June 19, 2016

We were very privileged recently to be able to attend a talk given by Dave Jones, the former CFO of Northern Rock and the only member of the senior executive team who was in place before (although only for a matter of months), during, and after the run on the bank and the ensuing crisis.  We have an enormous amount of respect for Mr Jones to have the courage to stand in front of an audience and describe the event and the aftermath, and to risk the opprobrium of anyone who wants to throw stones at the mistakes which were, with any level of hindsight, quite obvious.

Here was a sensible and honest man doing his best at his job, as we believe, with a small number of exceptions, were many of the bankers of the time.  And yet this was the first bank to so spectacularly fail since Overend & Gurney in 1866.  How did this happen?

A lot of the reason is down to the structural nature of banks.  Banks fail for two (often interconnected) reasons.  Firstly, banks have very leveraged balance sheets, and are therefore very exposed to the quality of the underlying assets.  Although there has been much done to repair the equity of banks since the Global Financial Crisis of 2008/9, banks still have assets and liabilities that dwarf their net worth (almost all banks still have less than 15% of their liabilities in the form of pure, un-callable equity, and most much less).  This means that if a percentage of their assets turn sour, the bank is up against the wall.  And when asset prices are a long way down the path of a long bull market (such as, say, housing prices in the UK), a significant percentage of the assets can turn bad relatively quickly.  This is the nature of asset cycles.

The second reason that banks fail, and the one that is most often the catalyst, is that there is an inherent mismatch between the maturity of banks’ assets and their liabilities.  In laymen’s terms, this means that every depositor has a right to their money immediately or in the near term but the assets (loans) don’t mature for years or even decades (i.e. mortgages).  Thus if everyone asks for their deposits back at the same time, the bank is bust.  Even worse, once there is a sniff of significant numbers of depositors asking for their money back, every other depositor has an overwhelming incentive to get their money out first (i.e. a run on the bank).  The last ones out lose everything.

If all leave their money in, there is no problem.  If everyone wants to get their money out, the bank is bust.  So it all comes down to confidence.  And the inherent weakness of the banking system is that, due to the interconnected nature of banks to each other and to the economy, crises tend to happen to the whole system at the same time.  At this point, the government can’t bail out the entire banking sector – the liabilities are simply bigger than government itself (discussed in our Thinking Aloud Paper Central Banks Strategy Watch in 2007).  Deposit insurance cannot protect against this – if everyone wants their money, there simply isn’t enough.

James Grant of Grant’s Interest Rate Observer fame is a gifted story teller of economic history, and we recommend his book Money of the Mind:  Borrowing and Lending in America from the Civil War to Michael Milken.  In it, he tells colourful stories of many individuals and corporations in the development of the lending system in the United States from early days up until the 1990s.  What is fascinating in this book of 500-odd pages is the recurring themes of the troubles that happen to the financial system, and in particular the section on the 1980s:  the troubles in Texas (where every major bank went bankrupt, was merged, or bailed out by the central government); Citibank and their wonderful then disastrously painful experience of Latin American and other developing world debt; and the exuberance of the LBO era in the late 1980s (including quotes from the prospectuses for the issuance of bonds that lay out in black and white how agonisingly onerous the assumed debt loads are, such as Storer Communications’ and Allied Stores Corporation’s prospectuses in 1987, and Dr Pepper’s in 1988).

At Kennox, we invest to protect and to grow the assets of our clients (in that order), and to do so, we invest with a value style.  We do not try to predict when the difficult times will come but we aim to hold a diversified group of companies who have the ability to weather difficult times (and buy them at attractive prices).  We feel this is the best way for us to serve our clients.  Although we understand how much money banks can make in good times, banks are very difficult to fit into our mentality of investing as they are inherently pro-cyclical.  As Chuck Prince famously said, these are corporations that have to dance if the music is still playing.   We prefer companies that haven’t, over history, had to keep dancing, and regularly danced themselves into very leveraged and dangerous corners.

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The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

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