coggan 3

The Bank of England


The Bank of England has been, for three centuries, the centrepiece of the British financial system, an institution which in the past has been able to influence the markets with a twitch of its Governor’s eyebrow. Today, having been given effective independence on monetary policy, the Bank is more important than ever.
The Bank was founded back in 1694, when King William III needed money to fight Louis XIV of France. A Scottish merchant, William Paterson, suggested that a bank should be formed which could lend money to the government. Within fifteen years, the Old Lady of Thread-needle Street, as it became known, was given the monopoly of joint-stock banking in England and Wales. That ensured that it remained the biggest bank in the country since those banks which were not joint-stock could by law have no more than six partners, severely limiting their ability to expand. However, that monopoly was eroded by Acts in 1826 and 1833 and the Bank’s pre-eminent position was not really cemented until the Bank Charter Act of 1844. The Act followed a succession of banking failures, which was blamed on the overissue of banknotes. Until 1844, any bank had the right to issue its own notes, opening up the risk not only of fraud but also of inflation. The Bank Charter Act restricted the rights of banks other than the Bank of England to issue notes, a restriction which became total (in England and Wales) in 1921. Scottish banks can still print notes.
By that time, the Bank’s position as one of the country’s most prestigious institutions had been established and the interwar governor, Montagu Norman, was one of the most influential men of his age. Such was the power of the Old Lady that the Attlee government thought it right to nationalize it in 1946.
The election of the Labour government in May 1997 ushered in a new phase in the Bank’s history. One of the first acts of the Chancellor, Gordon Brown, was to give the Bank the power to set interest rates. Now every month, traders wait anxiously to see what the Bank has decided.
Gordon Brown’s decision owed a lot to the rather unhappy history of UK economic policy during the war. Britain suffered from a much higher rate of inflation than many of its competitors and the pound endured a seemingly relentless decline (see Chapter 14).
Many people felt that one reason for the country’s poor performance was the control that politicians exercised over interest rates. When inflation started to pick up, politicians proved reluctant to raise rates, especially if a general election was in sight, because of the unpopularity with the voters that would result.
In theory, a central bank, consisting of ‘dispassionate’ professionals who did not have to face the electorate would not face the same pressures. Economists noted that independent central banks in the US (the Federal Reserve) and Germany (the Bundesbank) had been much more successful in controlling inflation.
For a time, under the Conservative government of 1992–7, a hybrid system was in place in which the Chancellor met the Bank of England Governor every month and the former then made a rate decision, based on the latter’s advice. Although the minutes of the meetings were published in a bid to create transparency, the system was not entirely successful; when the Governor proposed rate increases in the run-up to the 1997 election, the then Chancellor Kenneth Clarke turned him down.
The new system means that the Governor of the Bank is an extremely important person, with the effective power to set our mortgage rates. The current occupant, Mervyn King, is an economist by training who was promoted from within the Bank’s ranks after the retirement of Eddie George, who ran the bank during the early days of the post-1997 regime.
But the Bank’s new interest rate powers were offset by a substantial loss of influence elsewhere. The Bank no longer supervises the banking system – that role has been transferred to a new regulator called the Financial Services Authority (see Chapter 16). This turned out to be a vital shift when Northern Rock got into trouble in 2007.
And the Bank’s role in controlling the UK government debt market – deciding when to make new issues or smooth out fluctuations in the market – has been transferred to a new body, the Debt Management Office.
The Bank still, however, has the responsibility for printing new bank-notes. The earliest notes were handwritten on Bank paper and were payable for precise sums in pounds, shillings and pence. More standard notes were introduced in the eighteenth century. The appearance of the Queen’s head on notes, a subject which caused recent controversy when it was suggested that it would vanish with the advent of a single currency, did not occur until 1960.
The Bank produces around 600–700 million notes a year; the £20 note is the most popular with over £22 billion worth issued in 2006. Before the phasing out of £1 notes, the Bank was printing 7.5 million new notes every day (and withdrawing around the same number). That was equal to around thirty new notes per year for every person in the country. British people are notoriously unwilling to handle old banknotes; in Germany only nine new notes are printed per person per year.
The watermark and the metal bar are not the only reasons why notes are difficult to forge; the hand-engraved portraits and intricate geometric patterns are also extremely difficult to reproduce. In January 1999, the signature on the bottom of banknotes became that of Merlyn Lowther, the Bank’s chief cashier, the first woman to hold the post; she was replaced by Andrew Bailey in 2004.
Another duty which the Bank retains is for the overall health of the UK financial system. This remains an extremely important role, since it is this role that enables the Bank to set the level of interest rates throughout the economy. The Bank is the ‘lender of last resort’ for the banking system, that is, the institution to whom the private sector banks can turn when they are short of cash.
Most of these money market operations are nothing to do with rescuing banks like Northern Rock. Banks lend and borrow on a daily basis in the money markets (see Chapter 6), and often there are imbalances (more people want to lend than borrow or vice versa). The Bank steps in to supply credit (lend money) when there is a shortage.
The rate that the Bank charges for this facility is effectively the base cost that banks must pay. It was known for a long time as the base rate, or the minimum lending rate. Nowadays, for complicated reasons explained in the next chapter, it is known as the repo rate, but the effect is the same.
In a few cases, the Bank may have to help out in a more serious way, if it becomes clear that a financial institution is in danger of going bust. It organized a rescue package for Johnson Matthey in 1984, for example, but found it could not do so when Barings got into trouble.
But, as was clear in the Northern Rock crisis, the Bank has to balance its desire to help an individual institution with the need to protect the system. This is where the idea of ‘moral hazard’ comes in. If we rescue banks every time they get in trouble, then there will be no incentive for banks to avoid trouble; it will be heads they win (in the former of higher bonuses and share prices) and tails, we (the taxpayer) lose. Initially, the Bank of England felt that banks had been reckless in their involvement with US subprime lending and should be punished.
The trouble is that a banking failure at one high street bank inevitably raises doubts about the others. The queues seen outside the branches of Northern Rock might have switched to Alliance & Leicester or Bradford & Bingley. That would have caused enormous problems, as was seen in the 1930s. When customers withdraw money en masse, banks have not enough funds to pay them. As a result, they are forced to ask borrowers to repay their loans. That could force companies into bankruptcy, workers to lose jobs and the economy to slide into depression, as was the case after 1929. In the end, the Bank had to act and help out Northern Rock in an attempt to avoid such knock-on effects.
Eventually the Bank was forced to extend its help to other banks via a special liquidity scheme, under which banks who owned certain types of securities could exchange them for government debt. This involved the bank taking a certain amount of credit risk in an attempt to shore up the system. In 2009, the Bank also introduced a process known as quantitative easing. The aim was to expand the money supply via a less blatant route than printing more notes. The Bank will intervene to buy government and corporate bonds in the market. The money it uses to do so will come out of thin air. The hope is that the banks that receive this money will lend it to companies and individuals, easing the credit crunch and expanding the economy.
The Monetary Policy Committee


