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15 September 2018

Ten Years On (2)

Tag(s): Politics & Economics
Ten years ago today Lehman Brothers went into administration thus triggering a global recession. The ensuing financial crisis has dogged the world’s economy ever since. Last year I wrote a blog Ten Years On[i] from the beginning of that financial crisis but it was the Lehman Brothers debacle that was at the epicentre.

Lehman Brothers was a relatively minor bank as recently as the early 1990s with earnings of $75m. Over the next 15 years under the leadership of its notorious CEO and Chairman Dick Fuhd it expanded rapidly. It particularly focused on raising its holdings in subprime debt until it collapsed owning $85bn in mortgage backed securities, about four times its $22.5bn buffer against losses of shareholder equity.

When the crisis came a common cry from ordinary members of the public and also from HM the Queen was why no one had seen this coming. But that is simply not the case. I, for one, saw it coming as I had long since sold all my shares in banks which had included Bradford & Bingley, one of those which would soon go under. The banks’ focus on growth and size instead of balance sheet strength meant they were exposed to their own and to all the others in terms of holding risky assets. Put simply, too much had been leant to people who might never be able to pay it back.

Throughout 2008 there were signs of serious trouble. In Europe, there were BNP in France and Northern Rock in the UK. In the US, Bear Sterns fell in March 2009 after its exposure to subprime became clear. In the second quarter Lehman Brothers lost $2.8bn, its first loss in 14 years. Its share price fell 73%. On Wednesday 10th September Lehman announced a loss of $3.9bn in the third quarter after writing down $5.6bn on its stricken mortgage portfolio. Its share price fell a further 52%.  All confidence had gone.

On Friday 12th September, Timothy Geithner, the president of the New Your Federal Reserve, gathered together the leaders of Wall St.’s biggest investment banks with the financial authorities. They spent the weekend trying to find a solution before the markets opened on Monday morning. Two possible candidates emerged to mount a rescue: Barclays and Bank of America. Barclays, however, could not move without a vote of approval by their shareholders and there was no time. Bank of America looked at the books and realised that it was hopeless without government backing and so chose to save Merrill Lynch instead.

On Monday 15th September Lehman Brothers was placed in administration and when employees arrived as normal for work they were met by security staff who handed out printed emails with the news. They were told there was no cash, not enough even for their monthly check. Everyone packed up their personal belongings and Lehman Brothers not only ran out of cash, they even ran out of cardboard boxes for the staff to carry their goods home. Stock markets all round the world plummeted.

Some of the operation was saved. In Europe, for example, Nomura bought Lehman’s EMEA fixed-income operations for $2, saving most of the jobs. But by now the contagion, together with the results of a decade of bad practice, had spread to many European banks. This culminated in the £400bn bailout of the banks announced by Gordon Brown on Wednesday 8th October, three weeks after Lehman Brothers’ collapse hit global markets.  The direct cost to the Treasury of bailing out RBS, Lloyds, Northern Rock and Bradford & Bingley eventually hit nearly £140bn. The true extent of taxpayers’ exposure to the full package of emergency loans and guarantees later reached almost £1trillion, according to the National Audit Office.

There have been many books and articles written about the financial crisis of 2008-09, particularly on the causes. Clearly there was bad practice by many of the banks’ top management and the bonus culture drove much of this bad behaviour. Clearly, also, there was inadequate financial regulation. In the US the treasury underestimated the scale of interconnection of the banking sector. In the UK Gordon Brown’s decision as Chancellor of the Exchequer in 1997 to give the Bank of England independence but take away its responsibilities as the principal regulator of the banking sector was asinine.

But there have been fewer attempts to describe the effects of the crisis. But these are far reaching. I said in my blog last year that the crisis itself was not a crisis of capitalism as if capitalism had been allowed to work the bad banks would fail for lack of shareholder support and their business would be picked up by the better run banks. That is the capitalist way. But governments around the world deemed that some of these banks were too big to fail and so should be rescued by taxpayers’ money.

Taxpayers resent this as in their minds the bankers should have been punished for their ‘crimes’ and this has led to a lack of confidence in capitalism. So the crisis itself was not a crisis in capitalism but the consequences are. Some believe it is a cause of the rise in populism across Europe and the US. Professor Adam Tooze of Columbia University, New York, and author of Crashed: How a Decade of Financial Crisis Changed the World, argues that the unpopularity of the bailouts may have helped Donald Trump to become President. Others argue that there is now some kind of rebellion in the US and Europe against financial capitalism.

In fact the banks have been and are being punished. They have been hit by billions of fines of misconduct charges for everything from mis-selling toxic mortgage products in the US to manipulating foreign exchange markets in London. Retail banks are still coughing up billions in compensation for mis-selling payment protection insurance. However, a fine paid by the bank diminishes profits and so is actually a fine on the shareholder. It does not directly impact the management.

The Financial Conduct Authority (FCA) has brought out stricter rules to police misconduct by top managers. But these cannot be used retroactively and none of the worst offenders from that era lost their right to work in the City or were jailed. And that too is resented by the general public.

The problems at Lehman Brothers were down to its top management. Few of its more junior staff knew what was going on. Some of its ex-employees who worked in London are planning a reunion to mark the occasion. No doubt a few drinks will be consumed together with some canapés perhaps. People will reminisce about both good and bad times and catch up with what each other has been doing since. All quite normal and innocent behaviour one would think.

