The Courage to Act, or Not

Some of us have plenty of time to read good books while under house arrest. Here’s one I have been reading. It’s a memoir by Ben Bernanke, former Chairman of the Federal Reserve under the title “The Courage to Act”. It covers the major worldwide financial crisis of 2007/8 created by the defaults in sub-prime mortgages. The book includes a very good section on how that came about and how packaging up such mortgages eventually led to a complete lack of confidence in banks and other financial institutions.

Bear Stearns, a major US investment bank was one victim, but the failure of Lehman Bros which collapsed into bankruptcy had the worst impact. This was a “systemically important” bank because of its size and spread of activity and the US Government could not stop it. It demonstrated that the Federal Reserve (the US equivalent of the Bank of England), the US Treasury and other US institutions were powerless to prevent the debacle. Or at least did not have the courage to act in the face of public opposition to taxpayers bailing out financial businesses.

Another victim was AIG, the largest insurance company in the world but the reality of what happens when everyone becomes scared of the value of financial assets became very clear. Numerous “runs” on banks and savings institutions occurred.

The contagion spread worldwide and affected most large banks including those in the UK where Northern Rock had depositors queuing at their doors, and Royal Bank of Scotland and Lloyds were forced by the Government to take part in “recapitalisations”. It was clear that many financial businesses were grossly under-funded and had gone into more risky business sectors without increasing their capital to match.

The spectre of “moral hazard” reared its head both in the UK and USA, i.e. supporting companies that had pursued risky strategies might encourage others to do the same in future rather than discourage them. That seems to have been one reason why Lehman was abandoned to its fate, as was Northern Rock. That was despite the fact that Northern Rock appeared to have a positive asset position and hence should have qualified for “lender of last resort” loans from the Bank of England to cover a temporary cash flow shortage.

This is an interesting quotation from Bernanke’s book where clearly he changed his stance on the matter:

“You have a neighbor, who smokes in bed…..Suppose he sets fire to his house, I would say later in an interview. You might say to yourself….I’m not gonna call the fire department. Let his house burn down. It’s fine with me. But then of course, what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood? The editorial writers of the Financial Times and the Wall Street Journal [who had opposed bail-outs] in September 2008 would presumably have argued for letting the fire burn. Saving the sleeping smoker would only encourage others to smoke in bed. But a much better course is to put out the fire, then punish the smoker, and if necessary, make and enforce new rules to promote fire safety.”

The latter was what was subsequently done of course in the finance world.

Coincidentally I have seen an email from Dennis Grainger who is still campaigning for some recompense from Northern Rock shareholders who lost their savings in the nationalisation of the company. Apparently he wrote to the Prime Minister on the subject and got a response from the Treasury. You can read the letters here: https://www.uksa.org.uk/sites/default/files/2020-03/NRSSAG-letter-to-PM-28-2-2020.pdf and here: https://www.uksa.org.uk/sites/default/files/2021-01/Treasury-Response-20-March-2020.pdf

The gist of what Mr Grainger says is that bearing in mind that the Government subsequently made a large profit on the transaction the shareholders should be compensated. From my knowledge of events at the time I think it was clear that the Government always expected to make a profit. The response from the Treasury provides very poor excuses for not supporting private sector offers to rescue the company. The major reason was surely not financial, but that the Labour Government and its supporters were unwilling to see any taxpayers’ money rescuing a financial institution – just like the opposition in the USA. The Governor of the Bank of England, Mervyn King, also appeared to lack the “courage to act”.

The failure to support Northern Rock and subsequently Bradford & Bingley undermined the whole UK banking sector as the assets of all of them came under scrutiny and money markets closed. This caused a fall in the stock market and an economic recession.

This was indeed a very sad episode in the financial history of the world. I did of course lose money having invested in Northern Rock shares as I did not anticipate the Government and Bank of England would be so stupid as not to support the company, at least temporarily. But I probably recouped all my losses by picking up other shares that fell to very low levels and recovered in a few years (not banks though – I still do not trust their accounts!).

Bernanke’s book is well worth reading if you wish to understand the details of what happened. If anything it’s rather too detailed at 600 pages as if the author was writing for historians. But it does throw some interesting light on the events of 2008.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson  )

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