How does the Bank actually make its decision on setting interest rates? Gordon Brown created a monetary policy committee which consists of nine people, five from within the Bank and four from outside. The four outsiders have so far been economists with an academic background, with the notable exception of DeAnne Julius who was an economist at British Airways and her successor Kate Barker, who was chief economist at the Confederation of British Industry.
The committee meets, normally on the second Wednesday and Thursday of each month, and announces its decision at noon on the second day.
The Bank makes a fair attempt to make the process transparent. The minutes of the meeting are published two weeks later, with details of how each member of the committee actually voted.
Every quarter, the Bank publishes an inflation report, which reviews the progress made in combating inflation and forecasts the likely level of inflation over the next two years. And the Bank also has to go to Parliament to explain its actions to MPs.
These actions help deflect the criticism that the unelected central bankers are running the economy without reference to the concerns of ordinary people. Attacks on the Bank were particularly marked in June 1998 when it raised rates to 7.5 per cent at a time when the manufacturing sector was already struggling under the weight of a strong pound. It was noted then that DeAnne Julius, the sole member of the committee with experience in industry, was the only one to vote against the move.
But so far there has been little sign of the Bank members ‘ganging up’ on the minority of outsiders. Indeed, sometimes the five Bank representatives have voted in opposite directions.
The initial target set by the Chancellor for the Bank was to keep the inflation rate at 2.5 per cent. This was not the headline rate, known as the retail prices index that had been the traditional measure of inflation for decades but the ‘underlying’ rate, which excluded mortgage interest payments. This may seem a bit of a fiddle; most of us have mortgages and thus a rise in the interest rate reflects an increase in our cost of living. But if the Bank had included mortgage payments, it would have faced a paradox. Every time it increased rates to target inflation, the effect would have been to push up the headline rate. By stripping out mortgages, it could have a clearer picture of what is going on in the underlying economy.
In 2003, the Bank was asked to target a different measure, the harmonized index of consumer prices (HICP), which has since been renamed the consumer price index (CPI). This index is more in line with the inflationary data produced by other nations within the European Union and the initial rationale was that using it would make it easier for Britain to join the euro. However, there is little sign of euro membership happening. The new measure excluded other housing costs such as buildings insurance and council tax and generally ran at a lower rate than the old measure. As a result, the Bank was asked to aim for 2 per cent, rather than 2.5 per cent, as the annual rate.
As before, the Governor is required to send a letter of explanation should the rate deviate by more than 1 percentage point on either side of this target. The aim is to avoid either excessive inflation or deflation, a state of falling prices which is normally associated with economic contraction. The governor’s letter-writing was relatively rare until the summer of 2008, when inflation exceeded 3 per cent for a few months.
The committee members really see their task as ensuring that inflation stays within its target range over the next eighteen months to two years. They are looking at factors such as commodity costs, wage rises, the strength or weakness of the pound and the housing market in making their decisions. The key factor is whether the economy is growing at a rate above or below trend; if the former, inflationary pressures are likely to rise, if the latter, they are likely to fall. In the first ten years of its operation, the Bank was remarkably successful in keeping both inflation and interest rates much lower than they were in the 1970s and 1980s.
But the Northern Rock crisis did throw up a conflict between the Bank of England’s objectives, a conflict that faces other central banks such as America’s Federal Reserve. When inflation is high, the bank needs to raise interest rates in order to bring it down. But what if inflation coincides with a period when financial institutions are in trouble? Higher rates would make the troubles worse. Indeed, the Bank may well be trying to flood the markets with money (effectively pushing the price, or interest rate, down) to help out the banks.
The Bank’s Long-Term Future


The Bank of England’s new power over interest rates could, in theory, be abolished if the UK decided to become part of the European single currency, the euro. Then British rates would be set by the European Central Bank.
However, at the time of writing, neither the government nor the electorate seemed very keen on the idea. Gordon Brown, when chancellor, devised five economic tests which would determine whether euro entry was in the UK’s best interest. These were sufficiently vague to allow Mr Brown some discretion, and he was perceived to be sceptical of the euro’s benefits. The Conservative party, when and if they ever take office, are even less keen. And even if the politicians change their minds, euro membership would require a referendum – and opinion polls indicate that British voters are firmly against the single currency.
The problem with having rates set by the ECB is that it has to base monetary policy on economic conditions across the whole of Europe, based on its understanding of continent-wide inflation pressures. This tends to mean that even when inflation is high in, say, Ireland, little will be done to combat the problem if prices are stable in the core countries of France and Germany.
Euro membership would also mean that the UK would lack either of its well-worn tactics for climbing out of recession – devaluing the pound or cutting interest rates. And those industrialists who complain about remote City bankers would have to address their concerns to Frankfurt.
If the Bank seems unlikely to lose its interest-rate setting responsibility, it could even regain some of its supervisory role. The Northern Rock debacle revealed serious flaws in the tripartite (the Bank, the Financial Services Authority and the Treasury) structure of financial regulation (see Chapter 3). The FSA was seen as having been too lax in its supervision and in any case has no money with which to bail out the failures. While the Bank of England has that role, surely it should be responsible for regulation as well? So the Bank could even become more important in a few years’ time.

