Evercore Pan Asset

We learn that plans are afoot for another bank package. The first, very expensive, one has not led to sensible amounts of credit flowing in the economy. Despite all the cash and all the words and all the jet travel designed to rescue the banks and get the wheels of credit moving again, the alarming prospects for the UK economy in the first quarter of 2009, has prompted the government to look for more measures to prevent a large number of industrial and commercial company collapses.

We were told through the press at the start of last weekend that 4 possible options are being considered:

1. More money being invested in bank shares by taxpayers.

2. Establishing a state owned “bad bank” to buy up and work through some of the poor loans from the commercial banks.

3. Cutting interest rates further, perhaps to around zero.

4. Revisiting the state guarantee package for private sector lending.

This would be a dangerous package. I would rule out three of those four proposals, leaving just the state guarantee issue on the table. Let me explain why.

1. The taxpayer cannot afford to own more bank shares, and should not be expected to take yet more risk. The banks may lose a lot more money before this crisis is resolved. They are currently in a vicious circle. They cannot afford to lend more, so they are forced to undermine the companies they do lend to, as these companies are starved of additional working capital by the banks, and face less and less revenue from customers who cannot get access to new loans or do not seek new loans as they fear for their jobs. It is possible RBS has already lost the £20 billion the taxpayer was made to put in recently. When you go to the aid of a bank with a £2 trillion balance sheet you need a very long pocket. The last lot of share subscriptions did not lead to more lending to the corporate sector – just to lending it back to the government. This is the worst possible option.

2. The Bad Bank idea is a variant of the original Paulson plan in the USA which Gordon Brown criticised, preferring direct injections of capital into banks. The idea is unlikely to work for similar reasons to 1 above. The potential range of poor loans is very large. It would require huge state capital to buy them up, and poses a big problem about how to value them fairly. Value them too cheaply, and you undermine the banks you are trying to help even more. Overvalue them, and the taxpayer ends up with large losses. The sums involved are likely to be too large to be realistic for taxpayers to take on such a task safely. There is the danger of overseas arms of UK based banks seeking to sell their less desirable assets to the UK government at the same time.

3. Lower interest rates is an equally dangerous idea for different reasons. The problem today is not the price of credit but its availability. Cutting rates to zero will create a bigger gap between base rates and actual rates in the market, as no bank can afford to lend to people or companies at a small amount above zero, and no saver is going to willingly put his money on deposit for no return. With sterling already too weak, it would be another incitement to people to put their money abroad.

4. The state guarantee package announced last autumn was a potentially good idea. It too requires judgement about how much to guarantee at what price, but offers the scope to help get interbank and bank to company lending moving again at a lower cost to taxpayers. Government can secure the taxpayer interest by taking enough asset cover for the guarantees, but does need to price them sensibly so banks find the option attractive, but not too attractive so the taxpayer is left with too much risk. The lack of use of them so far shows perhaps they were not sensibly priced, as well as indicating that banking regulation may be at the root of the problem.

So what should the government do to ease the squeeze?

1. Open tripartite talks with the Regulator and the Bank of England over how much capital banks need to have to carry out a given amount of lending. It may be necessary to allow banks scope to have lower capital ratios for a bit as they work themselves through the bad and doubtful debts, with proper monitoring and support from the authorities. They need also to discuss how much needs to be marked to market, and how much can be valued in relation to its longer term economic value, on prudent assumptions about repayment probabilities. At the root of the current shortage of money is the authorities decision to demand higher capital ratios at the time they put more money in, which was a self cancelling move.

2. They also need to review their latest liquidity proposals, which will also limit lending to anyone other than the government. These should be delayed.

3. Announce there will be no further cuts in interest rates for several months, to create some stability, and offer some reassurance to savers.

4. Alter the guarantee scheme following discussion with the commercial banks about what it would take to get them lending more, assuming the taxpayers interests can be properly protected.

5. Discuss with markets how the corporate bond market can be made more effective as an alternative source of longer term loans for companies.

We would argue that many of the UKs economic problems are related and self feeding. The collapse in demand is leaving many companies short of cash and profit. They need to borrow more to tide them over, but the borrowing is not available. Individuals cannot borrow more to buy the companies products, and then fear the loss of their jobs when companies have to cut back. As jobs go so people spend less, feeling they need to save more. As overtime and bonus payments disappear, so people have less money to spend. Cutting VAT has not unlocked enough spending to save companies. Buying bank shares has not unlocked enough new lending to save companies. This is a big squeeze, which is going to intensify in the first quarter of 2009. Now Christmas and New Year are behind us many companies will have to face the grim reality of too few customers chasing too many goods. Shops will also have some hard decisions to face as they run out of cheap imported product to sell, and have to consider buying product which is around 20-20% dearer thanks to the collapse of the pound. Yes, they should look around for more UK suppliers, but No, they will be unable to source a lot of what they want locally.

As the week-end wore on the government let it be known they did not any longner favour putting more share capital into banks. It also appears a review of the capital requirements placed on banks is on the table for discussion. They are considering terms for loans to car companies. Let us hope they soon come up with a package which can provide some relief for a hard pressed economy.