Lessons from the overreachers

Opportunistic City banks have paid dearly for failed gambles in the past, writes William Kay

THE Warburg crisis vividly demonstrates that the carefully nurtured, rock-solid image of the merchant banks is little more than a facade.

The author Paul Ferris observed in his book on the sector, Gentlemen of Fortune: "High finance, like pornography or foreign travel, is no longer the prerequisite of an lite. Newcomers elbow their way into the business."

In 1934, Sigmund Warburg was one such newcomer, having escaped from Nazi Germany with just £5,000. He set up his merchant bank after the Second World War but was treated as an upstart until 1959, when he outraged the City establishment by winning the battle for British Aluminium on behalf of his US client, Reynolds Metal.

But Warburg had made its name and, during the takeover booms that followed, public company chairmen sought its services in the hope of boosting their chances of winning corporate battles.

Warburg was also one of the first merchant banks to seize on the significance of the Eurodollar market, which sprang up because US interest rates were artificially held down. Billions of dollars were sloshing around Europe looking for a home - and Warburg was inventive enough to see how that provided the basis for a lucrative market.

The legendary NM Rothschild merchant bank created the basis of its fortune in a similarly opportunistic way, making itself indispensable to various European governments during the turmoil that culminated in the British victory at Waterloo in 1815. The bank's courier system gave Nathan Rothschild advance word of that victory, and he used the knowledge to make a huge profit in British government bonds. But he had already made far more from financing Napoleon's return from exile. By the end of the century, Rothschild was helping the British government to buy the Suez Canal.

In the modern era, Rothschilds and Kleinwort Benson were the two banks that first saw the fee-earning potential in Margaret Thatcher's privatisation crusade as it gathered pace in the early 1980s. Then there were those fabulously profitable deals that flowed from being in the right place at the right time, and having the shrewd judgement to back the right people.

Hambros Bank did just that in the 1970s, when it backed Sir Mark Weinberg to start Hambro Life, turning £1m into several hundred million in the process.

As long as merchant banks stick to using their wits, to giving advice and acting as middle men, they are limited only by the strength of their name. But, as Warburg was sharply reminded last year, every so often they overreach themselves.

Hambro's success with Sir Mark was matched at around the same time by losses it incurred in loans to the shipping market.

In the second half of the 19th century, Baring Brothers was riding high as financier to North America and raising money for Imperial Russia to build the Trans-Caucasian Railway. But then, about 100 years ago, it effectively bet the bank on Argentine railways and nearly went broke, as the Argentine economy proved incapable of keeping up the payments.

Although Baring is still very much in business, and although a member of the ruling family is currrently the chairman of British Petroleum, that South American crisis began a long slow decline, and the company has never fully recovered its former prime status.

It stands as an awful warning to Warburg.