The Year in Review: Business

What went up had to crash down
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The Independent Online

From boom to bust in only 12 short months. It's a clich, I know, but this truly was a year of two halves. It began on the crest of the leverage buyout boom and continued that way, with few moments of doubt in financial markets, right up until July, when there were the first rumblings of the credit crisis that has dominated the news ever since.

Looking back, it seems scarcely possible that a year whose defining image came to be that of queues of angry depositors forming outside branches of Northern Rock could also have encapsulated some of the biggest takeover bids of all time.

Most economic cycles end in orgies of excess. For the late 1990s, it was the dot.com bubble and the fraudulent accounting of Enron, WorldCom and a host of other, one-time stock-market darlings whose soaraway profits were not all they seemed.

This time around the excess came to be symbolised by the debt-fuelled frenzy of private equity takeover activity. In Britain, this reached its crescendo with the 10bn takeover of Alliance Boots by the US private equity house Blackstone, and the debt-financed bid for J Sainsbury. The latter came just too late to take advantage of the apparent abandon of credit markets, and eventually had to be shelved when the finance dried up. But there were plenty that did get away in what appeared to be a repeat performance of the leveraged buyout boom of the late 1980s.

As the targets grew bigger, so did the interest of politicians and regulators. A large part of the supercharged returns that private equity was conjuring out of its purchases was being achieved not through superior management skills, but because of financial engineering and tax breaks.

At their most simplistic, leveraged buyouts are just a form of tax arbitrage. By acquiring companies with debt, private equity in essence does no more than buy the company with its own money. The costs of servicing the debt are charged against operating profits, with the result that earnings otherwise subject to corporation tax are shrunk to a level where little or no tax is paid. The private equity fund's gain is the exchequer's loss.

While the targets were small and innocuous, the phenomenon went largely unnoticed outside the business pages. But as the private equity funds grew, together with the amount of credit made available to them, the acquisitions became bigger until eventually they included household names. No company seemed beyond the reach of these financial players. Too late, the policymakers began to sit up and take notice. Yet the thing that most got people's goat was not so much the tax treatment of interest payments as the tax perks enjoyed by private equity partners on their billion-pound gains.

Instead of the 40 per cent marginal rate of tax that higher-income earners are ordinarily required to pay, private equity partners were able to get away with just 10 per cent.

This was achieved by taking advantage of the "taper relief" rate of capital gains tax introduced by Gordon Brown. The purpose of the relief was to encourage entrepreneurial start-ups. Yet it also came to be applied widely by private equity partners to the so-called "carried interest" they enjoyed in their buyout funds. Money earned became taxed not as income but as capital gain at the lower rate intended for business start-ups.

By mid-year, public anger was at boiling point on both sides of the Atlantic. A politically inspired crackdown seemed inevitable, and indeed, up to a point, there was one.

In his mini-Budget last autumn, Alistair Darling raised the rate of capital gains tax to 18 per cent a move which, as it turned out, satisfied no one. Private equity reasonably thought it had got off lightly, while business lobby groups were up in arms over the removal of a tax relief which had helped foster a new spirit of entrepreneurialism in Britain.

Yet it wasn't public policy action that finally brought the buyout boom to an end, but the markets themselves. Not before one final blowout, however. As the private equity bubble reached its zenith, there was an almost total collapse of lending standards.

"Covenant-lite" deals, in which bankers would lend on the barest minimum of conditions became the norm.

With money so easy, bankers were lulled into the belief that there was almost no deal too big or expensive that couldn't be quickly syndicated and securitised out so that the risk of default became widely spread among investors around the world. Ability to defray credit risk made bankers believe they no longer needed to be careful about whom they lent to. As it turned out, the assumption of risk-free lending was largely illusion.

The sudden refusal of bankers to finance "covenant-lite" transactions from late June onwards was the first sign that perhaps things were not quite as rosy in credit markets as they seemed. The Alliance Boots takeover was one of the last such transactions to take place, and even in this case, large chunks of the debt were left with the original bankers. The attempt to refinance in the usual way became one of the first victims of the credit squeeze, leaving bankers nursing big losses.

Throughout July and early August, credit conditions worsened, but not so badly that it could at that stage be called a crisis.

Meanwhile, the real economy barely registered the first tremors in the banking system. House prices continued to rocket, with silly prices being paid in the posher parts of London for very ordinary properties. Economic growth was still robust, and bankers remained so confident of the future that a number of them Barclays and a Royal Bank of Scotland-led consortium of European banks embarked on a fiercely fought takeover battle for ABN Amro.

On 9 August all hell broke loose. The Paris-based BNP Paribas was dramatically forced to close three of its hedge funds caught by the deterioration of debt markets. Up until that point, bankers had been in denial. On that day it was brutally removed, resulting in the virtual closure of normal inter-bank lending markets.

The roots of this year's crisis lie way back when in the financial turmoil of the Far East that occurred in the late Nineties. This caused developing countries to conclude that to achieve the financial stability they craved, they would need to generate big surpluses of capital in order to shore up their reserves of foreign exchange and to defend their currencies against further attack.

Steeply rising oil prices, themselves the result of rapid Asian economic development, further bolstered the surpluses separately being generated by the oil-exporting nations of the Middle East.

