Deserving Bank Shareholders?

The 'rescue' of various banks in the crisis of 2007-9 took various forms; partly depending on how far the crisis had run when the individual firm faced insurmountable difficulties, and partly depending on the perceived degree of blame that was laid at the door of the organisation's management.

I am moved to write this piece today because former shareholders in Northern Rock - a historically worthy building society based in north-east England - got nothing when their firm was taken over and dismembered by the government; while Lloyd's and Royal Bank of Scotland kept their names and their structures, and the shareholders retained some of the equity under Treasury tutelage. The Northern Rock shareholders have retained their organisation, and while some former shareholders have accepted their losses and moved on, a hard core has revived the claim that as the government will make a net 'profit' from selling off parts of the firm, it should now reimburse some of the losses that individuals suffered.

This is a technically complex, legally difficult and morally ambiguous area for debate, and I will just make two basic points.

One is that Northern Rock and the Royal Bank of Scotland were both based away from London, and both had rather buccaneering chief executives who became heroes in their regions. Although RBS had a nationwide shareholder base, largely due to the absorption of other major banks into the group, the board was largely focused in Scotland. It only became apparent how far off the rails RBS was going when a 'takeover too far' collapsed precisely as the liquidity crisis hit all the banks. The urgent need of the bank for a rescue of very large proportions placed it abjectly at the feet of the government, and ad hoc measures were taken, of necessity. It was decided that such a large entity could not be made to vanish, as Northern Rock was allowed to disappear: hence the restructure of the RBS conglomerate is still ongoing.

The principal asset of Northern Rock was a large book of mortgages on residential properties; which has over the succeeding years been sold profitably; largely because the policies of almost-zero interest rates and quantitative easing have resulted in a steady rise in house prices so that the assets of the old building societies have been consolidated in market 'value'.

The key point about the need to 'rescue' Lloyd's is that this was only necessary because Lloyd's board - without an time for consultation with the shareholders - had agreed to rescue Halifax Bank of Scotland, a conglomerate of a massive building society and a Scottish bank that had pursued similar policies to those of RBS. Lloyd's conservatively-managed balance sheet could probably have survived the storm without the HBOS increment of problems: so the Lloyd's shareholders were the least disadvantaged in the restructuring that was judged to be necessary in 2008-9.

The Northern Rock shareholders should have been more vigilant as the company's lending became more reckless: instead they were hubristic. Similar complacency affected the RBS shareholders until it was too late to 'save' the firm. The HBoS merger was dumped on Lloyd's shareholders by a board that was anxious to help the government. Lloyd's wide constituency of shareholders had no say in the decisive action that precipitated near-bankruptcy. RBS shareholders were complacent through a decade of increasingly reckless management. Northern Rock shareholders [mostly] gloated in the national success of their local bank until the truth was borne in on them. These attitudes have more-or-less fairly been rewarded since the crisis.

And, of course, Barclays shareholders are still taking action to challenge the possibly-illicit actions that their firm took to stay technically solvent.

These issues will run and run, but so far I think that rough justice has been done.

What the Fed is Doing

The Federal Reserve Board, the central bank of the USA, has announced that it will continue on a large scale to buy 'mortgage-backed securities'. A security is a promise-to-pay that has been issued by a firm or a government agency, that is considered to be highly likely to be cashed [or exchanged for another acceptable asset] when the owner demands payment in accordance with the terms on which the security was created. By concentrating primarily [though not necessarily exclusively] on mortgage-backed securities the Fed is slowly capturing the reckless expansion of credit during the nineteen-nineties and twenty-naughties, when the spending-power that was created was used to 'buy' houses. Hundreds of thousands of Americans were encouraged to participate in Bill Clinton's concept of a property-owning democracy by taking a material stake in the country - and gaining a material asset - through house purchase. Lending institutions, mutual funds and banks, were bullied by the agencies of federal government into making mortgage loans, even to people whose incomes and history of indebtedness indicated that they were incapable of resourcing and managing the repayments.

