- Bob McDowall is research director, Europe, at TowerGroup, a research and advisory services firm focused exclusively on the global financial services industry. The opinions expressed are his own. -

The banking results being published this week are inseparable from the catastrophic financial events of the last two years. It is time to glance back to where we have been and determine where we are now.

Almost two years ago, the slow-burning fuse to a financial services bomb was lit with the run on Northern Rock. The UK Government and its financial regulatory agencies defused that bomb “minutes” before it could devastate the UK banking and financial system in October 2008.

Official records will not be available for public scrutiny for 30 years or more, but anecdotal evidence indicates that at least one bank was within days of literally running out of cash. It has also been speculated that moves were planned by some businesses to prevent the customers of ailing banks from withdrawing cash from joint and third-party ATMs, although this has been denied.

Against this state of financial tension, the UK Government and the Bank of England had no choice but to save the UK domestic banks and stabilise the financial system. If they hadn’t, the loss of confidence in the financial system would have spread to the wider economy and would have weakened the sterling, perhaps irreparably.

It is unlikely that the Government or the Bank of England could have taken steps other than recapitalisation. Surviving businesses could not have been persuaded to acquire the ailing banks when significant financial assets had no market or known realisable value.

The lack of knowledge of the depth and materiality of the ‘bad assets’ held by banks made it near impossible for the UK Government to make a judgement call on how significantly damaging these assets were and how to manage them in any other way.

Recapitalisation was therefore an essential move by the UK Government and Bank of England, but it should have included a legal precedent that was missed.

We are currently in a situation in which the taxpayer’s money is funding the assets the UK Government has deployed and invested in the banking system. But the banks are still reluctant to lend. This power balance is not in the best interest of the taxpayer.

The UK Government appointed the UK Financial Investments plc (UKFI) as an arm’s-length agency to hold investments in the impaired banks and manage those investments for the beneficial interest of the UK taxpayer. However, the UKFI is also faced with the demands of the European Union competition interests and the other shareholders of the banks, including their employees and management.

If in its professional judgment, the UKFI believes that the taxpayer will make a capital gain, in the guise of a tax rebate, by retaining the taxpayers’ investments long term, then this is a course of action they should follow.

The danger in this strategy is that the UK domestic banking system could suffer from a lack of innovation and competition. It is the Government’s responsibility to ensure that this conflict of interests is managed for the best of the taxpayer and the economy.

— Margaret Doyle is a Reuters columnist. The opinions expressed are her own –

Three months is a long time in the markets, and particularly for banks. Alongside the rally in bank shares, investors have also bid up bank bonds, especially so-called tier 1 bonds which rank just above the equity in the list of creditors.

In some cases, the prices these bonds have tripled and, overall, yields to perpetuity have halved across the sector, according to Morgan Stanley.

This rally has now overshot and the risks are on the downside. Despite being labelled debt, tier 1 is pretty much like equity: issuers can stop paying coupons, the coupons do not always accumulate if missed and the issuer can choose not to “call” (redeem) them at the call date.

So the additional protection they offer over bank equity is not great. This is why prices crashed last autumn along with those of bank equity.

Over the past couple of months, confidence has returned as governments across Europe have recapitalised their banks, removing the risk of a systemic failure.

The ensuing confidence has enticed private banking clients — who are missing the income traditionally provided by dividends and bank interest — into this market.

Moreover, banks have themselves been buying back their own debt, trying to lock in the “profit” that many have booked on the write-down in the value of their debt.

Institutional investors have committed much of their substantial cash holdings to this market too. These factors have driven up prices.

However, the juicy yield that has enticed recent buyers may simply disappear: issuers could simply pass the coupon.

This is what has happened with Bradford & Bingley, a failed British bank whose loan book is being run down by the British government. Last week’s announcement failed to damage other bonds, suggesting that investors see B&B as a special case.

This assumption may prove too optimistic. Most banks are short of cash and will be tempted not to pay their tier 1 coupons if they do not have to.

This is especially true of state-owned banks, like RBS and Lloyds, and Ireland’s AIB and Bank of Ireland that are not paying dividends.

Their state paymasters may consider “optional” coupons to be a poor use of precious capital.
Moreover, the European Commission may stop them from doing so. It has already prevented Commerzbank from paying out on hybrid bonds.

The Commission is currently examining the British and Irish state guarantees and may conclude that insolvent banks should not be making discretionary payments to bond-holders who, after all, are typically institutional investors who should understand the risks inherent in such instruments.

The biggest risk — that investors will be wiped out by nationalisation — has not gone away, even if it has subsided.

If banks do need any more government bail-outs, the terms are likely to be harsher than in the past. Even in the absence of full-on nationalisation, governments may choose to impose a debt-for-equity swap on bondholders.

After all, everyone else — depositors, shareholders, taxpayers — have borne some pain. Why should bondholders be any different?

– Margaret Doyle is a Reuters columnist. The opinions expressed are her own –

Revolting shareholders were reduced to throwing shoes and coins at the chairman at Tuesday’s meeting to approve the carve-up of the failed Benelux bancassurer, but to no avail.

It looked like throwing good money after bad.