The massive pools of savings thereby created were channelled mainly into dollar assets, but also euros, too, helping to keep interest rates in the prosperous West lower than they would otherwise have been. An environment of easy money was created that was further compounded by the very low interest rates put in place by Western central bankers in the aftermath of 11 September 2001.

Like nature, capital abhors a vacuum, and with nowhere else to go, the money flowed into ever more high-risk forms of lending. Sub-prime mortgage lending in the United States to those who normally wouldn't have been able to afford to buy a house or keep up with the interest payments, was one of them. Hundreds of billions of dollars were lent to people with little or no credit history.

Again, the risks of this lending went largely ignored because of the ability of bankers to "slice and dice" different grades of lending, package them up into securities, persuade the credit-rating agencies to assign them low-risk attributes, and then sell them on to naive investors. When interest rates began rising, there was an inevitable flood of defaults in the sub-prime market, undermining the value of mortgage-backed securities sold to investors as essentially gilt-edged lending.

The fear of losses on sub-prime soon came to engulf the entire banking system. If bankers had been lending with such abandon to the trailer parks of America, what other risks had they taken on, too? Markets didn't need answers to act. Banks stopped lending to one another, partly because they were worried about their counterparties' creditworthiness, but also because they were concerned about losses on their own books, and needed to hoard cash accordingly.

As the crisis gathered pace, a whole series of previously unnoticed credit organisations and instruments invented over the years to feed the boom in lending emerged blinking into the cold light of day structured investment vehicles (SIVs), conduits and monolines among them.

Bankers stopped lending to these off-balance-sheet credit machines, too, leaving them unable to finance their loans as they fell due.

The first British bank to get caught in the maelstrom was Northern Rock, a one-time Newcastle-based building society that had floated on the stock market in the late 1990s. Run by a Geordie named Adam Applegarth, the bank had ridden the housing market boom more successfully than any other, enjoying stellar growth in business. At its peak, Northern accounted for one in five mortgages sold in Britain.

Nobody thought to question the manner in which it was funding this growth, which was not, as would normally be the case with mortgage lenders, from retail deposits collected through a branch network, but from the wholesale money markets. When these sources closed up shop, Northern Rock rapidly found itself unable to pay its liabilities as they fell due.

Neither the Bank of England nor the Government could have realised what they were getting themselves into when they agreed to act as lender of last resort to Northern Rock. At the last count, the Treasury, through the Bank of England, had lent a staggering 25bn to the Rock, with no obvious way of getting the money back without loss to the taxpayer.

What was billed originally as just a temporary support facility to get Northern Rock out of a short-term liquidity crisis has turned into a humiliating long-term liability.

Quite who was to blame for what now seems a wholly avoidable debacle is still the subject of fierce debate. Was it the Financial Services Authority, the banking regulator charged with supervising Northern Rock? Or was it the Bank of England, which stoically refused to provide the generalised liquidity support to the City which other central bankers were doling out to help their domestic markets? The Bank of England took the view that to provide indiscriminate support would be to underwrite reckless lending and thereby create moral hazard. In the event, it was forced to support the recklessness of Northern Rock in any case. Or perhaps the Government was to blame? It was Gordon Brown who created the regulatory framework that, when put to the test, failed to work.

As the credit crisis gathered pace, some truly horrendous losses and write-downs were announced by previously sure-footed Western bankers. Back in July, Charles Prince, chief executive of Citigroup, said that despite the deterioration in credit market, he and his team were "still dancing".

Three months later, Prince was being stretchered off the floor, clutching the mandatory multimillion-dollar pay-off. Ken Lewis, chief executive of Bank of America, seemed to sum it all up by insisting that there would be no more acquisitions in investment banking for him. "I've had about as much fun as I can stand from investment banking for the moment," he told investors.

As the losses mounted, the heads rolled. Few expect the banking cull to stop with Prince and his counterparts at UBS and Merrill Lynch. Many banks will need to raise new capital to see them through the crisis. Some have already tapped the only people who seem to have any money these days the sovereign wealth funds of the developing world. Again, others are expected to follow in what is another sign of the shifting power equation from West to East.

As the credit crisis trundles on, even the Bank of England has been forced to abandon its hair-shirted approach to moral hazard and join with other central bankers in mounting a more generalised bail-out of the banking system the creation of more than $100bn of new liquidity. It is not certain that even this will prevent Western economies from lurching into recession.

What does seem rather more certain is an extreme overreaction by politicians to the crisis that has engulfed the capital markets, with many of them now overtly calling for a reversal of the deregulation which has fed the explosion of credit this past 15 years or more.

This would be a shame, for the democratisation of credit has been one of the great social and economic boons of the modern age, helping to enable a level of property ownership and consumption that previous generations could only dream of. If this has been a case of massively living beyond our means, then we really are due a rude awakening.

Yet the more benign, and in my view correct way of looking at the disruptions of the last year, is as a necessary corrective to the excesses that were building up in the system. If allowed to go unchecked, these would eventually have resulted in a much more serious crisis in the years to come.

Markets are capable of extreme excess, but they are also self-correcting. The present purge has occurred in the nick of time, and though painful for some, is unlikely to result in the economic calamity that would undoubtedly have been the case had it run on for a great deal longer.

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