“Measures of central bank balance sheet expansion under-estimate the scale of liquidity support provided during the crisis … there has been a widening of the collateral taken by most central banks in their operations. The taking of imaginative forms of collateral has a history which predates central banking: in the 12th century, King Baldwin II of Jerusalem secured a loan using his beard as collateral. Nonetheless, recent efforts are probably unprecedented in scope.”
— Andrew Haldane, “Banking on the state”, Presentation delivered at the Federal Reserve Bank of Chicago twelfth annual International Banking Conference, September 2009.
“The form of execution once suffered by traitors was often (though not invariably) torturous. The condemned could not walk or be carried to the place of execution; the sentence required that they were to be drawn: they might be dragged along the ground, but were normally tied onto a hurdle which was drawn to the place of execution by a horse. A man would then be hanged by a noose around the neck, but not so as to die: there would be no “drop” to break the neck. Whilst still alive, he would be cut down and allowed to drop to the ground, stripped of his clothes, his genitals cut off, his viscera pulled out and burnt before his own eyes, and other organs would be torn out of his body. The body would be decapitated, and cut into four quarters. The body parts would be at the disposal of the Sovereign, and generally they would be gibbeted or publicly displayed.”
— From the Wikipedia entry on High Treason in the United Kingdom.
The more eagle-eyed will have noticed that something is still not quite right with our banks. Technical glitches; rogue traders; the mis-selling of various insurance schemes coming home expensively to roost; trading problems on the US exchanges; a rather strong whiff of money- laundering; attempts to rig Libor; dare one suggest, a certain inflexibility in electing to lend normally to SMEs (perhaps the inflexibility that comes with being functionally insolvent). Something would seem to be rotten in the state of Denmark. (And we will not even talk about the euro zone, that ongoing financial memento mori.) Having been largely absent in the run-up to the crisis, what JK Galbraith called “the bezzle”— the amount of undetected corporate fraud – has resurfaced quite visibly, and with a vengeance.
What is striking about the banks is not that, with Libor class actions hanging over the sector like gigantic clouds made out of ordure, they seem to be hopelessly accident-prone and run by crooks. What is striking is that there is a permanently masochistic hard-core of investors who seem determined to invest in them regardless. Perhaps those who scooped up “cheap” Barclays stock in the aftermath of its own recent embarras de richesses were only share-renters with no intention of clinging on for the long haul. But if they amounted to long-term investors, one feels obligated to ask them what they might have been thinking.
In a rather extensive hatchet job research piece on the banks, cited above, the Bank of England’s Andrew Haldane in 2009 pointed to why banks had delivered such good returns to shareholders in the run-up to the crisis. The answer ? Their management lost their heads entirely, and leveraged their organisations to the hilt. Those in any doubt can consider Aldane’s charts below:
This could only go up …
Because this came down …
The charts are blunt enough. The reason why shares in RBS (for example) delivered total returns to shareholders between 1989 and 2006 of 20% per annum (or over 2600% cumulatively) is because RBS levered its balance sheet to heaven and back. In other words, the pre-2007 results for any commercial banks are irrelevant to the foreseeable future because they were incurred during a period of grotesque and uncontrolled leverage that is absolutely unrepeatable within our lifetimes. We anticipate that banking stocks will perform a magnificent job for shareholders over coming years if they return zero. As Haldane points out, between the 1920s and the end of the 1960s, UK banks saw returns on equity in the single digits because leverage was also kept, by and large, under control. You could only get outsized banking returns by taking outsized banking risks. As we now know to our cost, those outsized risks were ultimately inflicted upon the entire economy and distributed across the taxpayer base of the entire country. We will be bearing those costs for some time still to come (another reason why Bob Diamond was so premature in calling for that period of remorse and apology to be over).
But the listed banks, albeit in their dwarfish and sickly current form, are only a sub-set of the broader equity market. And as Bill Gross is finding out, one merely raises doubts about prospective equity market returns at one’s peril. All sorts of capital markets flotsam and jetsam weighed in to correct Gross’ alleged errors (including Henry Blodget, who we seem to recall was banned from the securities industry for life, not that this has stopped him from bloviating without limit online about the stock market). But the argument centred on one irrefutable fact: that economic growth and the stock market are not correlated. (One suspects that the securities industry types were keener to defend the honour of a questionable bull market than they were the niceties of academic theory.) We would choose to fight on altogether less contentious ground, namely, that the most important factor under the control of any investor is the starting valuation of any investment he or she might choose to make. Buy good stocks cheaply, wear diamonds. Buy shares in even the best companies at too expensive a level, wear Claire’s Accessories. And in addition, disconnect where a business is listed from where it operates: by this measure, the UK stock market is even more defensibly valued (the FTSE 100 yielding 4% versus 2% for the S&P500) given that many of its constituents operate globally rather than just in the UK, which from an economic perspective looks like nothing so much as a black hole devoid of hope, energy or growth.
On the near topic of diamonds, we were intrigued to see last week’s news about the Chinese interest in African Barrick (Gold), from which we would make two further observations. One is that the Chinese are busily gobbling up material chunks of this “emerging” continent (see chart 4 below) – if this pace accelerates, at some point they may run into explicit political and economic conflict with those western nations that realise they may be fast depleting their own materiel. The second is that (hat-tip to Imara’s Colin McCulloch and Sanlam), gold equities are at a 28-year low relative to gold itself (see chart 3 immediately below). To reiterate, we like both. A lot.
Our rationale for the monetary metals and especially gold is simple to articulate and, we think, easy to justify. The banking insanity of the last four decades or so is only another manifestation of a broader dash towards monetary insanity, as governments, freed of any real constraints over currency or debt, issued endless amounts of both. So much debt has now been accumulated, it requires constant economic growth simply to service the debt. Now that the western economies at least appear to have gone ex-growth, that only leaves two possible outcomes: outright default, or inflation. Which do we think is the more politically palatable of the two ?
But when it comes to the banks, what is to be done ? The economic damage they have inflicted now being incalculable, any financial remedies against banking individuals would be inconsequential, and those levied against organisations would be doubly pointless (what the taxpayer doesn’t already own, it soon probably will). As a policy alternative we would suggest hanging (and perhaps drawing and quartering) the more errant senior banking executives under the UK’s High Treason laws (“… if a man do levy war against our lord the King in his realm, or be adherent to the King’s enemies in his realm, giving to them aid and comfort in the realm, or elsewhere”), on the basis that if bankrupting the nation doesn’t provide aid and comfort to our enemies, we would like to know what does. If nothing else, hanging, drawing and quartering some of our more notorious fraudsters, thieves and banking con-men might do wonders pour encourager les autres.
1. “Remember your mortality.”
Tim Price is Director of Investment, PFP Wealth Mangement, London.