Governments, not bankers, are to blame

Bankers' foolishness may have got us into the current crisis, but they acted with the connivance of governments and central banks worldwide. And now governments are making a pig's ear of putting things right.

I'm very glad I'm not a banker.

In the current environment of hysteria and muddle, everyone is blaming bankers for the credit crisis which threatens to plunge the world economy into another great depression.

But bankers only did, usually legally, what they were employed to do make money for their companies.

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They operated in an environment of abundant cheap credit provided by central banks, and within a framework designed by politicians and administered by regulators.

There was no secrecy about the huge rewards they received for their creative financial operations, and shareholders acquiesced in those rewards and the means used to earn them.

They catered to the demand from those eager to go deeper into debt to deliver immediate satisfaction, to finance greedy speculation, or to seek higher returns from investments whose risks they didn't understand.

What bankers did was foolish -- but they did so with the connivance or even active assistance of those in a position to stop their nonsense.

Now we are engulfed in the resulting mess. Central banks seem to be doing a reasonably competent job flooding the system with money to prevent its seizure, but governments are dithering or being panicked into often unwise reactions.

The Americans equivocate between stern rectitude (letting Lehman Brothers go bust) and buckling to pressure from foreign creditors (the Fannie/Freddie and AIG nationalizations).

The off/on Congressional rescue package is a dog's breakfast that focuses on using taxpayers' money to buy the dodgiest financial assets rather than addressing directly the problem of recapitalizing of the banking system.

It is a grossly wasteful exercise in political bribery, with the enabling act incorporating huge tax breaks for Alaskan fishermen, Puerto Rican rum producers and low-budget film makers. Anything to gain the votes of Congressmen under pressure from hostile voters.

Hostile, that is, to the idea of giving a finance minister who personally profited immensely from the credit bubble, hundreds of billions of taxpayer dollars to spend on what they see as a rescue for his friends. Especially as in recent months his policymaking has been unstable, unsure, even incompetent.

George Soros, the famous fund manager, says that when Hank Paulson got his first blank cheque from Congress to deal with the Fannie/Freddie crisis "his solution landed the housing market in the worst of all worlds: their managements knew that if the blank cheques were filled out they would lose their jobs, so they retrenched and made mortgages more expensive and less available. Within a few weeks the market forced Mr Paulson's hand and he had to take them over."

His proposed purchase of distressed mortgage-related securities "poses a classic problem of asymmetric information. The securities are hard to value, but the sellers know more about them than the buyer" in any auction process the Treasury will "end up with the dregs."

His plan, now approved by Congress, is "rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief. But if the scheme is used to bail out insolvent banks, what will the taxpayers get in return?"

Who was in charge when the bankers earned mega-bucks?

In Britain prime minister Gordon Brown, who managed the financial system throughout what he now calls "the age of irresponsibility," has rescued a couple of lesser banks whose business practices were least defensible, even though their bankruptcy presented no systemic threat, to shield his weak and incompetent administration from flak.

His government now outrageously plans to eventually recover the cost of such rescues from surviving mortgage banks that lost business to their now-bankrupted rivals because they pursued more responsible policies.

The Brits even hypocritically complained about the sensible Irish move to guarantee the deposits of their largest banks, after themselves already having effectively promised the same thing. Months ago UK Treasury officials made it clear that the 100% government guarantee given to Northern Rock depositors would be available to other banks if required.

The Europeans, having allowed their banks to operate on average with even lower capital ratios than the Americans, and having done nothing to discourage their pension and insurance funds from loading up with high-risk US mortgage-backed rubbish, found themselves in deep shtook (in Belgium, France and Germany) within days of publicly sneering about the failure of the American capitalist model.

Confusion is understandable given the scale, complexity and severity of the crisis, but on the whole governments, as different from central banks, are handling it unwisely.

Their focus is on rescuing financial institutions that have been poorly managed and least deserve to be rescued, while doing far too little to strengthen the best-managed ones -- provide them with the capital that would make it possible for them to swallow up the weak, resume broad-based lending, and rebuild the global credit system.

As has so often happened, Warren Buffett provided the role model, boosting the permanent capital of Goldman Sachs by investing in its preferred shares. There is no reason why governments should not do the same.