The Money Markets


The primary aim of most financial institutions is quite simple. They need to borrow money more cheaply than they can lend it. The most obvious illustration of this principle is the commercial banks. They bring in billions of pounds from customers putting money into their current accounts; those accounts usually pay a token amount of interest but can be withdrawn at any moment. They lend out such funds at market rates of interest. Because depositors can demand their money immediately, the banks want to keep a substantial proportion of their money in liquid form. This they do by lending it to other financial institutions in the so-called money markets.
Banks can also find themselves short of the cash needed to meet their obligations and thus have to borrow in the money markets. The markets are therefore one of the main channels through which banks can iron out day-to-day fluctuations in their cash flow. For the investment banks, the money markets are a very important source of funds since they do not possess the customer deposits of the clearing banks. To distinguish them from the retail markets, the money markets are often known as the wholesale markets and the deposits or bills involved are usually denominated in large amounts. A typical deal might involve a loan of tens of millions of pounds.
Investors in the markets tend to be anyone with short-term funds – banks, companies and fund management companies. Retail investors can get involved via money market funds – unit trusts which offer returns that are competitive with bank and building society accounts. This is a huge business which normally works very well, but broke down spectacularly in the summer of 2007.
Transactions in the money markets have traditionally been in the form of either deposits or bills. Deposits are made (with the exception of money-at-call) for set periods of time at an agreed rate of interest. Bills are pieces of paper which are issued at a discount to their face value. The bills can then be traded by their holders after issue.
The practice of discounting bills was the main activity of a group of institutions called the discount houses. The discount houses were for a long time the main link between the Bank of England and the money markets.
THE MONEY MARKETS


What instruments are traded in the money markets? Much trading is in short-term bank deposits. Interest rates were quoted as the spread between the bid and offer rates. The bid rate is the rate which a bank is prepared to pay to borrow funds; the offer rate is the rate at which it is prepared to lend. The average of the offer rates, the London Interbank Offered Rate (LIBOR), is an important benchmark for other loans, although it came under some criticism for its accuracy during the credit crunch of 2008. LIBOR is used as a benchmark for loans to the corporate sector, with the interest rate being set every six months or so in line with the rates paid by banks.
In this huge market, currencies are borrowed for a whole range of maturities from overnight to one year and beyond; rates for the major currencies are quoted every day on the currencies and money page of the Financial Times. With the growth in the size and depth of the market, many billions of dollars can be moved between banks in anticipation of tiny changes in rates.
Another important instrument is the Treasury bill, although its importance varies with the government’s financing needs. In the 1970s, the Treasury’s weekly offer was sometimes over £500 million. In the 1980s, the figure dropped to around £100 million a week.
As a result, commercial bills became a much more important part of the money market. These can be bills in the real sense, referring to some specific commercial transaction. The customer gives the supplier an IOU; the supplier sells it to a financial institution for less than its face value in order to get the money in advance. When the customer eventually pays up, whoever holds the bill gets the money. However, commercial bills are often not related to any particular business deal. They are just one more means of borrowing money.
As well as commercial bills, many companies borrow money in the form of commercial paper. Commercial paper facilities can extend to the hundreds of millions of pounds and are used by companies to fund their short-term financing needs, such as acquisitions.
In addition to Treasury and commercial bills, another widely used instrument in the money markets is the certificate of deposit. The simplest definition of a certificate of deposit (CD) is that it is a tradeable document attesting that the holder has lent money to a bank or building society.
CDs are a highly important form of investment in the money markets. If an investor puts his or her money into a term loan, it cannot be withdrawn until the loan matures. A CD, however, can be sold by an investor if the funds are needed suddenly. They are dealt with on an interest-accrued basis (i.e. the money that the CD would have earned is added to the CD’s face value). However, the rate which the investor will effectively have earned will depend on the way that interest rates have moved since the CD was purchased.
For example, an investor buys a three-month CD for £100,000 at an interest rate of 10 per cent. If the CD is held until maturity, the bank would repay the investor £102,500. That sum will be repaid to whoever holds the CD when it matures. After a month, the investor decides to sell the CD. Its price will not necessarily be one-third of the way between £100,000 and £102,500 (i.e. £100,833); it will be so only if interest rates have stabilized and if investors expect interest rates to stay at 10 per cent. If rates have dropped (or are expected to drop), the price will be more than £100,833 because it will be more attractive to other investors. If rates have risen (or are expected to rise), then the price will be less than £100,833 because investors will be able to get more attractive interest rates elsewhere. In either case, the price will settle at the level where it is equivalent to other prevailing market rates.
In return for receiving the extra liquidity that the CD provides, investors are ready to accept a slightly lower interest rate than on the equivalent term deposit. Borrowers (which are mostly banks) get the benefit of the slightly lower interest rate and are still guaranteed that the money will not have to be repaid until the CD matures.
CDs may be issued for periods up to five years and are normally issued in amounts ranging from £50,000 to £500,000. In the UK, the size of an individual certificate is at least £10,000. In the US, however, they have been issued in smaller denominations in order to attract individual investors.
Another component of the money markets are gilt-edged securities near the end of their life. Since the gilts are about to be repaid, they start to resemble the other instruments prevailing in the markets.
All these instruments share a feature noted in the Introduction to this book – their price changes when interest rates move. If short-term interest rates fall, then CDs, etc., which pay a higher rate, will be more valuable and will rise in price. If interest rates rise, then the price of previously issued instruments will fall. Conversely, those who invest in the money markets tend to hope for interest rates to fall, since they then make a capital gain on their investments.
In 1996, a new element was added to the money markets, the gilt repo. These are short-term agreements, whereby borrowers use government bonds (gilts) as collateral for loans. The development of this practice, which had been in existence in the US for some time, added liquidity to the gilts market and widened the number of institutions with which the Bank of England could deal.
Shortly afterwards, the Bank moved to make the repo one of its main tools for intervening in the money markets. By varying the rate it charges banks for lending against gilts, it can affect the level of interest rates charged throughout the economy. Hence, the key UK interest rates which used to be known as the base, or minimum lending, rate is now known as the repo rate.
Not all instruments in the money market are tradeable. Local authority loans form one of the oldest sectors of the money markets. Lending money to local authorities is a steady and unspectacular business but the 1980s storms over rate-capping highlighted the fact that local authorities look to the City for funds.
THE PLAYERS IN THE MARKETS


