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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RBS Share Buy-Back

The Royal Bank of Scotland (RBS) is proposing to buy-back up to 4.99% of its shares from the stake held by the Government (by UKFI on its behalf). At present the Government holds 62% of the company stemming from the bailout in the banking crisis ten years ago. They have been trying to get shot of it ever since as no Tory government thinks it should be investing in banks. This latest proposal makes it clear that UKFI cannot easily sell the shares in the market, nor place them with institutions, perhaps because there are still outstanding lawsuits faced by the company.

Should shareholders support this proposal? I don’t think so, and I will be voting against it with the few shares I hold which were acquired to support the ShareSoc campaign for the appointment of a Shareholder Committee. Incidentally this proposal rather suggests that it is now even more important to have such a Committee because this proposal may be of advantage to the Government but it is not at all clear whether it is of benefit to shareholders as a whole.

Fortunately UKFI won’t be able to vote their shares at the EGM to approve the proposed buy-back so other shareholders will decide the issue.

Other shareholders might wish to ask themselves, why should shares only be bought back from UKFI and not all shareholders, e.g. via a tender offer. Another negative is that this share buy-back is effectively a reduction in capital when banks like RBS still have a relatively thin equity capital base. In any case, I generally vote against buy-backs other than in investment trusts. They are usually misconceived. The Government commissioned research into share buy-backs a year ago on the grounds that they may be being used to inflate executive pay (reducing the number of shares in issue increases earnings per share which is a common element in executive pay bonus and LTIP schemes). The research has yet to produce a report.

Personally I would like to see share buy-backs made illegal except in very limited circumstances, as they used to be. They are rarely of benefit to other shareholders and can be used by foolish management to try to manage the share price.

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

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Royal Bank of Scotland on BBC2

Some readers may have watched the BBC2 programme on Tuesday about the collapse of the Royal Bank of Scotland (RBS). It showed the hubris of Fred Goodwin – suites at the Ritz, private jets and a new headquarters opened by the Queen in which he had an enormous office. But when I posted a brief comment on the Stockopedia blog to the effect that the bail out had political overtones, it got some criticism. Indeed to my mind the programme seemed to suggest that Alistair Darling and Mervyn King were heroes who rescued the bank, and the country, from financial disaster and there was no contrary opinion on the merits of what they did.

So here’s some more explanation of the problems of RBS and how they should have been tackled.

RBS certainly was acting aggressively before the crash in 2008. It had one of the lowest capital asset ratios of any bank and then proceeded to acquire ABN-AMRO after competing with Barclays in a bidding war. RBS seemed to expect the profits from ABN-AMRO to improve its cash flow. Although it’s not easy to see the cash flows in banks, they can run out of cash particularly when loans they have borrowed become due for repayment.

One needs to understand that all banks operate on a knife edge – they have massive liabilities backed by massive assets, with only a thin slice of shareholders equity in the middle. So you will find in the December 2008 balance sheet of RBS that it had assets of £2,401,652 million, liabilities of £2,321,154 million and shareholders’ equity of only £80,498 million.

When the financial crisis arose as a result of the realisation that the US sub-prime mortgage market was heading for a fall, liquidity in the bank loan market disappeared. That is what caused the crash at Northern Rock – see: https://roliscon.blog/2017/09/02/northern-rock-10-years-after-collapse/ for past comments on that. Northern Rock was not balance sheet insolvent which would have triggered administration, it was cash flow insolvent. It just ran out of cash because folks were withdrawing cash from the bank and it could not refinance the short-term loans it had taken out in the money markets. Similar problems caused the collapse of Lehman Bros and Bradford & Bingley and the former had world-wide repercussions. The whole world was suffering a banking liquidity crisis.

There were of course subsequent steps taken to tighten up on the bank asset ratios which meant they had to raise more capital. That put many banks into an even more difficult situation. There also was a growing realisation that many banks had assets on their balance sheet that were questionable in value, i.e. debts might not be repaid but they had not been written down because of defective accounting standards (see more in today’s FT on that subject).

In addition the UK Government made the mistake of nationalising Northern Rock and Bradford & Bingley which told any international investor of equity, or even debt, into UK banks that they had no real security. The Government could prejudice their investment using the new legislation that was introduced, at the drop of a hat.

As the BBC programme described, there came a day when RBS had to tell the Governor of the Bank of England that they would run out of cash in a few hours. The collapse of RBS would certainly have undermined the whole UK banking system with other banks also crashing as they had outstanding loans to RBS. The Government’s answer was to launch a massive “recapitalisation” of RBS and other banks via forcing then to sell equity stakes in return for cash. They were given no option but to accept overnight. This effectively meant a nationalisation of RBS because they acquired control of it, along with major stakes in other banks.