American commentator John Hussman says the TARP package now approved by Congress wastes taxpayers money without addressing the fundamental solvency problems.

"The government is taking on financially non-viable securities and warrants on common equity, while failing to improve the capital position of these financial companies at all (unless it overpays)," he says.

The US government should have gone the same route as Buffett "provide capital in return for a financially viable security that is senior to common shareholder equity, have it accrue a relatively high rate of interest, and allow it to be repaid early (Buffett's preferred is callable by Goldman) as soon as the financial institution can secure cheaper financing."

Stuffing the government's coffers with overpriced junk

The FT's commentator Martin Wolf writes scathingly that the Paulson Plan "is neither a necessary nor an efficient solution" to the credit crisis.

"It is not necessary because the Federal Reserve is able to manage illiquidity through its many lender-of-last-resort operations.

"It is not efficient because it can only deal with insolvency by buying bad assets at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors

"The government risks finding its coffers stuffed with huge amounts of overpriced junk even if it tries not to do so."

Policymakers don't have to reinvent the wheel. Sweden showed how to do it in the early 90s, solving its banking crisis with a combination of a blanket guarantee for creditors, capital injections, tough management, and nationalization of banks that were later reprivatized once the crisis had passed. Most of the taxpayer money paid out was eventually recovered.

Nearly all politicians daily confirm, by their statements and behaviour, that they are hopelessly lacking in the competence needed to deal with the financial and economic issues that will dominate policymaking for the next decade. That's a frightening prospect.

There is already much talk about how banking must be more tightly regulated in future that is, we should give more power to the politicians and bureaucrats who made such a disastrous job of exercising their powers in the past.

Such mind games distract attention from the much greater priority of getting out of the mess we've been landed in. It's like worrying about the design of our new home when the one we're in is burning down.

What to do now

So where do we go from here, and what lessons should we draw for management of our personal finances?

I am confident that the authorities will soon solve the liquidity crisis the fear-driven refusal of banks to lend money to one another as they have unlimited power to print money and guarantee deposits.

Much more frightening is the solvency crisis financial institutions are going to have to recognize their capital losses from writing off assets that are now worthless, such as "toxic" loans whose capital is irrecoverable, and from writing down assets whose tradeable market values have fallen, such as real estate and shares.

Those who can avoid bankruptcy are going to have to adjust to their losses by reducing or suspending dividends, selling off assets, raising additional permanent capital, contracting business operations and firing staff.

Ponder on the consequences of that happening on a huge scale right across the world.

Even more frightening is the crisis that must inevitably follow from a world economy forced to go "cold turkey" by being cut off from the abundance of cheap readily-available credit that has been a prime driver of economic growth for many years, to a world where credit is scarce, expensive and hard-to-get.

Once it becomes apparent that the authorities have overcome the liquidity problem, and before the full extent of the solvency and economic problems becomes clear, I expect a "relief rally" in equity markets.

The usual suspects who have a vested interest in promoting the idea of buoyant and rising markets (stockbrokers, fund managers and politicians), and have been consistently wrong as the crisis has unfolded over the past year, will bombard us with optimistic talk about how the worst is over.

The relief rally could last several weeks, even a few months, before the degree of severity of the global crisis and the developing collapse in corporate profits becomes apparent.

My expectation is that the next couple of years are going to be extremely tough for everyone; that the recovery, when it starts, will be timid and protracted in the developed economies. We have probably entered what one fund manager calls a decade of pessimism.

When it comes, the recovery will be led by and be strongest in China, which has the greatest resources of investible capital, domestic demand potential, business drive and growth-oriented governance.

Long-term investors should focus for a while on the most conservative assets such as government bonds and government-insured bank deposits; physical gold, whether in the form of coins or bars, or exchange-traded fund certificates; and the handful of funds and shares that have already proved their ability to ride out the financial crisis and even gain from it.

When things bottom out in a year or three, we should be looking at the equities of China (especially) and the rest of Asia; multinationals with strong franchises, managements and balance sheets; and natural resources, especially energy, where supply will be a bigger problem than sluggish demand.

This article was written by Martin Spring for On Target, a private newsletter on global strategy. Email