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Not so long ago the government’s critics lined up to slam a new tax before it had even been announced. When Gordon was chancellor it was suggested he planned a windfall tax on our banks – British banks, the custodians of our wealth – banks which stand central to the UK’s success story; banks, the wealth creators of Britain.
Of course, not everyone likes banks. Do you remember that ad back in the 1980s for Barclays. The ad was filmed with a Bladerunner type backdrop, with the central character saying “I just to want to talk to someone.” It’s all quite ironic, because twenty years on banks really do remind one of that very situation. If you ring your bank these days you are quite lucky if you manage to get past a computer.
So the idea then of taxing banks has a lot of grassroots support – it's just that this government likes to be portrayed as the government of business. To tax banks any more is tantamount so saying "we don’t care about business," or so they say. It was also argued that a wind fall tax on banks would be a short-termist thing – it would bring money into the exchequer but the loss of jobs overseas that would inevitably follow would mean the government was in effect shooting itself in the foot.
But then, isn't that short-termist argument a little rich. Isn't the banks' preoccupation with the short-term the very thing that created the current credit crisis?
Be under no illusion, the current financial crisis is very serious. If the credit crunch continues much longer, if next year it really is much harder for buy-to-let investors to to obtain mortgages, if the 1.4 million people coming off fixed mortgages in 2008 really do struggle to find affordable replacement mortgages, and above all, if people who are struggling to pay off debt find they are no longer able to top up their mortgage, then it seems unlikely the UK housing market can avoid a crash, and it seems unlikely the UK will be able to avoid recession.
In the US, the land of the free and arch-exponents of capitalism, it has fallen to the government to try and bail out the economy with its plan to extend the life of teaser rates on some subprime mortgages.
As for the UK, this weekend, the FT reported that Michael Coogan, director general of the Council of Mortgage Lenders wants the government to provide money to help those who could be in danger of falling off the housing ladder next year.
You may recall from the early 1990s, repossession levels soared, creating a new supply of cut-price properties, exacerbating the housing crisis of that era.
On a micro scale it may make sense for a bank to repossess a property if a lender is behind with payments, but if applied across the land at a time of rising debt default, such an approach can make the situation much worse, with bank profits falling as a result.
And so it seems, that both here in the UK and in the US, it’s down to the government to try and stop recession by providing support to troubled borrowers.
At the same time, tax payers see their exposure to Northern Rock approach £30 billion.
Right now it seems that actually the government should have taxed banks more heavily in recent years, when times were good, providing the funding for the rescue plan the UK now needs.
Time and time again banks have proven to be unreliable custodians of our wealth – maybe it’s time the government chose to protect the banks from themselves, and tax them in the good times so that there is a lifeboat for them and us when their exuberance proves to have been irrational.
Turn to the index pages of an economics text book and look for words beginning with ‘Fr’. It’s not likely you will find the letter formation Freud (Sigmund). As a general rule of thumb psychology and economics are not good bed fellows, unlike those two great lovers economics and biology whose affair has lasted since the time Charles Darwin built upon the ideas of the early economist, Thomas Malthus.
Economics is very good at describing and predicting rational behaviour, but not so good at predicting or explaining irrationality. And yet, irrationality is often the driving force of economic cycles.
On Friday morning and throughout the weekend two types of headlines were dominant. There was the “don’t panic” type of headline, seen for example on the front page of the Sunday Times Money Section, and the “fears grow for British economy” type headline, for example, splattered on the front page of the business section of the Observer.
And how do people react when they see these kinds of headlines? Well, perhaps recalling the famous call not to panic regularly proclaimed by Corporal Jones, but whose actions actions belied his words: they panic. Throughout the weekend, and even this morning, news broadcasts showed one particulr queuer outside Northern Rock, unaware he was about to enjoy his 15 minutes of fame, saying “when the government tells me not to panic, I panic.”
The panic seen over this weekend was not strictly speaking rational, or not at first anyway, and yet the reaction we saw threatens to turn a little local difficulty with the money markets into a full blown and very serious crisis.
We are witnessing a backlash. Not many people like banks. Their ads might try to convey a soft and cuddly image, but most of us turn against our bank at the first sign of an excuse. So, when Alistair Darling calls for a return to good old-fashioned banking, across the land people agree, no doubt holding an image in the head of Captain Mainwaring.
Of course banks should base their lending on the deposits they hold. Of course, banks should be responsible for their own banking, rather than farm out loans to a sinister and secretive line-up of hedge funds and other banks, or so they say.
And yet it's been this very modern and sophisticated form of lending that has created the global economic boom of the last ten years, that has created a very real increase in global capacity, in our ability to produce real, not paper, wealth.