A majority of shareholders still backed the deal, rightly recognising that it represented the best hope for their beaten-down shares. By going to the law over the nationalisation of the Benelux banks and the sale of the Belgian bank to BNP Paribas <BNPP.PA> last October, the shareholders won some baubles for the rump Fortis Holding company <FOR.BR>.

It held onto the Belgian insurer as well as a ragbag of foreign insurers. The group’s exposure to Fortis’s old structured credit portfolio was also reduced, and its cash increased, from 1.3 billion euros to 3.4 billion euros.

But Ping An, the Chinese insurer that holds almost 5 percent of Fortis Holding, and thousands of private shareholders, were not satisfied. The rebels hoped to reverse Fortis Bank’s nationalisation.

Shareholders’ anger with previous management is understandable: the shares are trading at under 10 percent of their peak. However shareholders should count their blessings at having salvaged anything from the wreckage. They are not the only bank shareholders who thought they were buying the financial equivalent of government bonds only to find they had bought into a casino.

Moreover, there were no more goodies on the table. The Belgian government made it clear that, even if the sale of Fortis Bank to BNP were blocked by shareholders, it would not hand the bank back.Moreover, shareholders would have also lost out on some 4 billion euros of funding for 11 billion of dodgy structured assets from Fortis’s delusions of grandeur.

Even if the Belgian government had been willing to hand back Fortis Bank, it’s hard to imagine that shareholders could have afforded the capital injection required: Fortis Holding’s entire market capitalisation is around 4.5 billion euros, a fraction of what the government has already injected.

Like in casinos, there comes a time when you have to choose to hold or quit. Shareholders were right to quit before they lost the lot.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The Citigroup bailout is sure to succeed, but only if you count avoiding making unpleasant but needed decisions as success.

It won’t work if you define success as building confidence and attracting private capital back to the banking system. It fails to work out a clearing price for rotten assets, and though it underwrites $306 billion of them even this huge sum is not enough to suspend disbelief.

It won’t even work if you define success as jump starting Citibank lending to private borrowers. The bankers have every reason to keep their heads down and pray they can slowly rebuild capital rather than lending into the biggest downturn in two or three generations.

At best it buys Citibank some time, though heaven knows what they can do in the next little while to stave off a cascade of writedowns in their housing and consumer loan books, much less their emerging market businesses.

It also, and I think tellingly, avoids taking a credible decision on whether Citigroup, and by extension the U.S. banking industry, can avoid explicit as well as effective nationalization.

We are in a really dangerous moment when is it apparent not only that no one really knows what to do, but that the people making decisions now are not the ones who will be left to sort them out once a new administration takes power in Washington. That provides a ready excuse to simply kick Citigroup’s can along the road.

One thing is very clear; the terms extended to Citigroup were a lot less difficult to bear than other earlier bailouts. I would guess that this is because the government is terrified that they have become the only game in town. The government is in a double bind; they must extend capital to banks or see them fail but every time they do it they make the banks less attractive to private money.

Any more radical solution would be difficult for a lame duck administration to attempt, and given the size of the banks involved, very daunting.

The United States will invest $20 billion in Citi preferred shares which will pay an 8 percent dividend. The government will get 10-year warrants to buy $2.7 billion of common stock at $10.61 per share, as against Citi’s $3.77 price just before the deal was announced.

The government will guarantee $306 billion of Citi assets, with Citi taking the first $29 billion in pre-tax losses and the government on the hook for 90 percent of the losses after that. These assets will remain on Citi’s balance sheet and it will continue to get any income they generate but Citi will issue $7 billion of preferred stock, which will also pay 8 percent, as a fee. These assets will only be 20 percent risk weighted, which will free up an estimated $16 billion of capital. All in all, it was enough to underwrite a more than 70 percent rally in Citigroup shares.

Crucially, we’ve not yet seen any indication that we will get a full accounting of exactly how that $306 billion was valued, other than it was agreed between Citi and the United States. It is another example of the U.S. saying: “Don’t worry, we will make it all OK,” without exactly specifying what “it” is.

CIRCLE OF CYNICISM

And of course without being able to see what the assets will actually fetch, especially in a declining economic environment, who would want to buy the pig in the bank’s poke?

That being the case, and in the firm expectation that loan losses will mount as the economy worsens, it’s a fair bet that the vicious cycle of writedowns and capital need will continue. In the absence of some real clearing mechanism for banking assets, and a willingness for government to pick up the pieces for those banks that can’t survive, expect more requests for life support from more banks.
But governments are finding it increasingly frustrating, at least publicly, that they pour money into banks yet see little in the way of lending come out the other end.

“The heart of the fear for all of us that still value free markets is that governments will eventually decide to nationalize whole swathes of the global banking system to ensure that the money they’ve invested in the recapitalization trade filters through into the wider economy,” Deutsche Bank credit strategist Jim Reid wrote in a note to clients.

“Ironically there may be a time when banks have to decide whether they need to make loans that may prove to be loss-making just to avoid governments losing patience and nationalising them.”

It is really a worst of all worlds, a circle of cynicism; governments prop up the good and the bad in the banking system, which in turn makes loans it doesn’t really think make any sense.
It’s a heck of a way to allocate capital, and almost as bad as the old system.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –