chen at Panmure Gordon, then of the 1.2 trillion UK mortgage lending, there would be 360bn of mortgages in negative equity, affecting 3 million households (Research note: 13.05.08) . That risk must be reflected in the balance sheets of the banks and demand, at some point, a return to the stock markets to raise more capital to meet the adequacy requirements.
5) But all is not well in the world of rights issues. The HBOS rights issue has been politely described by commentators as "a disaster". Only 8% of small investors decided it was worth buying the shares. The underwriters were initially left with 2.5bn of unsold shares, a position which they then had to do some nifty financial footwork to ameliorate. It is reported today that the FSA is looking at new rules to speed up rights issues and prevent potential market manipulation; however this does not address the worst-case scenario that finance boffins are worried about: that at some point there will be a bank that HAS to raise capital but CANNOT raise capital on the markets. Cue a string of cutprice takeovers (a breakup bid for HBOS is being reported today by the Telegraph; Alliance and Leicester is the subject of a takeover bid by Santander at a price of £3.18 per share (currently trading at £3.39, price just over £10 one year ago).
If it comes to pass that an ailing bank cannot be taken over, then that is where Sir Richard Mottram's famous phrase will become appropriate. That is what I think hedge fund people are worried about when they ruminate about a banking collapse - and of course the really frightening thing is that there will be people out there who believe they can make money out of it, just as they make money pushing the price of grain or oil higher.
If you read the briefings coming out of government during this weekend of crisis/backstabbing you can see this linked problem of the mortgage market and the banking system is high on their agenda: someone has been briefing that they are to launch a US-style bailout system for the mortgage market where the government effectively becomes the guarantor of new mortgage lending; and a stronger depositor insurance scheme looks likely to be rushed in.
If all this makes you nervous, at least we know now - after Northern Rock, Fannie Mae, Indy Mac and Bear Stearns - what happens when a bank fails: its depositors get bailed out by the government and its shareholders don't. No pattern has yet been established about the bailout of investment banks and other hybrid institutions though (with Bear Stearns the USA had to bend its own rules).
A final note on all this: I am not a banking analyst and I can only go off what the experts tell me, and to report what I hear. I am not saying there's going to be a banking collapse and I have no inside knowledge. There are many checks and balances in the system and the regulators are patrolling like Bondi lifesavers at shark feeding time. Do not take any decisions on the basis of what I write: it's only meant to aid understanding of the financial, regulatory and political news as it develops. If you think different or know better, please hit the comment button and set me straight!