But, just as dotcoms went from the bee's knees to an idea from Hell practically overnight, and after the dotcom crash when the reality was that the Internet actually was an incredibly good idea that had fallen victim to too much hype, so too is there now a very real danger that the backlash against debt and all those clever financial instruments will swing the pendulum too far. The dotcom industry suffered as irrational exuberance turned to an irrational desire to exacerbate all the negatives.
Economists and central bankers and the media (with a few exceptions: we would like to think our piece on Friday morning qualifies us an exception) did not predict the panic Northern Rock saw.
There’s a good and a bad side to debt. Debt that funds technological advance, debt that funds greater efficiency and brings a return that is higher than the cost of debt is a good thing. Debt that funds bubbles, that funds for example the illusion that we are all a lot wealthier thanks to growing property prices when our ability to produce has been unaffected, is a bad thing.
Yesterday, the Sunday Times journalist David Smith continued his attempt to win the award of most optimistic journalist of the decade, when he argued that the housing market will merely stall for a tad in reaction to the crisis.
But central bankers, economists and chancellors, in additional to not being good at psychology, are also bad at understanding the mindset of a person who is not on a six figure salary.
Some have pointed to the relatively low levels of property possessions as evidence that debt is affordable, but they mix cause with effect. The reality is that for most home owners over the last few years it was actually quite difficult to get into so much debt that their property had to be possessed. The solution to debt difficulties was to use the growth in the value of their properties to fund a top up on the mortgage.
But in this post-Northern Rocks and rolls under era, it would take a brave bank to raise significant funding from the money markets, a brave bank to encourage mortgage top ups, buy-to-let investors, subprime mortgages or corporate debt funded from the very place they have turned to over the last few years.
As we saw this weekend, the public can easily turn their wrath on the banks, and make a bad problem a lot worse.
How could it have been be avoided? It seems that one of the reasons why the public are so quick to turn on the banks and the city fat cats, is because they felt divorced from much of the economic boom.
Distribution of income in favour of the richest has left many feeling alienated from the growth, and while many have seen their wealth grow in the form of higher house prices they often fail to see the connection. There were no shortage of warnings of the dangers implicit in the move to less-even distribution of income and so taking that into consideration, maybe the backlash is not so irrational after all.
When banks start to suffer, many celebrate. When Mervyn King talks about refusing to reward money lenders for their past excesses, and when our silver chancellor, Alistair Darling, talks about a return to “good, old-fashioned banking” you can imagine Brits across the land nodding in agreement.
City bonuses are likely to fall. Most will be cheering. We hear that hedge funds too are suffering. Can’t imagine many tears over that, can you?
It’s a funny thing with hedge funds. They are supposed to be able to make money when markets slide – they are supposed to thrive on crisis, and yet this time around they haven’t.
According to Hedge Fund Research, August saw about 1.3 per cent knocked off their value. That may seem quite modest, but there are extremes.
The Goldman Sachs Global Alpha hedge, for example, fell 22 per cent in value and it is now 44 per cent down on peak value in 2006.
A part of the problem with the hedge funds is that they base many of their decisions on complex mathematics and carry out what’s called quantitative investing.
Quantitative investing is an attempt to bring science into investing. It’s not about instinct or gut feel, it’s about what the numbers say.
In August, the numbers got it wrong. For those of us who use our instincts when considering investment, the current financial crisis was a disaster that had been waiting to happen and Investment and Business News is far from being alone in warning of troubles long before they happened. In fact, two years ago, Warren Buffet talked about hedge funds as financial weapons of mass destruction.
And now we have found that not only have the banks got it wrong, not only will bonuses be slashed, but those mathematicians who are too clever by half have got it wrong too – isn’t it great?
Just remember, though, the lessons from the dotcom crash. When things turn down we tend to overreact. Dotcoms didn’t suddenly become a bad idea overnight, but many seemed to think so.
Debt syndication isn't all bad.
For years the UK was held back because business found it too difficult to raise money and good old-fashioned banking was the curse of many frustrated entrepreneurs.
Subprime has allowed people who at some stage went through a bad patch (which they survived), to enter the housing market.
Yesterday's pronouncements by Alistair Darling had elements of back to basics. "In crude terms," he said, "(lenders) need to know who they're lending to, how much they're lending and what the risk is.
"Now, that's elementary banking, one might think, but there are times when going back to good old-fashioned banking may not be a bad idea."
He is right but, then again, he is oversimplifying, and so is the growing public backlash. The real danger lies not in the irrationality of bankers’ exuberance in lending money – but in the irrationality of a backlash.