The bulk of the activity in the markets consists of banks borrowing and lending to and from each other, sometimes with the assistance of a broker. Most of the loans have maturities of three months or less.
Much of this trading takes place electronically or via the telephone. Each trader will be seeking to manage the bank’s money for profit. He or she will attempt to do so in one of two ways. As in the foreign-exchange markets (see Chapter 14), dealers charge a spread between rates. They will lend at a slightly higher rate than the rate at which they will borrow. The spread may be as small as a few hundredths of a percentage point. Because of the size of the deals involved, the cumulative effect of spreads can add up to a sizeable profit.
However, the dealer cannot rely on the spread alone. Interest rates are constantly fluctuating. This can wipe out the dealer’s spread. For example, a dealer may agree to lend at 8.04 per cent and borrow at 8 per cent. He accordingly lends money at 8.04 per cent. While he is making the deal, the market moves to a spread of 8.06–8.10 per cent. If the dealer now borrows the money the bank needs to cover the loan, he or she will now have to pay 8.06 per cent, 0.02 per cent more than the bank is receiving, even allowing for the spread.
The second way that money market dealers make money, therefore, is by trying to anticipate these moves in rates. If they expect rates to rise, they will borrow more than they lend (in market parlance, ‘go short’). If they expect rates to fall, they will lend more than they borrow (‘go long’). So in the above example, the dealer went long at the wrong time – when markets were rising. Had he or she gone short and borrowed at 8 per cent, then when rates rose the dealer could have lent the bank’s money at the new higher rate.
Money Brokers


Linking the activities of the money market dealers are the money brokers. They wheel and deal on the telephone, linking lenders and borrowers in return for a commission. Unlike the dealers, they do not lend and borrow themselves. They depend on high turnover to make money. Fortunately for the brokers, turnover has grown considerably over the past few years as interest rates have fluctuated more violently. The commission the brokers earn is tiny (less than 0.02 per cent). However, all those small percentages add up to a lot of money when the principal sums involved are so large. Even the advent of negotiated commissions at the start of 1986 did not prevent the larger brokers from maintaining their profits.
The real importance of the money markets is that they react very sensitively to economic changes. Rates will rise very quickly if, for example, dealers think that inflation is increasing or that the pound is about to fall. Foreign investors can quickly withdraw their funds if they are worried about the UK economy. The flight of this so-called ‘hot money’ can put real pressure on a government.
The money markets were at the heart of the credit crunch. Banks became reluctant to lend to each other, and outside investors (such as money market funds) were also unwilling to lend to banks. The result was that Libor rose sharply. Instead of being a few hundredths of a percentage point above base rates, Libor was two or three percentage points higher. This raised the cost of borrowing for everyone, and prompted central banks to lend directly in the money markets to try to ease the pressure.
The central banks had some limited success but the difficulty of obtaining money at a reasonable price was one reason why the credit crunch became so serious. Companies struggled to refinance themselves; speculators who had borrowed money to buy assets were forced to sell, sending prices sharply lower. The money markets are the plumbing of the financial system; when they get blocked, the result is an almighty stink.

Borrowers


The financial institutions described in the last few chapters play the function in the economy of channelling funds from those who wish to lend to those who wish to borrow. In this chapter we will look at the borrowers. There are three main groups in the economy: individuals, governments and companies.
INDIVIDUALS


Individuals borrow for a host of different reasons. Perhaps the most common is that income and expenditure are rarely synchronized. Christmas comes but once a year but drives many people into overdraft. Few people can afford to buy larger consumer durables (like cars) without borrowing the funds involved. Unplanned events such as illness or redundancy can reduce income without a corresponding effect on expenditure. Food must still be bought and rent and mortgages must be paid.
Most people borrow by taking out an overdraft from a bank or carrying a credit-card balance. Banks will also lend money for more specific projects, like study courses or home improvements. Finance companies and big businesses will lend money to those buying expensive goods. However, the most important debt which most people incur is to buy a home with a mortgage.
GOVERNMENTS


