Jeremy Warner's Outlook: FSA sounds warnings over credit crisis

M&B's financial engineering folly; Sky-high price for Virgin Media block
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The Independent Online

Thanks very much, guys. The time to be told that things were looking grim was six months ago when the boom was still in full swing, not now that the horse has bolted and the downturn arrived. In the circumstances, neither the FSA's warning of more credit crunch pain to come, nor the IMF's dramatic downgrade of its growth forecast for the US to just 1.5 per cent, were terribly helpful. Still less so were vague proposals from Gordon Brown and a clutch of other European leaders last night for reforming the so-called global financial architecture. It all looks too much like fighting the last war.

We already know that "a significant minority" of consumers face problems of over-indebtedness, as detailed in the FSA's Financial Risk Outlook published yesterday. We also know that a large number of the mortgages written in the past two years are exceptionally risky in terms of their loan-to-income and loan-to-value ratios.

Nor does it take much in the way of brain power to figure out that banks need to be extra vigilant in stress-testing their business models and controls after the Northern Rock and Société Gé*érale debacles. Thomas Huertas, director of banking supervision at the FSA, was quoted as saying that "as bad as things are, they could get worse". Well I never.

Warming to the sound of his own voice, he went on to say it was too early to be confident that conditions in credit markets were improving. "The question is whether this is the all clear or the eye of the storm. There are ample signs this is the eye".

Golly. Talk about back covering. If things do get worse, at least the FSA will be able to say it told us so. Whenever there is a crisis, the call goes up for more vigilance and more regulation, yet one way or another the markets always stay one step ahead of the politicians and it is not until we are in the depths of the next crisis that anyone figures out how it might have been averted.

M&B's financial engineering folly

If ever there was a lesson in resisting the siren calls of clever financiers urging the use of complex financial engineering for the creation of shareholder value, Mitchells & Butlers is it.

M&B was a perfectly decent pubs and restaurants group which was actually already doing rather well by its shareholders until along came Robert Tchenguiz, the property magnate, to argue that by separating the property assets from the operating company, billions of pounds worth of value could be unlocked and heaped upon investors. Unfortunately for the M&B board, it listened, and as a result has ended up with a calamity which is highly likely to result in the company losing its independence. Admittedly, M&B was unlucky in that a transaction that would otherwise very probably have succeeded was derailed by the crisis in credit markets just as it was being shunted into the station. The company was also badly let down by its bankers – step forward Royal Bank of Scotland and Citigroup – which having signed off on the deal and insisted that M&B enter into some highly dangerous hedges as a condition of the transaction, then cited "force majeure" to pull the plug. M&B was left holding hedges that were designed for the benefit of lenders who had vanished over the horizon.

Even so, the primary blame for this folly quite plainly lies in errors of judgement by the directors themselves. It is easy to see why, in the frothy market conditions that existed prior to 9 August, they could have been seduced into believing that money could indeed be magicked out of nothing. After all, everyone else did.

All the same, there's little excuse. They should have been able to see through the illusion of wealth creation offered by Mr Tchenguiz. In very similar circumstances, J Sainsbury successfully argued against what Mr Tchenguiz was proposing. Why did M&B fall for his plans quite so whole heartedly?

Pubs and restaurants are only valuable as properties because of the profits they manage to generate. Otherwise, they are merely pieces of land. To attempt to separate one from the other and somehow pretend that you have created two companies where previously there was just one is therefore an entirely cosmetic exercise of no underlying commercial value.

Where once upon a time, the pub operator was its own landlord, there is instead a publican paying rent to someone else. Profits are correspondingly reduced.

Having gone the Tchenguiz route, the board then compounded its error by failing to ditch the hedges when the deal first collapsed last summer. Egged on by Mr Tchenguiz, they instead hung on to their positions in the hope that the credit crisis would ease and the "propco" idea could be revived. Losses that originally stood at £60m became magnified through the hedges first to £120m, then £180m and finally yesterday's jaw-dropping £274m as markets behaved in the opposite way to which they were supposed to, with interest rate expectations falling even as inflationary expectations were rising.

What a mess. The finance director has been thrown to the wolves and all bonuses have been cancelled, but the chief executive and the chairman remain, apparently because they are so good at their day job of running pubs that they cannot be dispensed with. What a shame they didn't stick to what they knew best. As with corporate diversification, meddling in financial instruments you don't understand is always bound to end badly. Maybe private equity could make a better job of it, but then again, the debt markets are closed and financial engineering is, for now at least, mercifully out of fashion.

Sky-high price for Virgin Media block

Just which investors did ITV have in mind when it warmly welcomed, on shareholders' behalf, the Government's decision yesterday to force BSkyB to sell down its expensively acquired 17.9 per cent stake? Looking at the misery of the ITV share price, it's hard to see what there is to celebrate and quite impossible to understand how it could be described as in shareholders' "best interests". All traditional, European media stocks are down in the dumps, but ITV is doubly so as a result of the overhang created by the Government's decision on Sky.

Michael Grade appeared to indicate he was agnostic about BSkyB when he became chief executive of ITV a year ago. Then he changed his mind, and said that Sky's ability to block special resolutions in its own commercial interests was potentially anti-competitive. He is perfectly right about this, but I'm not sure shareholders were ever going to thank him for trumpeting it from the roof tops. In any case, the Competition Commission used Mr Grade's line of argument as the primary reason for finding against Sky.

I hold no candle for Rupert Murdoch. He's got quite enough media interests of his own to do that for him. Yet it doesn't seem to me this is a particularly good decision. A perfectly acceptable remedy given the nature of the complaint was offered by Sky, which was to make the shares non-voting, but still it was not good enough for the Commission.

This left John Hutton, Secretary of State for Business and Enterprise, in an extremely awkward position. By going with the Commission, he risks the wrath of Britain's most powerful media magnate, who now stands to lose a bundle on his share-buying spree. Yet if he had gone against the Commission's independent findings, he would have been accused of corruptly kow-towing to Rupert Murdoch by the rest of the British press. He was damned if he did, and damned if he didn't.

Sky's primary purpose in buying the shareholding was to stop Virgin Media from doing the same and thereby potentially becoming a more formidable competitor to BSkyB. That threat to Sky has now gone, probably for good. Yet it was never clear Virgin could have pulled off such a merger, and even more doubtful it could have made it work. In any case, the £343m loss Sky faces on the stake is quite a price to pay for something that probably wouldn't have happened anyway.

j.warner@independent.co.uk

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