Not John McDonnell, the Shadow Chancellor of the Exchequer. An unreconstructed Marxist McDonnell thinks this is “sickening” and he is sure that most of us will find it as “absolutely disgusting “as he says he does. I try to ignore most of what this man says and trust and hope that in the end the Great British people would not be so stupid as to let him have the keys to No. 11 Downing Street, and therefore the Treasury. But this kind of comment may reflect a still prevalent view that there is something inherently wrong with banking and therefore about its employees, however lowly; that the financial crisis was all down to them. The fact that people might have lied about their ability to repay a mortgage is ignored. The fact that a regulator may have failed to spot that the two sides of a balance sheet did not actually balance is not understood. The fact that an independent auditor may have failed to check the quality of the loan book is overlooked. And the fact that it was the leftist President Clinton who positively exhorted US banks to behave this way is conveniently forgotten.

The greatest of all economists, Adam Smith, said “it is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country”.

The efficient allocation of capital is the cornerstone that secures capitalism, and therefore our collective prosperity. For all its faults, our financial industry is an essential part of a successful economy. Government’s role is to set up the right laws and regulations to help the banks create this wealth and in return they will receive considerable tax receipts. The City of London alone provides enough tax revenue to pay for all our state schools.

It is bewildering to me that socialism can ever attract support when it has never succeeded in improving the conditions of mankind.  Communist countries like the Soviet Union and China produced devastating loss of life in their attempts to plan agricultural and industrial production from the centre. The Soviet Union eventually disintegrated and rather shamefully its successors have adopted a kind of crony capitalism which is not much better but at least people are free. China finally adopted a form of state sponsored capitalism which has lifted millions out of poverty and allowed China to become first the major producer for much of the world and now a rival in terms of consumption.

There have been many perfect laboratory experiments where we have been able to compare the results of capitalism with socialism in equal conditions.  Germany was devastated after the Second World War and was split into two. The West was revived by the Marshall Plan and the help of the British in corporate governance and labour relations. It rose to become the strongest economy in Europe. The East had the dead hand of socialism imposed and its people kept in poverty. When the two halves were reunited the appropriate rate of exchange would have been 8 to 1 for the Deutsche Mark against its eastern equivalent. Helmut Kohl had the magnanimity to equalise them 1 to 1 at great cost to the richer German tax payer.

Even more extreme has been the experience of Korea after its split into two. The Southern part has embraced capitalism and created one of the strongest economies in Asia producing high quality goods for sale throughout the world and an exceptionally high standard of living. In the North the people are suppressed into starvation.

Communist nations have to build walls to keep their people inside. Thousands escaped from eastern Germany to the West. Not one tried to go the other way.

Today we have the tragedy of Venezuela which despite having the largest proven oil reserves in the world has ruined its economy with socialist measures and is now worse than a basket case. Its economic collapse is without precedent outside of war or the fall of the Soviet Union. It recently devalued the bolivar by 95% and its present rate of inflation is 200,000%. Millions are fleeing from its borders causing major disruption throughout the region. This economic collapse is now a humanitarian disaster. Medicines are not available. Food is short and everyone except the Socialist elite is undernourished. Despite this catastrophe every measure taken by the Socialist government of President Maduro is yet again a socialist measure which can only make things worse. He has increased the minimum wage which will increase the public sector wage bill, stoke even more inflation and bankrupt even more businesses.

But as well as this empirical analysis we can also look at the experience of people who have lived under both systems. One amazing story which I will refer to briefly here but give you the links to find out more if you are interested is that of Roberto Ampuero. A writer, politician and intellectual he was born in 1953 in Valparaiso, Chile, the same year and city as my wife. He grew up at the heart of a middle-class family of German descent, and graduated from a German private college. His socialist convictions led him at 17 years old to join the Communist Youth of Chile. Due to his affiliation with this group, he fled the dictatorship of Augusto Pinochet in 1973 for the German Democratic Republic (GDR), then under Soviet control. There he met Margarita Flores, the daughter of the Attorney General of the Cuban revolution. They went to Cuba and got married there in 1974.

With a baby on the way, the couple entered a university and labour system under complete state control. Ampuero began to appreciate the underlying culture of a totalitarian system, the rigid modes of thought and the absolute loyalty demanded of all Cubans. “Only those who have lived through it, and have experienced for themselves the hardship of daily shortages, extreme restrictions over every aspect of life, and the messianic message of an unopposed government, can understand what socialism is and the painful mark it leaves on you for life”, Ampuero reflects about Cuba under Castro.

He left for the GDR in 1979 but this time with the intention of getting away to the West. He finally made it across to West Germany in 1983. Remarkably, he is now the Minister for Foreign Affairs in Sebastian Piñera’s right wing government in Chile.

“I don’t want dictatorships of the right or the left,” says Ampuero. I don’t care if they justify it under the name of national security or social revolution. Dictatorships are dictatorships, he continues, incredulous that the belief still exists that the state should determine the life of a society.

“Why have we come to idealise the state and prefer it to the infinite variety and creativity of millions of individual entrepreneurs?” Ampuero asks, inviting us to reflect on those totalitarian states that still repress, censor and lock up their citizens, not for their crimes but for their thoughts

[i]  Ten Years On 12th August, 2017
Sources: ”Financial Crisis 10 years on” Helen Chandler-Wilde Sunday Telegraph 9th
MoneyWeek, several articles 24th & 31st August, 2018
More sources for Roberto Ampuero

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