Was there a different way they could have taken? Banks frequently run out of cash because of the narrow equity they hold. They can go for years without a hiccup, paying out good returns to shareholders in the meantime, until minor events disrupt this idyll. But the Bank of England can always provide loans to relieve the cash flow pressure if nobody else will. The Bank can of course effectively print money if necessary to do that. RBS did of course undertake a massive rights issue (the largest ever) to strengthen its balance sheet but that was not sufficient. Could they have got by with funding from the Bank of England when the crunch came? I suggest they might. I suggest the prime reason for the approach that was taken was the desire of the Labour Government (headed by Gordon Brown and Alistair Darling) to take control of the banking sector.

In reality other countries tackled their similar problems in different ways. But the UK was the most severely hit by the financial crisis. It was of course not just RBS that had exposure to US sub-prime mortgages. Other major world banks had similar difficulties. But the approach taken in the UK destroyed confidence in the UK financial sector in very short order.

That does not of course make any excuse for the mismanagement of RBS by Fred Goodwin and the general incompetence of the board of RBS in the critical period. But it is all too easy to lay the blame for the UK banking crisis on one individual – it’s called “personification”. But there were no heroes either.

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

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RBS Sale and Blackrock Smaller Companies AGM

The Government is selling off another tranche of its holding in the Royal Bank of Scotland (RBS). By selling another 8% it will reduce its holding to 62% of the company. The Government (or “taxpayers” as some described them) will face a loss of about £2 billion on what it originally paid for the shares. There were howls of protest from some politicians. John McDonnell, shadow chancellor, said “There is no economic justification for this sell-off of RBS shares. There should be no sale of RBS shares full-stop. But particularly with such a large loss to the taxpayers who bailed out the bank”.

I think he is suffering from the problem of “loss aversion”, i.e. a reluctance to sell a losing investment rather than looking at the current value of the bank and its prospects. The market price is surely the best indicator of the value of the company – it’s what willing buyers will pay, and what sellers consider a fair price. One aspect to consider is that the value of the business may be depressed because nobody likes to buy shares in companies where there is one dominant controlling shareholder and particularly so if that shareholder is a government. The only way the UK Government can solve that problem is to reduce its holding in stages, as they are doing. Forget the prospective loss on the share sale. Better to accept the price offered and reinvest the proceeds in something else. The Government has lots of things where it needs more cash – the NHS, Education, Defence, Brexit plans, you name it.

Mr McDonnell may be particularly unhappy as he hopes to take power at the next General Election and RBS is one of the few remnants of the past Labour government’s major stakes in UK banks. After Gordon Brown nationalised Northern Rock and Bradford & Bingley, they took effective control of RBS, and to a large extent Lloyds. Only Barclays managed to escape by doing a quick deal with middle-east investors which has been the subject of legal action, only recently thrown out by the courts. For any socialist, particularly of the extreme left like Mr McDonnell, the ability to tell banks what to do is an undoubted objective. Banks tend to reduce lending when the economy worsens and their clients start to have difficulties but the claim is often that such reduction in lending compounds the economic woes.

Yesterday I attend the Annual General Meeting of Blackrock Smaller Companies Trust Plc (BRSC). What follows are some brief highlights. This company has a good track record – some 15 consecutive years of outperforming its benchmark by active management. So much for passive index investing. It has been managed by Mike Prentis for many years assisted by Roland Arnold more recently. The share price rose by 25% last year but the discount to NAV has narrowed recently to about 6% so some might say it is no longer a great bargain. The company does not have a fixed discount control mechanism and has traded at much higher discounts in the past.

It’s a stock-pickers portfolio of UK smaller companies, including 43% of AIM companies and 143 holdings in total. Many of the holdings are the same companies I have invested in directly, e.g. GB Group who issued their annual results on the same day with another great set of figures.

Mike Prentis gave his key points for investing in a company as: strong management, a unique business with strong pricing power, profitable track record, throwing off cash, profits convert into cash and a strong balance sheet. They generally go for small holdings initially, even when they invest in IPOs, i.e. they are cautious investors.

When it came to questions, one shareholder questioned the allocation of management fees as against income or capital (25% to 75% in this company). He suggested this was reducing the amount available for reinvestment. But he was advised otherwise. Such allocation is now merely an accounting convention, particularly as dividends can now be paid out of capital. But he could not be convinced otherwise.

Another investor congratulated the board on removing the performance fee. Shareholders were clearly happy, and nobody commented on the fact that the Chairman, Nicholas Fry had been on the board since 2005 and the SID, Robert Robertson, had also been there more than 9 years – both contrary to the UK Corporate Governance Code. The latter did collect 5% of votes against his re-election, but all resolutions were passed on a show of hands.

I was positively impressed on the whole.

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

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