A couple of years ago, an economics journalist by the name of Dr Martin D. Weiss, tried to find out the size of the derivatives market. He produced his report, made a few guesses, and a few days later got a phone call. It was the Office of the Comptroller of the Currency (the OCC). "We're doing a major study on derivatives," said the voice at the other end of the phone, "and I'm having a hard time finding any meaningful data on them. But we've seen your work on the subject and we'd like to know what your source is." Why is this story interesting? Well it’s interesting because of the incredulous reply the economics doctor gave. "Our source? That's funny," he said. "Our source is the OCC — your office. In fact, just the other day, I called your office to try to find out more about your sources." Follow this link for an account of the saga
And that anecdote, in a nutshell, expresses the real danger behind the scenes right now. There might be a lot of volatility out there right now, opinions might vary as to whether the US economy is about to grind to a standstill, but if there is one consistency it is this. Traders, analysts, regulators and commentators are consistently ignorant of what is really going on.
We have seen crisis break out in just one small area of the debt markets: subprime. By the way, the majority of subprime mortgage holders will repay their debts on time and schedule. In fact it would be interesting to find out whether the incremental revenue the financial industry makes from charging extra costs on its subprime mortgage debts makes up for the losses it incurs. So that's a problem in just one small area of the debt markets, but the repercussions have spread across the world.
But what would happen if there is another crisis and failure occurs in another debt subsector?
The trouble is, hedge funds and banks have piled debt upon debt.
Imagine this scenario. Set up an investment vehicle, funded to the tune of say £150 million. Then assume two thirds of this backing is in the form of debt, with a third provided by shareholders. Now assume the stocks, or indeed property, into which this vehicle invests, grows in value by around 50 per cent. What a coup; what savvy investors. The investment vehicle is now worth £225 miillion, debts are still £100 million, meaning shareholders have seen the value of their investment soar from 50 to £125 million
Now assume investors repeat that trick. They take that £125 million and re-invest it into a new vehicle, again matched two to one by debt. Assume this vehicle also rises by 50 per cent. Lo and behold, that initial £50 million is now worth £312 million. Such is the magic of leveraged investment; such is the stuff modern-day wealth is often made of.
But pause for a moment. The analogy above was not made up to describe a modern hedge fund, or even a private equity backed venture.
No, the above example was taken from a book written by John Kenneth Galbraith entitled "The Great Crash 1929". Mr Galbraith, one of the top economists of the last century, described this form of leveraged financing as madness on a heroic scale.
When debt is piled on more debt, you only need a failure at the bottom of this pyramid, and it could all cave in.
Now imagine that a shortage of credit and higher borrowing costs leads to the failure of a hedge fund that is not in subprime at all? Remember, syndicated debts have encouraged creditors to make loans which in any other era would have been deemed too risky. The idea being that since the debt is syndicated, individual creditors only pick up a small percentage of the tab if the debt goes bad, so it's okay to be more risky.
That reasoning is fine if risky lending is an isolated occurrence, But when it becomes endemic, we must then face the possibility of multiple failures, and with the benefit of hindsight it will appear as if syndicated debt was in fact a syndicated illusion of safety.
Warren Buffet once described derivatives as "time bombs for the parties that deal in them" and then said "derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The crisis we are seeing unfold is a crisis that was made in the land of finance. It turns out that the clever old mathematicians and analysts were in fact too clever by half. And now things could go one of two ways.
Central banks could bail us all out. But, after the dust has settled, financiers go back to their old ways, until the next crisis, which no doubt, will be even more serious. Alternatively, central banks could sit back, and allow the system to implode.
What we really need is something in the middle. The financial system should experience a good deal of pain, failure should occur, and the industry should be left feeling very badly chastised, but that is it. More than that and the global economy might come off the rails - but less than that, and we are just shoring up problems for the future.
Talk about the worm turning! The consumer campaign being waged against the banks in the pursuit of penalty charge refunds is taking on a life of its own.
There's nothing like the Brits (normally so passive in matters financial) when they get fired up by an issue. It's all rather reminiscent of the poll tax riots in the 1980s and the petrol price rise protests in 2000.
Hardly a day passes without a report on the latest number of complaints being made to the Financial Ombudsman's Service and the estimates of the bill which the banks could face.
The FOS says it has been receiving between 3,000 - 5,000 calls a day since Monday, following saturation media coverage in the weekend’s press.
And as if disgruntled bank customers needed any further encouragement in their pursuit of the banks, Credit Suisse announced earlier this week that the banks could be making as much as £1.2bn a year from overdraft charges.
