A bad year in the City

The London stock market has been trading at a ten-month high. The best traders are signing multimillion pound contracts. Sealed bids have returned to the top end of the housing market. A year after the collapse of Lehman Brothers on 14th September 2008, the City feels like it is returning to normal.

But the City looks very different. The crisis was well underway when Lehman went bust but the firm’s collapse introduced an intense period of turmoil. British taxpayers have over the past year spent £50bn on shares in British banks and put at least a further £500bn into supporting the financial system.

Lehman’s collapse froze the western financial system. If the authorities were willing to allow the failure of Lehman, a large company close to the centre of the financial world, any bank might be allowed to topple. Trust between banks evaporated. “Overnight dollar Libor”—the rate at which banks lend to each other—rose from 2.15 per cent to 6.44 per cent. Money-market funds, on which many banks rely for cash, cut back the duration for which they would lend.

Much of Lehman’s actual business was stabilised quickly. Barclays, the British high-street lender with ambitions to build a global investment bank, bought the core US operation out of bankruptcy. Nomura, the Japanese bank with similar global pretensions, bought the European and Asian parts out of administration. Lavish bonuses were offered to keep staff from leaving. Ironically, Lehman became a safe place to work.

But if Lehman’s demise was good for Barclays, it was disastrous for HBOS, owner of Halifax and Bank of Scotland. HBOS relied on tricksy money-market funding. Its shares plunged as much as 69 per cent in the three days after Lehman’s collapse. In an unprecedented move, the Financial Services Authority (FSA) issued a statement saying the bank had sufficient cash and capital, and banned speculators from practices that could put downward pressure on financial shares.

But the watchdog’s action only increased the panic. A Northern Rock-style run was prevented only by a leak to the BBC that HBOS faced a takeover by Lloyds TSB. Lloyds had long coveted such a deal but was blocked by competition law. Now it had the government’s blessing for a merger. The hasty deal later cost Lloyds chairman Victor Blank his job.

On the other side of the Atlantic, the waning Bush administration was struggling to get its Troubled Asset Relief Programme—a $700bn plan for buying up bad debt from banks— through congress. American International Group, the world’s largest insurer, was rescued from the brink of collapse.

October: Financial Armageddon seemed imminent. Confidence in Britain’s banks continued to ebb away. On 8th October, the British government took action, agreeing to provide up to £50bn of capital, £200bn of short-term funding and guarantees on £250bn of British bank debt. It was a year since the difficulties at Northern Rock. Back then, the Bank of England had censoriously explained that central banks did not try to keep banks from collapsing. But desperation softens many principles. And there was still the hope that the confidence fostered by the explicit declaration of state support might render actual support unnecessary.

By the time markets closed on Friday 10th, shares in Britain’s banks had fallen sharply again. Monday brought the watershed moment in Britain’s financial crisis. The government said it was sinking £37bn into Royal Bank of Scotland, owner of NatWest, and the soon-to-be-merged Lloyds and HBOS. It was a humiliation for RBS’s empire-building chief executive, Fred Goodwin. Two of Britain’s biggest banks were now de facto nationalised and full nationalisation of the entire sector seemed possible.

Even so, the crisis at this point remained financial. The real economy looked relatively healthy. The MSCI World Index of stocks rallied nearly 21 per cent in the last weeks of October.

But another chapter of the crisis was yet to come.

November: Citigroup, once the world’s largest bank, went into in a “death spiral” as equity and then debt investors withdrew support, feeding off each other’s fear. Fresh losses were emerging at Merrill Lynch, the investment bank bought by Bank of America while Lehman was sinking. Barclays, intent on resisting government intervention, raised capital from middle eastern investors.

Each day brought news of job cuts at the big-name investment banks in London’s Square Mile and Canary Wharf—Citi, Merrill, UBS, Morgan Stanley, Credit Suisse, even the “crisis winner,” Goldman Sachs. Entire firms were disappearing. Dresdner Kleinwort was radically shrunk following the takeover of Dresdner Bank by German peer Commerzbank.

Hedge funds, which use borrowed money to multiply their bets, were suffering too. Toscafund, run by one of the City’s most respected money managers, Martin Hughes, made an emotional written appeal to its investors not to pull money out. And private equity companies were staring at portfolios full of debt-ridden companies approaching negative equity.

January 2009: The new year brought a fresh collapse in confidence when British bank stocks plummeted in the last half hour of trading on Friday 16th, hours after the FSA lifted the trading curbs introduced when HBOS was in freefall. Yet again, the government scrambled over a weekend to finalise a second banking bailout. On Monday, the government said it would insure banks against future losses—a radical step-up in the taxpayers’ exposure, later set at a possible £585bn. It also committed to cover any losses on a new £50bn initiative to get credit flowing.

The mounting public costs were now making the crisis a political issue. The media whipped up public outrage with revelations that RBS might pay bonuses in spite of coming under state control.

February: The treasury select committee began show trials of Britain’s banking chieftains. The directors’ scripted apologies were perhaps a necessary step but for some, they weren’t enough: Fred Goodwin’s Edinburgh home was vandalised a few days later, one of surprisingly few acts of violence in the crisis.

In the City, some older bankers privately voiced shame that bonuses were being paid at all. But many investment bankers were still quick to trot out age-old justifications: “We’ll go offshore otherwise,” and “I wasn’t the one who lost money.”

March: Global stocks hit their crisis trough on Monday 9th, with some indices at 12-year lows. With hindsight, this point—almost six months on from the collapse of Lehman—looks like the nadir.

By now, the extreme weakness of the markets was taking its toll elsewhere. Insurers’ assets had been pummelled. Legal & General, Britain’s fourth largest insurer, cut its dividend for the first time in living memory. Shares in rival Aviva fell 36 per cent during a single trading session.

And the financial crisis had become an economic crisis. Economists were forecasting that Britain would suffer the deepest recession in decades. The Bank of England started its policy of “quantitative easing,” or printing money.

April: An absence of further bad news—in particular, the continued survival of Citi—helped to restore calm. By the time world leaders met in London for the G20 summit on 2nd April, there was talk of “green shoots” in the markets.

The results season was starting to show that the market turmoil wasn’t all bad for the banks. The City had a new buzzword: “flow businesses.” This referred to high-volume trading in areas such as currencies, commodities and government and corporate bonds. While all markets had been whipsawed in late 2008, these businesses were staging a rapid recovery.

Indeed, the crisis was creating favourable conditions for those banks still standing. Huge government deficits created by bank bailouts and economic stimulus had led to a surge in government debt issuance. Companies were tapping the global markets for cash because banks were reluctant to lend. The activity was frenetic and the profits available were being spread around fewer institutions. It is hard to imagine a better demonstration of why investment banking is so often called a merry-go-round.

As world leaders agreed a new blueprint for financial regulation—and protesters hurled rocks at an RBS branch in the heart of the City—bankers bandied around a new acronym: BAB, “Bonuses are back.” Those favourable market conditions continued into the summer. Barclays’ investment banking division made £188,000 per employee in the first half of 2009 (it employs 21,900 people).

August: The City is making money again. But it has also witnessed creative destruction and corporate concentration. Britain’s voice among global regulators has lost much of its former authority. That may explain the newfound confidence in European attempts to regulate private equity and hedge funds, a big business for the City.

The new regulatory framework has yet to be written. But while the FSA softened some proposals to curb bankers’ pay, new regulation is set to increase banks’ cost of doing business and dampen super-profits and bonuses. The flipside is that these costs also raise barriers to entry—and will help sustain the tighter oligopoly that the City has become.