British governments have historically spent more than their incomes and, like anyone else, they have to borrow to cover the difference. They borrow in the form of long-dated securities called gilts and short-dated securities called Treasury bills. Money is also borrowed direct from the public through the various national savings schemes on offer (see Chapter 15). The government can give itself a built-in advantage in the market for personal savings because it can allow savers to escape tax. It does so on some schemes. However, the loss of tax income increases the government’s cost of borrowing. As a result, it tries to maintain a balance between the amount it borrows in the form of savings schemes, bills and gilts.
The total amount that most governments have had to borrow has increased in the last few decades, because of the growth of welfare economies in the West with the resulting inbuilt increases in expenditure. The result has been a steady rise in the tax burden and regular battles between the treasury and spending departments like the Ministry of Defence.
The difference between the government’s total revenue and its expenditure is known as the public-sector borrowing requirement (PSBR) or more recently the Public Sector Net Cash Requirement. Reducing this deficit was one of the main aims of the Conservative government of 1979–97.
In the early days of Mrs Thatcher’s administration, the economic rationale behind the government’s desire to reduce the PSBR was that a fall in government borrowing would stimulate the economy. If the PSBR is too high, it was reasoned, the available funds for investment will flow to the government (a safe credit) rather than to industry. Companies will be able to borrow only by offering investors penally high rates of interest, discouraging them from investing in new plant and machinery. Without new investment, the economy will not grow. The government will effectively have ‘crowded out’ private-sector borrowing. A low PSBR, the government argued, would result in low interest rates. Businesses would be encouraged to invest and the economy would grow.
The drive to cut government deficits spread more widely in the 1980s and 1990s. The heavy defence expenditure incurred by the US during the cold war had caused its deficit to rise sharply. Tax rises and some spending cuts imposed by Presidents Bush and Clinton helped bring down the shortfall in the 1990s.
In Europe, an annual deficit of less than 3 per cent of gross domestic product was one of the key ‘Maastricht convergence criteria’ that countries had to meet in order to qualify for the single currency. Governments duly cut back, albeit with the help of some dodgy accounting tricks.
This attention to deficits owes something to a general realization by politicians that running up debts on the never-never is a short-sighted strategy. Gradually, interest payments on previous debts consume an increasing proportion of the annual budget.
And the rise of the so-called ‘bond market vigilantes’ has also made it more difficult for profligate governments. Countries have to raise money from the international markets and in these days of free capital flows, investors will be quick to sell the government bonds of a nation if it suspects its finances are deteriorating. That will increase the cost of raising new money and make the government’s finances even worse. However, the credit crunch has encouraged, indeed forced, many governments to borrow more than they have for a generation. When economies falter, tax revenues decline and spending (on things like unemployment benefit) rises. Governments also spend more in an effort to substitute for private sector spenders, who may be reluctant to open their wallets.
There are no easy exits. If a country’s position gets really bad, it will be forced to go to the International Monetary Fund for help – but the IMF will impose tough conditions in terms of spending cutbacks and tax rises. The option of default – refusing to pay the nation’s debts – will cut the country off from international capital for a long time, and lead to further economic hardship.
The bonds issued by the UK government are called gilt-edged securities, or gilts, because of the near certainty that they will be repaid.
They fall into three categories, conventional, index-linked and the irredeemables. Conventional gilts pay a fixed rate of interest twice a year and have repayment dates varying from five to thirty years.
Index-linked gilts pay a low rate of interest (1–4 per cent) but this interest, and the repayment value of the bonds, is linked to the retail price index. If prices double over the lifetime of the bond, then those who bought when the bond was first issued will be repaid twice their original investment.
Irredeemable issues are a bit of a historical throwback. They are literally issues that will not be repaid. Some were issued in the nineteenth century on very low rates of interest and now trade well below their face value. But their yield (the interest rate divided by the face value) is at around the same level as other issues in the market. Examples of irredeemables include Consols and War Loan.
A new type of gilts trading has also been introduced, called strips. Under a strip, a gilt issue is separated into a series of different payments; all the interest payments between now and the repayment date and the final repayment value. These separate units offer an interesting investment opportunity; they have a certain final value but pay no income in the interim.
Of course, the UK government bond market is not the largest in the world. By far the biggest, and most important, is the US Treasury bond market. Even though the US has had a long-running tendency to budget deficits, its government bonds are the most liquid and are seen as a ‘safe haven’ when other markets are in turmoil. The Japanese government bond market is also important, and notable in the late 1990s for temporarily offering yields of less than 1 per cent; the European bond market may eventually rival the US.
COMPANIES


Why do companies borrow? Unlike individuals, for whom borrowing is often a sign of financial weakness, borrowing is a way of life for most corporations, no matter what their prospects. Firms which are very successful often have substantial amounts of debt. There obviously comes a point beyond which companies can be said to have borrowed too much, but frequently, corporate borrowing merely indicates a willingness to expand.
What routes are open to a company which wishes to finance expansion? It might be imagined that the ideal method would be to generate the funds from past profits (retained earnings). In other words, the company would finance itself and thus reduce its costs by avoiding interest payments. However, self-financing is not always possible. While companies are in their early years, they have little in the way of previous profits to draw on, since many of their investments will not yet have generated a return. Nevertheless, in order to establish themselves, companies must continue to invest in further projects, necessitating capital outlay. If they were forced to wait until funds were available internally, they might miss profitable opportunities and spoil their long-term prospects in the process. Company results are often judged by their profitability in relation to their equity base (the value of the combined shareholdings). Debt can be used to increase the return on equity (a process known as leverage or gearing) by allowing companies to seek profitable investment opportunities when retained earnings are insufficient.
Another way that a company could generate cash for expansion would be to sell existing assets or alternatively not to replace old and worn-out assets. Both, however, are one-off ways of raising money and are more indicative of a company which is winding down than of one which is expanding.
A company could increase its capital base by issuing new shares or equity. However, it might not wish to do so because that would weaken the control of the existing shareholders. In companies where control is exercised by a small majority of shareholders’ votes, that could be particularly important.
It is also possible for a company to have too much equity. It is in the nature of equity (see Chapter 9) that, unlike debt, it cannot be redeemed. If the company issued more equity and then failed to expand, it would be left with large cash balances. Paying those balances back to shareholders in the form of increased dividends would have severe tax disadvantages.
In the 1990s, many companies moved to return cash to shareholders by buying back their own shares, rather than paying dividends. This had the effect of pushing up share prices (the same level of demand was chasing a smaller supply) and was one of the factors behind the long bull market.
Often companies borrowed money to finance the buy-back of shares. Debt, as a financing technique, has some distinct advantages. Interest is tax-deductible from company profits, so the effective cost of borrowing is reduced. In addition, debt is reversible. If a company finds itself flush with cash or lacking in investment opportunities, it can repay some of its borrowings. Most shareholders will accept the need for a company to borrow, provided that they expect that the project in which the borrowed funds will be invested will yield a higher return than the cost of borrowing the funds. As already noted, a company can be described as being inefficient if it achieves a very low return on equity – borrowing can increase that return.
Company analysts tend to watch the debt–equity ratio, which is very roughly defined as the company’s borrowings relative to its shareholders’ funds. Ideal debt–equity ratios vary from industry to industry, but most companies start to look a little exposed if their debt exceeds their equity capital – in other words, if the ratio is larger than 1.
How companies Obtain Extra Finance


