I love banking bail outs, and so should you. What would life be like without them? Without bail outs bankers would have to behave like the rest of us, and where is the fun in that? Of course, banking could be a pretty straight forward job. You look after people’s savings by investing them in profitable enterprises. The savers get a return on their money, the enterprises thrive and a little way down the road society as a whole is richer. It is not very different to laying bricks or running a shop really. A bit of common sense and some hard work; you make a nice living and do your bit to improve life for everyone else.
But be honest, wouldn’t that just be so dull! It is a lot more fun to lend out more money than you actually have to lots of very risky projects which pay a good return.
You have to love bankers. They just can’t stop themselves, the little dears. They really are the wild and crazy guys of the business world. In the past they have financed rickety governments, rapacious clerics and wars, often backing both sides. In the seventies it was third word debt, piling cash into the poorest and most corrupt governments on the planet. In the nineties they threw money at any company with dot com in the name, with hilarious results. Recently they were lending money to people with no income or deposit to buy really fancy houses. If you have a dream, no matter how impossible or indeed unpleasant, somewhere there is a banker who will make it come true. Briefly.
Of course, if one banker lends foolishly he simply goes bust. But if lots of them do the same foolish thing at the same time, they can all become enormously rich. This works because they are all lending into an expanding market where rising asset prices mean there is no such thing as a bad loan. And only a killjoy would point out that the ‘growing and developing market’ is in fact a ‘speculative boom that is about to bust’. Until that is, one or two of the risks come unstuck and the whole thing unravels.
This is where the fun bit comes in. Because it isn’t the bankers’ money they are investing. When they lose the lot, it is the savers who lose out. They, not surprisingly, will be very unhappy when their money which yesterday was safely invested in solid high performance assets, today has vanished. They after all, thought they were being prudent and virtuous. So the government feels it has to step in to make sure that it doesn’t have a lot of very very unhappy people making lots of trouble.
So governments can always be relied on to bail the banks out, and the bankers can carry on creating all the fun. It doesn’t really matter much which kind of government it is. They all react the same way in the same circumstances. So I thought I’d cheer everyone up by sharing a few of my favourite bail outs so we can all have a jolly good smile at those lovable bankers and their madcap capers.
The Medici bestrode the Renaissance like a whatever the collective noun for a colossus is. Their influence came from running the biggest bank in 15th century Europe, a source of ready cash that gave a degree of influence and power that the monarchs and emperors of the time could only dream of. This enabled them to effectively and openly rule their home town of Florence. They also popped up as popes and married into the big royal families.
They weren’t the first big bankers, and they didn’t do anything particularly innovative apart from invent double entry book keeping, starting the tradition of wrapping finance in complicated terms that the rest of us struggle to follow.
But there wasn’t really any mystery to the source of their wealth. Like all banks, they lent out considerably more than they had on deposit. In fact it is estimated that they had as little as 5% capital to cover their loan book. It would only take a couple of bad debts for the whole thing to come tumbling down. Inevitably this happened. The problems started in the London branch – starting another tradition that is still going strong – and spread to Bruges. As with all bank runs there is always a chance that an injection of cash might save the day.
The Medici used their political power in Florence to use the state’s funds to keep their bank going. They even ransacked a charitable foundation. It didn’t work sadly, but I am sure that the ordinary Florentines were only too happy to see their taxes contribute to keeping the Medici going just a little bit longer.
Continental Illinois, the seventh biggest US bank at the time, went bust in 1984 after a combination of poor lending decisions and some bribery at a senior level. If Ronald Reagan had followed his free market philosophy he ought to have let it collapse and to heck with the consequences. But despite putting striking air traffic controllers in handcuffs and building up the biggest arsenal of weapons the planet had ever seen to scare off the communists, deep down our Ronnie was a big softie. He just couldn’t bear to see financiers losing out so a $1 billion dollar bail out made sure that nobody lost any money.
It is nice to know that he had a heart of solid gold. Unlike the dollar since 1971.