This is less than the £4.7bn being claimed by campaigners, but bank analysts are warning that the retail banks might have to set aside hefty provisions, if the Office of Fair Trading rules that the level of penalty fees they have been charging is unlawful.
Some reports suggest the total repayment bill faced by banks and building societies could be as high as £10bn, if customers claim for six years’ worth of charges - as many are doing.
The FSA is waking up finally to the issue, and looking at whether banks have been “treating customers fairly,” in particular where banks have closed customers’ accounts after making a complaint.
In the meantime, I would normally tell disgruntled bank customers to buy their banks’ shares to participate in their excessive profits, but if the banks have to make hefty provisions to meet the compensation bill, perhaps that’s not such as good idea.
The world has gone upside down.
Economic theory tells us that when an economy's consumers are out spending their money like it’s going out of fashion, and to utter the word “saving" is a form of fashion blasphemy, then the economy probably has a rate of interest that is too low, and the local currency is plummeting.
On the other hand, if saving is the new black, then the currency should soar, and the rate of interest probably needs to fall.
Except that in the UK and Japan, it's the precise opposite.
The yen recently fell to its lowest ever level against the euro, while sterling is in such good shape, it's as if the UK has joined the local gym, and the pound has been out pumping iron.
It's another odd thing, but saving and consumption in the UK and Japan is the wrong way round too. Economic theory says you spend when you are retired, and save when you are working. And yet, in Japan, which has a higher percentage of its population in retirement than any other major country in the world, (less kids are coming on the labour market while the average Japanese person can expect to live to 85) consumers are saving almost to the point of excess.
In the UK, on the other hand, where we should all be saving and attempting to reduce the effect of our demographic time bomb, we are just not getting it.
It's as if human nature can't accept there's a problem until it's staring you in the face. In Japan, the demographic crisis is already there eyeballing a good percentage of the populace. In the UK, it's still very much an obscure idea lurking somewhere over a distant horizon, somewhere between the blue sky and the rising sea level.
But if we are spending too much, and the Japanese saving too much, why are our local currencies going in the opposite direction?
To find the route of this particular evil, we need look no further than money.
While manufacturers and retailers bemoan the UK's relatively high interest rate, and buy-to-let investors bury their heads in the sand, the money-men love it.
They also rather like Japan, but for quite the opposite reason.
Until a week ago, the Japanese rate of interest was 0.25 percent, that's a remarkable twenty times less than in the UK. Then, on Wednesday, the rate was upped to 0.5 percent. Sure that represents a doubling in the rate, and halving in the UK to Japan differential, but it's still enormous.
So, from hedge funds to great aunts, savers and borrowers alike, they move their money from Japan to countries such as the UK, or US. In the case of the aunties with their savings, it makes sense because the return is so much higher, but for the money-men it’s a quite spectacular business model. You borrow at 0.5 percent and lend at 5.25 percent - or around that amount. That's a tenfold return on your money.
Economists have dragged out the name carry trade from their lexicon to describe the phenomenon.
But can it last? The august economic think tank Capital Economics reckons Japanese rates will hit 1.25 percent by the year’s end, and two percent next year. If they are right, then the differential will fall, so that Japanese rates are merely half the level seen in the UK and US. That's still a big differential, but given the risks associated with cross border flows of money, perhaps enough to kill the carry trade altogether.
Does this matter?
There are obvious implications of further rises in the Japanese rate of interest leading to an end to the carry trade. For one, sterling might crash, for another, all that liquidity that has been out there boosting the coffers of mortgage lenders and private equity companies might disappear, leaving the over-exposed looking… well somewhat exposed.
Ultimately, though, as the UK populace does wake up to the idea that we need to save more, then maybe, the UK rate of interest will fall, and money will flow the other way - but then, that's getting carried away with the carry trade.
The end of free current accounts must surely be nigh.
In one of the more bizarre stories in the weekend’s personal finance press, Robert Watts of the Sunday Telegraph wrote on how the US credit card provider, MBNA, is charging its customers for having a credit balance - yes, for being in credit.
The story brought home just how desperate the banks must be to find new ways of charging us for the honour of handling our money.
Having a credit balance on one’s credit card can occur quite easily. It could be that you over paid by mistake or the credit card provider made a mistake. Either way, to be punished by your bank for having a credit balance smacks of rank stupidity.
In the case in question, the customer said that as far as she was concerned the credit card account had been closed several years earlier and that the statement showing the credit balance had been redirected to her from an old address.
So it was by sheer chance that she received MBNA’s breathtakingly cheeky letter telling her that unless she cleared the credit balance on her card by the end of March, she would be charged £10.