Notionally the books balanced. The population collectively borrowed more money each month to buy an increasing housing stock, comprised of properties whose resale prices were increasing in line with the rising price of new homes. The public's debt to the banks notionally matched the liability of the banks in the form of the sums that they owed to the investors who had supplied them with the credit that they had advanced as mortgages. Month by month the vast majority of mortgaged householders paid the sums due to their mortgage lenders. The lenders used the inward cash flow to pay their business costs and to pay the interest that was due on the credit that they had borrowed, and to repay those creditors and depositors who asked for their money back: and they had enough left to carry on lending to more borrowers at higher prices. Then during 2006 economic conditions became tougher for low income groups. Unemployment and prices were increasing, and an increasing number of 'sub-prime' borrowers either surrendered their properties or were evicted from them as their arrears on mortgage payments were deemed intolerable by the lending institutions. The mortgages had partially been funded by sales of securities that were 'bundled' with other mortgage lenders' debts and with the ownership of loans that had been made for other things. These 'complex' securities  were said to be 'safe'  because they would not lose more than a fraction of their value if any one of the lending institutions became unable to pay out against the security on demand. During 2007, however, it became clear that several major mortgage lenders had so large an exposure to sub-prime mortgages that there could no longer be a guarantee of the value of the securities that they had issued; and it was unclear, in the case of many complex securities, how much of the asset had been eroded because it was not clear how much of the asset was devalued. So the only way to treat such a security was to assume that it had no determinable value. This caused the catastrophic collapse of banking confidence and of asset values generally that was quickly dubbed the 'credit crunch' and which spread around the world.

A variety of headline-grabbing measures was taken by governments and by central banks both to calm down the markets and to prop up the values of as many shares and securities as could still be seen to retain positive value. The banks were enabled to carry on allowing customers to access their own money, and to service those of their debts that it was necessary to pay off. Where it was deemed necessary the government took partial or even total ownership of the banks; though the most preferred method was to 're-capitalise' the banks by topping up the cash that they had available so that they could continue to met their obligations.

Though house prices fell significantly, valuations were still quoted and contracts for house purchase continued to be made; and the vast majority of mortgage holders carried on making all or most of their payments. For a while the mortgage backed securities could not be valued, but they continued to exist. But then in 2011-12 conditions became more stable, particularly in the US housing market, as the massive spending on infrastructure by the federal government and the constant increase of the amount received by the American people in welfare and unemployment pay and the sluggish creation of new jobs worked together to increase confidence in the valuations of most US house property. Significant value could again be attributed to the securities from the 'nineties and the 'noughties that had been in limbo since the credit crunch. The Federal Reserve has now announced the continuance of its programme of taking such securities into the asset registers of the banks that are members of the Fed, in turn for new credit that is given to the banks to support their ongoing operations.

The short-term impact of this policy will be slightly to stimulate activity in the US economy, adding to business turnovers and employment. The major impact of the policy of 'Quantitative Easing' will be to increase the notional money supply; to convert the inflation of credit that had been confined to the housing sector to general credit within the banking system. The excess debt that was accumulated in the housing sector is being nationalised in the hands of the Fed, and a huge amount of spending-power is placed in general circulation. It will create inflation of general prices; and will stimulate modest economic growth. Without allowing any other major default of a bank to occur since Lehman's disappeared at the height of the crunch, the absurd sectoral credit expansion from the bubble era is being legitimated. This will be a phenomenal achievement, if it can be brought to completion. The objective is clear. In Britain the promised continuance of quantitative easing is not similarly targeted at 'monetising' the inflation of house prices that went so disastrously wrong through the sub-prime experiment; it is principally helping the banks to continue to meet their obligations from past casino banking, and secondarily allowing them to perform the statistical tricks that are needed to 'strengthen' their balance sheets to meet new global capital requirements. However long it goes on, it is unlikely to assist the growth of the real economy.