Which are the debt instruments most used by companies? The overdraft is probably still the most common method of borrowing for small firms. The overdraft has built-in advantages – it is very flexible and easy to understand. An upper limit is agreed by the bank and the borrower: the borrower may borrow any amount up to that limit but will be charged interest only on the amount outstanding at any one time. The rate charged will be agreed at a set margin over the bank’s base rate and thus the cost of the overdraft will move up and down with the general level of rates in the economy.
The overdraft is a very British institution. In the US, it is virtually unknown. American companies use term loans – the amount and duration of which are agreed in advance – and interest is charged on the full amount for the full period of the loan.
Companies have found that the ‘hard core’ element of their overdrafts has increased over the years, suggesting that they are funding their long-term needs with short-term loans. Accordingly, many companies have begun to switch to funding with term loans from banks instead of overdrafts. Term loans are normally granted by banks for specific purposes such as the acquisition of machinery, property or another company, rather than for the financing of working capital needs such as the payment of wages or raw-material costs.
Overdraft financing was probably the only source of funding for the smaller companies up to twenty years ago. Many companies now borrow in the money markets, often using the services of a money broker to find a willing lender, which is likely to be a bank. In return, the broker (who never lends or borrows money himself) receives a commission. Money market loans are for set amounts and periods and are therefore less flexible than overdraft facilities. However, interest rates in the money markets are generally below those for overdrafts.
Larger companies borrow hundreds of millions, or even billions, of pounds from groups of banks in the form of syndicated loans or loan facilities (see Chapter 11).
Longer-term finance for large firms is most frequently obtained by the issue of bonds which pay a fixed rate of interest to the investor. Such bonds usually have maturities of over five years. Multinational firms which have very large financing needs may turn to the international and Eurobond markets (see Chapter 11). Those markets give firms access to a very wide investor base and allow companies to raise tens of millions of pounds at a stroke.
The more sophisticated financing techniques of the Euromarkets are not open to the small- and medium-sized British firm. Their long-term financing needs are normally satisfied by some kind of bank loan. However, there are a variety of options open to firms seeking shorter-term finance. One in particular is the acceptance credit or banker’s acceptance. A bank agrees that it will accept bills drawn on it by the company, in return for a commission. When the company needs funds, it will send the bills to the bank, which will then discount them – that is, pay the company less than the full amount of their value. The amount of discount is equivalent to the rate of interest charged by the bank. So, if the company sent the bank a three-month bill with a face value of £100 and the interest rate on such bills was 12 per cent a year, the bank would discount the bill to £97. As with other loans, the credit rating of the company will affect the cost of the borrowing: the poorer the credit rating, the bigger the discount.
The Financing of Trade


Many of the more specialist methods of raising finance revolve around the financing of trade. The key principles are that it is better to be paid by debtors as soon as possible and pay creditors as late as possible. It is also important to ensure that debtors settle their debts. This is a particular problem for exporters who are dealing with customers out of reach of the UK legal system.
There are four main methods of payment for exports: (1) cash with order; (2) open account trading; (3) bills of exchange; (4) documentary letters of credit.
The best method for the exporter is cash with order. That way the exporting company already has the money before it sends off the goods; however, importers can obviously not be so keen to pay by this method and it is rarely used. Open account trading is the opposite end of the scale – the exporter sends the client the goods and then waits for the cheques to arrive. It offers the least security of all the payment methods but is still the most widely used, at least in trade between industrialized countries.
Bills of exchange offer rather more security to the exporter. The firm will send the bill (‘draw’ it) to its foreign customer with the invoices and the necessary official documentation (referred to as a documentary bill). Then the firm will inform its bank, telling it to obtain the cash from the client. The bank will send the documentary bill to a bank in the importer’s country. Under some arrangements, the buyer pays for the goods as soon as he receives the documents. Often, however, he is given a period of credit. He must accept the bill (otherwise he will not get the goods), and accepting a bill is proof of receipt of goods in law. When the credit period is up, the bank presents the bill to the buyer once again.
Bankers’ documentary credits, normally known as letters of credit, are the most expensive of the forms of payment but offer a great measure of security. The onus is on the importer to open a credit at his bank, in favour of the exporter. The importer’s bank then informs the exporter’s. The credit tells the exporter that if he presents certain documents showing that the goods have been shipped, he will be paid.
There are many different types of letters of credit. Revocable credits can be cancelled or amended by the importer without the exporter’s approval – they are therefore very risky for the exporter. Irrevocable credits, despite their name, can be altered, but only with the approval of both parties. Confirmed irrevocable credits are guaranteed by the exporter’s bank, in return for a fee – as long as the exporter has kept to his side of the bargain, the bank will ensure that he is paid. If the importer fails to pay, it is the bank’s job to pursue the debt. These credits are the normal method of payment for goods shipped to risky countries. Revolving credits allow two parties to have a long-term relationship without constantly renewing the trade documentation. Transferable credits are used to allow goods to be passed through middlemen to give security to all three parties – exporter, middleman and importer. With all these payment instruments, the finance comes, in effect, from the exporter or his overdraft. If he has to wait for, say, sixty days before being paid, he is, in effect, making an interest-free loan to his customer. Only when the credit is medium-term (more than six months) will the customer normally be expected to pay interest.
There are three further methods of trade finance which involve the exporter in passing to another institution part or all of the responsibility for collecting its debts. One is to use an export credit agency in return for a premium. The other two are factoring and forfaiting.
A company which is involved with all the problems of designing, producing and selling a range of products may feel that it has enough to do without the extra burden of chasing its customers to settle their debts. Instead, it can call on the services of a factor. Factors provide both a credit collection service and a short-term loan facility. Their charges therefore have two elements, the cost of administration and the charge for the provision of finance. Most factoring covers domestic trade but it has a distinct role in exporting.
Companies which have called on the services of a factor will invoice their clients in the normal way but give the factoring company a copy of all invoices. The factors will then administer the company’s sales ledger, in return for a percentage of the turnover. They will despatch statements and reminder letters to customers and initiate legal actions for the recovery of bad debts. In addition, some companies will provide 100 per cent insurance protection against bad debts on approved sales.
Factoring is a particularly important service for expanding companies which have not yet developed their own full accounts operations. Factors will also provide short-term finance to corporations short of cash. When the company makes out its invoices, it can arrange to receive the bulk of the payments in advance from the factor. Effectively, the factor is making the company a loan backed by the security of a company’s invoices. In return, the factor will discount the invoices paying, say, only 90 per cent to the company. The extra 10 per cent covers both the factor’s risk that the invoices will not be paid and the effective interest rate on the ‘loan’.
Like factoring, forfaiting is a method of speeding up a company’s cash flow by using its export receivables. Forfaiting gives exporters the ability to grant their buyers credit periods while receiving cash payments themselves. While factoring can be used for goods sold on short-term credit, such as consumer products or spare parts, forfaiting is designed to help companies selling capital equipment such as machinery on credit periods of between two and five years.
Suppose that a UK company has sold goods to a foreign buyer and has granted that buyer a credit period. A forfaiting company will discount an exporter’s bills, with the amount of discount depending on the period of credit needed and the risk involved to the forfaiting company. In order for the company to make the bills more acceptable to the forfaiting company, it will ask the buyer of the goods to arrange for the bills to carry a guarantee, known as an aval, from a well-known bank. The more respected the bank involved – and the less risky the country it is based in – the cheaper the cost of forfaiting. Unlike factoring companies, forfaiters often sell on these bills to other financial institutions. Their ability to do so helps reduce the cost of the service. (In general, the more liquid the asset, the lower the return.)
This chapter has discussed the needs of the major borrowers in the UK economy. In the next chapter we will look at those individuals and institutions with funds to invest.
Investment Institutions


