Monday, 13 October 2008

Governments - Drinking At The Last Chance Saloon - Nobody's Buying A Round...

GOVERNMENTS have been drinking at the Last Chance Saloon when it comes to rescuing the world financial system, but it seems there is still a great reluctance to pay for the rounds.

Last night's announcement from the emergency meeting of EU leaders fell short of the all-out strategy now being advocated by most economists.

This would see governments putting fresh money (capital) into the banks so that they can begin counting and admitting all the capital they have lost through making loans which have not been repaid and, worse, buying loans and derivatives of loans at prices far above their real value.

How far above was horribly illustrated on Friday at an auction of bonds issued by failed investment bank Lehman Bros. They were sold at less than 10 cents on the dollar, which means those banks which bought the bonds have lost over 90pc of their money.

There is a general consensus now that losses in the global banking system are over a trillion dollars ($1,000 billion). It is an unimaginable sum but, to get a better handle on it, losses in the Irish banking system are estimated at between €10bn and €20bn. No-one knows for sure. No-one knows for sure anywhere, which is the root cause of the virtual closure of the banking system.

As those losses are taken on board, banks will shrink in size, their profits will drop and many will go bust, but how much and how many? This is why banks are holding on to the cash they have, and are unwilling to lend to others. Until that changes, the world faces the catastrophe of a failed financial system which would shrink not only banks but economies as well.

Different governments have tried different solutions, and none has worked. One reason why not, it is felt, is that the solutions are all different. Ireland's blanket guarantee of deposits and bank borrowings for six lenders was particularly unpopular, because it led to runs on the deposits of other banks which were not covered.

One of the main purposes of yesterday's meeting was to get EU governments to all act in the same way. It appears to have succeeded in this task, with an approved "toolbox" of measures governments can take. The box does not contain the deposit guarantees offered by Ireland, but Taoiseach Brian Cowen seemed optimistic that the scheme will get approval from the Commission in the next few days. Watch for the small print, though.

However, the key part of the agreement was that which said governments will take stakes in troubled banks, to ensure the smooth functioning of the eurozone economy. (It was essentially a eurozone meeting, but Britain was included because of its size. There is also the curious fact that the toolbox bears an uncanny resemblance to measures announced by the British government last week).

The agreement falls short of the co-ordinated, immediate re-capitalisation of banks which many analysts had called for. But it is widely expected that Germany, France and others will begin the process quickly. Mr Cowen said it would be "unhelpful" to speculate about what he will do, which will strike many in financial markets as very unhelpful. Uncertainty is the problem.

With a €15bn deficit yawning before Brian Lenihan tomorrow, one can see why the Irish Government does not want to think about finding another €14bn (to take a figure used by NCB Stockbrokers) to re-capitalise the banks. It is not quite the same as the Budget deficit, though. Because the money would be used to buy an asset -- bank shares -- it would not count under EU rules. There would be dividends and perhaps fees from the banks in return. And in the end, if it worked, the taxpayer might make a tidy profit. But the interest repayments on such as sum would be around €700m a year, and that is serious money.

The Government's hope still seems to be that it can merge one or two of the small, weaker lenders among the six, and that the bigger banks will take them over, under the protection of the guarantees. Not surprisingly, they are not too keen on the idea. And one reason for last night's agreement is that rescues like this have a habit of coming unstuck. It failed with Hypo in Germany and there are still doubts about the Lloyds TSB takeover of HBOS -- parent of both Ulster Bank and Halifax Ireland.

Last night the Norwegian government added to the pressure on governments to re-capitalise banks by committing the huge sum of $55bn. It intends to buy troubled mortgage debt with the money.

In a way, it is all quite simple. Until banks admit their losses, and start writing them off, we will not begin to get back to normal. They cannot do it without new capital. But banks don't want to write off such huge sums, and neither the markets nor governments particularly want to invest in banks in this state. But waiting for some softer option to arrive is no longer an option.

Report by Brendan Keenan - Irish Independent
Cartoon - Irish Independent

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