The woman unsurprisingly said: “When I first read it, I just felt it was a bloody cheek,” and that she would move her business elsewhere.
Sadly, this may have been the response that MNBA wanted. Banks are not charities and simply don’t want customers they cannot make money out of, or in some cases, customers who are just too troublesome. If you complain about your bank to the Financial Ombudsman Service, the likelihood is that your account will be closed.
What this story shows is the desperation of the banks to find new sources of revenue in what is becoming a more difficult trading environment for them.
The Office of Fair Trading has called for a competition enquiry into the competitiveness of the market for payment protection insurance which may lead to a mis-selling enquiry. A number of banks have already been fined for poor sales practices in connection with PPI and thousands of clients are expected to receive or claim compensation, or at least a refund of their premiums.
Elsewhere, the banks are under fire for charging exorbitant fees on credit cards and bank accounts for common customer misdemeanours such as exceeding credit limits, going overdrawn, late payments and bounced cheques.
Ever since a ruling from the OFT (www.oft.gov.uk) last April which found that credit card penalty fees were ‘unfair,’ thousands of disgruntled bank and credit card customers have been extracting refunds of thousands of pounds from banks for charges which customers can prove were disproportionate to the amount of work involved.
For instance, banks typically charge about £30 a day if you fall into an unauthorised overdraft, and a similar amount each time you make an unauthorised payment by debit card or cheque, even though the actual cost to the bank of administering these transactions is around £4.50, according to the BBC’s Money Programme (www.bbc.co.uk/money).
Which?, the consumer group (www.which.co.uk), says that banks make about £4.7bn from these default charges each year, even though the Banking Code (www.bankingcode.org.uk) requires banks only to pass the administration costs of such transactions onto their customers.
Some industry analysts claim that banks have paid out £40m-£50m to customers in compensation already and that they are bracing themselves for a flood of further claims which could reach a million in 2007.
If this is true, it is small wonder that credit card providers are trying to unearth new ways of making money out of their customers. The same applies to the high street banks, some of which are starting to make a charge for current accounts, even for those customers who remain in credit.
This will mark a radical change in retail banking in the UK which to date has been one of the few countries in the world where free banking has been generally available.
Most European countries, America and Australia charge a monthly fee for holding a current account, as well as charging for individual transactions. Spanish banks, for instance, charge for every bank service you could care to mention, even when you’re in credit.
With the UK’s retail banking model depending heavily on delinquent customers subsidising the solvent, those in credit get a pretty good deal and can earn interest on their current accounts of around 1 per cent below base rate, with all standard transactions (direct debits, standing orders, cheque clearance and cash withdrawals) being free providing you’re in credit.
So will solvent customers be prepared to give up the status quo in order to subsidise banking services for delinquent customers? I think not.
Aware of this, a number of high street banks are looking at ways of shifting the current cross subsidy which exists between delinquent and solvent customers, but in a way that creditworthy customers might find acceptable.
So what are the options?
Charging all customers on a fee per transaction (pay-as-you-go) basis is one option. Charging tiered fees according to the level of your bank balance is another.
Others may adopt First Direct’s Bogof (buy-one-get-one-free) model whereby you are allowed free current account banking, providing you buy another of the bank’s products or services, or deposit at least £1,500 a month into your current.
Or what about all customers paying a flat fee, irrespective of their credit status, in the interests of simplicity? Or will ‘premier accounts,’ - monthly fee charging accounts which come with a package of ‘free’ extras, such as roadside cover and travel insurance – become the norm?
Halifax launched its first premier account this week (19 February) which costs £10 a month with 6 per cent interest on credit balances of up £2,500.
The free extras include worldwide multi-trip, family travel insurance, RAC breakdown cover, £300 interest free overdraft, home emergency cover and discounts for various insurances and retail outlets.
Meanwhile, First Direct will start charging its current account customers £10 a month from March, unless they meet the criteria mentioned above.
Charging a flat monthly fee or dressing up fee-paying accounts as premier accounts look set to be two of the models for the future. Which of these models becomes more prevalent remains to be seen.
Either way, free current account banking could become a thing of the past, apart from a few niche players.
Angela Knight, the income boss at the British Bankers’ Association (www.bba.org.uk) hinted this week in a Radio 4 Today programme interview that any crackdown on fees could spell the end of free banking in the UK.
Given that Barclays alone made record pre-tax profits of £7.14bn in 2006, it is unlikely that the banks are going to give up this level of profits without a fight, so Ms Knight, regrettably, may well be right in her prediction that the end of free current account banking is nigh.
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