If the origins of the current economic crisis could be encapsulated by one word, that best candidate would be leverage. The explosion of debt that over-extended every consumer and business in the western world has led us to a massive hangover now that the party is over, and morning has broken. The house party got out of control and now, in the cold light of day, our home is trashed. We can now either crack open another can and carry on or, pull on the marigold gloves and get busy with the vileda supermop.
But, before we start pouring salt on the red wine stain in the white shag pile, lets remember exactly what leverage is. Very simply (and please may those with even the most basic business knowledge humour me for a minute), leverage is the ratio of Debt to Debt + Equity for any enterprise or business. The debt portion of this ratio has got out of hand for almost every company and consumer in recent times and so, the fraction has exponentially veered towards the magic number 1 that signals insolvency, as the equity portion got dwarfed by cheap cash and easy finance. Now we are struggling to keep get this ratio back under control. The most high profile front in this struggle has been within the banking industry and the fight to control the capital ratios decimated by their highly leveraged balance sheets. Almost every country in the western world has furiously thrown money at their banks' equity and attempted to bolster this part of the ratio in order to recapitalise their balance sheets. This one way of doing it but, let's go back to 1st grade mathematics to see the other...
Fractions are a ratio of two numbers, a numerator on the top and, a denominator on the bottom. The ratio can be reduced by either increasing the denominator or, decreasing the numerator. In throwing billions of dollars/pounds/euros at their banks' equity, the US, UK and EU have obsessed about increasing the denominator. Raising more equity to recapitalise banks, does nothing to solve the root problem. Bank equities are exposed to the free market forces of the stock market which have simply pushed the equity valuation down further because the toxic debt instruments that caused the losses in the first place are still there and the problem hasn't been fixed yet. The equity portion of the bank leverage ratios is being eroded as fast as the government bail-out plans are pumping money into them. Call me crazy but, has anyone thought about reducing the numerator instead..?
In October of last year, the Swiss government pulled aside the UBS board of management for a bit of an honesty session, and the bankers revealed all the horrific skeletons in the embarrassing closet that their balance sheet had become. Once the beatings had finished, the government created the accounting equivalent of a toxic waste dump to stuff these illiquid debt securities into. This resulted in $60bn of damaged goods being transferred off the UBS balance sheet and into a Swiss-government-owned fund. In exchange, UBS invested $6bn in the equity of this fund, which would only generate a return if these assets recovered back above their transfer value. The $60bn of bad assets that were amputated from the UBS balance sheet would have been the most difficult to fund and so, the biggest strain on its capital ratios. Exorcising themselves of these troubled assets enabled UBS to eliminate the borrowings that were being used to finance these positions and so, dramatically reduce its leverage. This cleansing of the UBS balance sheet had the neat (not particularly my choice of adjective but that of the NY Times) effect of spectacularly reducing the numerator in its leverage ratio and also reassuring the equity market that the cancerous tumour had been successfully removed.
The beauty of this solution is in the value for money that the Swiss government has achieved in implementing this solution. They identified the root problems (toxic assets), isolated them (govt toxic asset fund), and gave UBS a new lease of life (clean balance sheet). This wasn't cheap but, it was very clean and definitive. The cost to the Swiss taxpayer (who are they anyway?) was capped ($60bn) and achieved exactly what they were looking for - a fresh start for Swiss banking. Removing the trouble-assets, and paying down the debt used to finance them, enabled UBS to reduce its dependence on the demon weakness that is leverage.
Let's compare this strategy to how Gordon Brown and Biffo Cowen have approached the crisis. The Irish government initially took the bold step of guaranteeing all the debt of the five major indigenous banks so that they could more easily fund the assets (good and bad) that sat on their balance sheets and then, the UK government began ploughing money into the equity of the UK banks. Both these approaches are basically an attempt to maintain the existing leverage ratios of the banks and hope that the problem sorts itself out. In Ireland, the hope was that by giving the banks easy access to cheap financing (in the shape of the government guarantee), the equity market would look favourably upon their equity prices and so, the denominator in their leverage ratios would cease to be impaired. In the UK, Gordon Brown simply decided to directly bolster the denominator in the banks' leverage ratio, by throwing money at the banks' equity. Both these strategies are flawed in that they simply seek to preserve the status quo rather than fix the root problem.
Effectively reducing a bank's leverage ratio (or even keeping it under control) is critically dependent upon stabilising one potentially very volatile factor - its equity price. This means that whatever strategy one employees, as long as the bank remains publicly quoted on a stock exchange, the value of its stock price (and so its equity market capitalisation) can fluctuate to reflect investor opinion of the strategy employed. The difference between tackling the top part of the leverage ratio and the bottom part is that the numerator (debt) is not open to outside influence so, any reduction effected is sustained. However, focusing on the bottom part of the leverage ratio by trying to bolster the bank's equity market capitalisation can be undermined directly by the equity market. The main problem with this strategy is that it leaves the onus upon the management of the bank to use the cash, given to them by the equity recapitalisation, to reduce debt and so, strengthen their balance sheet. However, within the UK at least, the banks are simply using the government bank guarantee to raise new debt and simply maintain the existing leverage, not reduce it. This mainly because the banks still can't face up to the real value of the toxic assets on their balance sheet. The indirect nature of this solution merely allows the banks to sustain the illusion and goes nowhere towards really solving the problem. Much like giving a junkie money to pay his dealer, the dependence remains.
Okay now, Gordon & Brian, if you manage to read this, let me spell it out really simply. Remember the ratio I was talking about - leverage? Well, making the bottom bit bigger so that the top bit doesn't look so bad, ain't no solution. If you force the banks to reduce leverage by taking the problem assets off them, the resulting clean nature of their balance sheets will mean they can use the government debt guarantee in the right manner - to raise more cash to give out as new loans and mortgages to the man in the street. As long as the banks sell the assets at a realistic value, into the government fund, the taxpayer will not be forced to overpay and may even benefit from any recovery in their value. Even if they end up being worthless, the cost to the taxpayer is capped. Any drop in the banks' equity price due to the write-downs on the loans they transfer into this fund, will be limited because, the underlying problem will have been extricated. A kind of financial root-canal therapy.
The proof is in the pudding and, all one has to do is go back to October, last year, and look at how Swiss and UK fortunes have diverged since then. Switzerland spent $60bn on UBS, in the same week that the UK government invested £37bn ($64bn at the time) in RBS, HBOS, and Lloyds stock. Most of the UK's £37bn was pumped into RBS and, since then, the UBS stock price has outperformed the RBS stock price by a massive 20%. Much like a rogue trader would double-down on a bad bet, last week Gordon Brown announced another £50bn of investment in UK bank stocks and, in Ireland, Biffo has had to nationalise Anglo Irish Bank. If tax were considered an investment in a country's fortunes, we should all be considering a change of fund manger or moving our money elsewhere. Only question remaining is, when are we all moving to the Alps..?
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