Evercore Pan Asset

The Obama package to save the world is now under scrutiny to see if it can save America. Adding too much public borrowing to protectionism is not a winning recipe for success. Markets were inclined to be optimistic about the new President’s plans at the beginning of the year, but are now having second thoughts.

Many realise that governments need to fix the banks. The Paulson packages are still unfinished business.

The US and the UK economies are not going to function properly again until the problems of their bloated banks are solved. The US and the UK authorities from time to time announce new packages of huge sums of money to help the banks, in between their preferred choice of planning to spend huge sums of borrowed money on public works and projects in the hope these will reflate them out of trouble.

There are several solutions being investigated on both sides of the Atlantic to tackle the banks:

1. Establish a bad bank, to take away all the toxic debts from the current banks. The slimmed down banks can then resume lending.

2. Nationalise the existing major banks, pumping in enough money so they can start lending again.

3. Create a state sector good bank which starts lending

4. Offer state guarantees to the commercial banks for new lending to encourage them to start it up again

5. Relax regulatory constraints to allow more lending from stretched balance sheets

6. Print more money and inject it into the banks to encourage them to lend more

Proposals One and Two would be very expensive. Transferring the bad debts from private to public sector doers not cure the malaise. It merely shifts the losses from shareholders and bankers to taxpayers for no obviously good reason. There is no evidence that a state owned bank would be better run than a private owned bank, despite the poor performance of several private sector banks. Governments themselves anyway say they do not want to run the banks they nationalise.

If more lending is the aim then establishing a new state owned competitor to existing banks and giving it capital so it can lend would be a less expensive way of creating new lending, pound for pound, than subsiding and propping up an existing bank. It could not realistically be large enough quickly enough to make a lot of difference. If it lent too much too quickly it would soon itself have lots of toxic debts, whilst its capital requirements would impose a substantial strain on public finances. Lending in these conditions is not easy, as many companies will struggle to repay the borrowings. Toxic debt is not a large pool of bad loans from a past era of excess that can be identified and tackled. The toxic loan pool is growing all the time as the economy deteriorates.

Offering guarantees to stimulate lending, relaxing regulatory restraints on capital and injecting more cash into the banks are all helpful measures. If done in moderation they could help solve the problem.

None of this, however, tackles all the underlying problems of overstretched balance sheets, too much dangerous business on banks books, past large errors by banks and a new climate of fear engendered by market movements and government hostility. There are a couple of other proposals in the debate which need to be dealt with:

1. Make the banks declare the full extent of their losses – the full transparency approach

2. Bankrupt selected banks that have performed especially badly to force out their losses and get them behind us

The first idea has some merit, but is not of itself a solution. If the losses are too large markets will be spooked and then there will be even larger losses as the market value of banks assets falls further. To some extent this is happening anyway, as auditors and Directors consider what to put in accurate accounts at the 2008 year end. RBS is going to declare around £28 billion of losses as a result.

The second proposal was tried when the US authorities allowed Lehmans to go under. It led to further falls in asset values, destabilised other banks and made most in authority think they should not do that again.

So what should the authorities do? The regulators and the commercial bankers have to work together where a bank is in trouble, to find a way of getting from over lent, overstretched and sitting on too many losses to a position where the bank’s balance sheet is strong enough to resume normal banking.

This requires case by case analysis, and agreement between regulator, central Bank and commercial bank about the timetable for remedial work. All the time the commercial bank is making the agreed adjustments it should receive lender of last resort support, and continue to receive regulatory approval.

Actions bad banks need to take include:

1. Cutting costs sharply. They need fewer highly paid people. There must be no bonuses. In some cases higher paid people will need to take a pay cut. These banks need to make more profit to pay the past losses.

2. Going through all loan books and having a plan to maximise the repayments on each loan – as many of them are doing to an extent already. Tough judgements have to made – will continuing the loan and keeping the customer going result in a better outcome, or is it better to demand repayment now because the customer losses and asset values are going to get worse? There was a lot of wishful thinking about property values and the like in the early phases of the downturn.

3. Closing down the investment banking and trading activities that put too much bank capital at risk. The world market has been oversupplied with derivatives, futures, options, collateralised debts and the like. Big book positions should be closed out wherever possible by banks at risk, and losses taken where too many bad bets have been placed.

4. The large banks created by expensive and over rapid acquisitions should be broken down into their old components, re-establishing the separate brands. Individual businesses should be sold off to reduce risk and raise cash.

5. Adding selective new business where risks and margins look attractive, but resisting efforts to make these banks lend to whoever at whatever, recreating past errors of optimistic lending.

This is just a sketch of what needs doing. Call it if you like the intelligent bank manager approach. This is a big problem, so it requires hard work and patience to get ourselves out of it.

I can see why Mr Obama thinks that if he is going to borrow and spend such huge sums on a reflationary package, he should at least say that the money spent should be spent on American supplies and American labour. After all, he will reason, the point of the package is to revive the US economy, so it must make sense to spend the money on employing Americans. The USA has been importing too much. It would make no sense for the US state to borrow more and spend it on imported Chinese steel or Japanese cars.

Unfortunately things are not as simple as that. Drawing up a list of purchases where the US is more likely to win the contracts is one thing. Placing a ban on products and labour from overseas is another. If the USA moves from the former to the latter, other countries around the world may follow suit, making it more difficult for the USA to export its goods. There would be no winners from a trade war.

Sometime the world has to address the huge imbalances between countries that lies behind the current crisis. Of the five largest economies in the world at the start of the crisis, two, the USA and the UK were borrowing too much, spending too much and importing too much. Three, Japan, Germany and China were saving too much, exporting too much and lending too much. Part of the crisis lies in the painful process of seeking to adjust to a point where the three exporters import and spend more, and the two debtor countries borrow less and export more.

Policies in the UK and the US to borrow more and spend more may delay this adjustment. In the UK the government’s attempts to offset the iron laws of economics have led to a sharp collapse in the pound, cutting the spending power of all of us and putting us off buying so many imported goods. This is offsetting some of the fiscal profligacy and thwarting the government’s hopes of avoiding a fall in living standards. If the US overdoes its attempts to borrow its way out of trouble, it too could run into difficulties requiring higher interest rates and a lower value for the dollar. The US reflationary package is dependent on the goodwill of the creditor nations continuing to hold US government bonds and adding to their holdings as new ones are issued in huge quantities.

The world needs agreement between lenders and borrowers. Adjustments need to be made by both groups of countries. The successful exporters and savers do need to spend more and save less. China has announced a reflationary package with that in mind. They do need to allow their currencies to appreciate, so imports are cheaper and more attractive to them. Some of this has happened with the sharp upward movement in the yen and the lesser upwards moves in the Chinese and German currencies. It is in the interests of the creditor countries to reflate, as their economies are being hit hard by the collapse in demand for their exports which have accounted for such an important part of their past economic activity. Germans need to buy more of their own manufactured cars and trucks, and the Chinese need to buy more of their own electricals and textile products, as the debtor nations can n o longer afford to.

Markets are gyrating between days of optimism when people think all the money being promised and actions being taken will succeed in getting the major economies out of their downwards spiral, and days of pessimism when investors continue to worry about damaged banks and over borrowed governments. We still recommend avoid the risks of UK real assets, whilst moving some money into corporate bonds and Pacific oriented equities.