This bailout also gave us the memorable phrase ‘too big to fail’. It’s a neat phrase. But aspiring coiners of aphorisms should note that it is about twice as long as it needs to be. The first two words are enough to describe the situation perfectly. The bank was too big, but it was more than up to the task of failing.
Until the recent financial crisis this bail out was the biggest in history and would have had a significant effect on the US balance sheet if it weren’t for the fact that Ronald Reagan’s mind bogglingly large spending on star wars inspired arms had already created a budget deficit large enough to be seen from space.
Long Term Capital Management
Long Term Capital Management must be about the most inaccurately named company in history. In reality it was a short lived exercise in extraordinary mismanagement of very large amounts of capital. It was basically an investment fund, and it did generate good returns when it was first set up in 1994. The returns were in fact so good that many investors who wanted to share in them were turned away. However it failed to keep this up and in 1998 managed to lose $4.6 billion in less than 4 months. That number is a shade more than the current GDP of Germany.
This astonishing level of incompetence was made possible by advanced mathematics created by a couple of respected Nobel prize winning economists. And they weren’t just ivory tower academics. They were on the board making sure that their ideas were followed precisely. I think it is a good habit to get into to remember this whenever you see an economist in the media pontificating about, well, anything really.
The fund was effectively bust, and was bailed out by banks and other financial institutions who quietly wound it up. This bail out did not directly come from the public, although the US Federal Reserve did co-ordinate it so it wasn’t exactly the market sorting things out itself. The biggest lesson of the affair was that complex mathematical modelling of risk was not a good way to ensure either stability or profits. This lesson sunk into the financial sector in much the way rain drops sink into wax coated lead. Complicated mathematical modelling was soon back, and generating more fun than ever.
Northern Rock was formed from the amalgamation and demutualisation of a number of building societies in the north east of the UK. These building societies dated back to Victorian times, and were mutual organisations where savers deposited money which was lent out to other members for the purposes of purchasing houses. Building societies were dull and conservative stick in the muds who never achieved anything other than providing a safe place for savings and a way for people to own their own house.
When Northern Rock became a proper bank it instantly became a lot more exciting. It soon became a by word for having a relaxed approach to risk regularly offering loans openly in excess of the value of the property against which they were secured. This created the first bank run in the UK since Mary Poppins. This became one of those great shared public experiences like royal weddings which the British enjoy so much. It was a great chance for people to get out of their houses and join in the fun queuing outside in the hope of getting their money out before it all disappeared.
But they needn’t have worried. The government turned up and nationalised it. The chief executive, a mathematician by training, got a £760,000 pay off. He may not have had any actual business ability but at least with his maths degree he’d be able to count his cash. Shareholders in Northern Rock lost all their investment but didn’t have to fork out to clear up the mess created by the company they owned. So everybody was a winner really. (Except the taxpayer.)
The whole shooting match – 2008
Looking at history it is hard to escape the conclusion that every bank eventually goes bust. And lots of them go bust in spectacular and entertaining ways. Sometimes they drag other banks down with them. For connoisseurs of banking crises 2008 was the vintage year. For years the profitability of companies like Lehman Brothers and Bear Stearns and the earnings of the people in them had defied the understanding of outsiders. In 2008 it was revealed that it was just as much as a mystery to the bankers themselves. Financial institutions the world over suddenly seemed to have, well, financial problems.
In October of 2008 the Bank of England estimated that the financial sector as a whole was sitting on losses of $2,800,000,000,000. Lets call it 3 trillion. I imagine bankers greeting one another, slapping their hands on their foreheads and saying ‘what are we like, eh?’.
With losses like this the world faced a major problem. There was a risk that cash machines would stop dispensing cash we were told. Something had gone horribly wrong. What to do? It was a crisis and governments responded. They dished out large sums of money to the people who had caused the crisis. What else could they do?
This isn’t the first worldwide financial crisis, but it does seem to be the biggest. It has also had the biggest bail out. Nobody seems to know what the effect is going to be, but I think it may turn out t be no laughing matter.