Nowadays the majority of the nation’s shares are held not by wealthy individuals but by institutions – pension funds, life assurance companies, unit and investment trusts and the new powers on the block, hedge funds and private equity (see Chapter 9). These institutions are also the biggest holders of gilts and wield significant power in the property market.
The institutions had already become powerful in the 1980s when the City was forced into the ‘Big Bang’ in order to meet their needs. The abolition of fixed-minimum commissions dramatically brought down the costs of share-dealing to the big investors. Previously they had shown signs of being enticed away from the Stock Exchange and into the telephone-based, over-the-counter markets made by the big securities firms.
Most fund managers do not feel very powerful, however. Each of the investment institutions has outside forces to which it is beholden. Pension fund managers must look to the trustees of the companies whose funds they administer, life assurance and insurance companies to their shareholders and policyholders and unit and investment trusts to their unit- and shareholders respectively. Conspiracy theorists can follow the chain of ownership back and back without finding a sinister, top-hatted capitalist at the end of it (although when it comes to hedge funds and private equity, it may be a different matter).
Some people, particularly company executives, worry that investment institutions will gang together and try to alter the policies of the companies in which they have substantial holdings. This is happening more than it used to, with so-called activist investors often demanding that companies take action to create ‘shareholder value’ and other ethical investors demanding that companies respect the rights of workers in developing countries, adopt sound environmental policies and so on.
In the majority of cases, however, institutions do not exercise their power to intervene in the day-to-day running of firms. One reason is that they do not have the time or the expertise to do so. Another is that investors will not necessarily agree on the action that needs to be taken. In other countries, even in America, their right to intervene may be restricted.
There is also an alternative to intervention: if institutions dislike a company’s policies, they will sell their shares, bringing down the price in the process. Too low a share price will attract predatory rivals, who will buy up the company, and the management will lose its cherished independence.
The time when institutional investors are most powerful is during takeovers, when both sides vie for the institutions’ favours. Traditionally, the sizeable holdings of the institutions mean that the way they jump will decide the success or failure of the bid. In recent years the institutions have shown little tendency to be loyal to existing managements and appear to be more than willing to sell out to the highest bidder. Often indeed they sell out quickly and hedge funds end up holding the balance of power.
THE GROWTH OF THE INSTITUTIONS


The extraordinary growth of investment institutions is due in part to the increased wealth and longevity of the population. Before the twentieth century, few people survived into old age, and those who did often had independent means. As people have lived longer there has been a greater need for pensions. The pension provided by the state offers not much better than a subsistence income, so occupational pension schemes have evolved, with both employees and employers making tax-free contributions.
Occupational schemes come in two kinds. Defined benefit schemes contract to pay employees a set sum based on their final salary. The employer is responsible for making up any shortfall in the fund; there is rather more debate about who is entitled to any surplus. In a defined contribution scheme, the employee and employer put in monthly payments but the pension is entirely dependent on the investment performance of the fund. In short, in a defined benefit scheme, the employer takes the risk; in a defined contribution scheme, the employee does so.
Defined benefit pension funds are run by a trust, which can either manage the funds itself or (in the vast majority of cases) appoint outside fund managers. The outsiders are normally specialist fund management companies. The pension fund trustees, usually acting under the guidance of actuaries, often split up the fund between several managers to ensure that a bad set of decisions by one manager does not affect the solvency of the whole fund. In defined contribution schemes, employers will usually offer a range of funds for employees to choose from; most will opt for the default fund, which will invest in a range of assets.
Another set of institutions is the insurance companies. Many people will have some form of life insurance. These policies can be divided into two: term policies, which will only pay out if the policyholder dies during a set period; and savings-related policies, under which policyholders pay regular premiums in return for a lump sum at the end of a set period. These policies contain an element of insurance, since if the policy-holder dies before completing the payments, an agreed sum will be paid immediately to his or her dependants.
For much of the 1980s and 1990s, the UK savings market was dominated by the endowment policy, which was taken out by people when they applied for a mortgage. The idea was that, with the benefit of regular savings, the policy would grow sufficiently to repay the mortgage (normally after twenty-five years). Endowment policies came in two forms: with-profits or unit-linked. The former offers a smoothed investment return; the latter a return which is more directly linked to the market.
The problem with such policies was that they had high charges and offered poor value to those who surrendered them in their early years. In addition, a fall in inflation during the 1990s meant that many policies did not grow sufficiently to repay the mortgages. Endowment mortgages are rare nowadays. Nevertheless, the life insurance companies still have plenty of assets under management, thanks to other products such as pensions and savings bonds.
Added to this group are the general insurance companies (see Chapter 12) which collect premiums in return for insuring property holders against risk. Car insurance, travel insurance, even pet insurance – the small sums paid by policyholders every month or year eventually add up. These three sets of institutions – pension funds, life and general insurance companies – make up a distinct branch of the institutional investment family.
They all have essentially long-term liabilities – pensions to be paid, life assurance policies to mature. They create portfolios of assets with the contributions they receive – portfolios which are designed both to be safe against loss and to provide capital growth. If the institutions invested only in one company or in one type of security, they would be exposed to the chance of heavy losses.
PORTFOLIO INVESTMENTS


What are the ingredients of these portfolios? A significant proportion, which has been increasing in recent years, is invested in government securities. Government regulations require insurance companies to hold a certain number of gilts as reserves to ensure they can meet claims when they occur. Bonds tend to be more stable in price than shares.
UK government bonds or gilts can be used to match long-term liabilities because of their long-term maturities, which stretch out for fifty years. Index-linked bonds, which compensate investors for higher inflation, are seen by many observers as the closest match for pension liabilities. Gilts also offer a high level of income and this can be extremely useful for pension funds where most of the members are retired. The government would have enormous difficulty in funding itself without the gilt purchases of the institutions.
A further chunk of the funds’ investments goes into property – buying land or buildings that are used for factories, offices and shops. Property investment goes in and out of fashion; popular in the 1970s and early 1980s, it was out of favour by the 1990s. Ironically, that turned out to be a pretty good time to buy. The plus side of property is that it has a tradition of being a good long-term investment, with an attractive yield and a record of more than keeping pace with inflation. The negative side is that property is illiquid; it is most difficult to sell at the moment you really want to (when its price is falling). There also can be a lot of administrative hassle (finding tenants, maintaining buildings) involved in owning property directly. As a result, in recent years, there has been a growing trend for institutions to invest in property funds run by fund management companies.
The biggest proportion of institutional investment goes into equities, and in Chapter 10 we examine the effect of institutional investors on the share market. Equities have historically offered much better returns than bonds or money market instruments and thus have greatly benefited the institutions. However, the long bull market of the 1980s and 1990s caused investors to overcommit to the stock market, leaving them very exposed when the dotcom bubble burst in 2000. As share prices fell, many defined benefit pension funds went into deficit, forcing the companies that sponsored them to cough up more cash.
In the aftermath of the 2000–2002 bear market, many pension funds decided they had staked too much on the success of the stock market. They decided to diversify into alternative asset classes such as commodities, hedge funds and private equity. The hope is that a diversified mix of such assets can deliver better returns than government bonds, but with less volatility than equities. The spare cash of the investment institutions goes into the money markets. Although their immediate outgoings are usually met by the premiums and contributions, the institutions still need liquid funds to meet any disparities. So they invest in bank certificates of deposit and money market funds. At certain times, when shares seem unsafe investments, the proportion invested in the money markets increases.
OVERSEAS INVESTMENTS


Nowadays, institutional portfolios are very international. In 1979, the government abolished exchange controls. This allowed the institutions to invest substantial sums abroad. In 1979, the proportion of pension fund portfolios held in the form of overseas equities was 6 per cent; by 2008, it was almost 30 per cent.
The amount of money that pension funds invest depends on a variety of factors. First of all, the fund managers must decide whether overseas markets look more attractive than the UK, perhaps because the prospects for economic growth and corporate profits look better, perhaps because overseas shares look better value, relative to company profits and assets.
Secondly, the managers must decide whether sterling is set to rise or fall. If the pound rises, then the value of overseas assets, when translated back into sterling, will reduce; if the pound falls, then the value of such assets may rise. They can separate these two decisions, by buying shares in the US and then hedging the risk that the dollar will fall against sterling.
Thirdly, managers must pay attention to matching their assets and liabilities. The beneficiaries of the funds (future pensioners) will use the money they receive to buy goods and services in the UK, so it makes sense for the fund to have a significant UK element. Many UK companies already receive a large proportion of their income from abroad, so investors can get a reasonable amount of diversification without leaving the London stock market.
The overseas diversification of funds used to come under some criticism from the left but with the increasingly free flow of international capital, the complaints have died down. There is little evidence that UK companies are short of capital and US and European investors are active in the UK market.
Just as UK institutions invest overseas, overseas institutions buy into the UK market. Other countries have their own pension funds and insurance companies, of course. They also have mutual funds, the equivalent of unit trusts (see below). A fast-growing group of investors are so-called sovereign wealth funds. These are funds accumulated by overseas governments, such as China, Russia, Norway and the middle Eastern oil producers. All these countries have accumulated trade surpluses. This allows them to build up reserves. Traditionally, a lot of this money was held in the form of deposits or government bonds. But the countries have become more adventurous, buying equities and sometimes whole companies. This has created some controversy, with commentators worrying about ‘back door nationalization’ and about the potential influence that overseas governments can hold over the UK economy.
FUND MANAGEMENT COMPANIES


The next main set of institutional investors is the trusts. They are divided into unit and investment trusts, but both serve roughly the same function – to channel the funds of small investors into the equity markets.
Much of this institutional money is run by professional fund management companies, which look after the portfolios in return for an annual fee. These managers run the portfolios of pension funds, charities, unit and investment trusts (and manage money directly on behalf of rich individuals as well).
Fund management is a fairly reliable business, since the annual fee tends to rise when markets do. The likes of Fidelity manage many hundreds of billions of dollars. They live and die on performance, with individual managers trying to pick the stocks that beat the market average. Some travel the world, meeting company managers and poring over balance sheets in an attempt to outperform; others rely on computer programs to identify attractive stocks.
The reputation of individual fund managers can rise and fall with the markets. In the late 1990s, the institutional market was dominated by four groups: Gartmore, Schroders, Phillips & Drew and Mercury. Two of those companies have been taken over; Mercury is now part of Blackrock, a big US group. Phillips & Drew lost business in the late 1990s because it was sceptical about the dotcom boom. Although it proved right in the long term, it lost clients in the short term and was taken over by UBS, the Swiss bank. In the US, by contrast, Janus was a fund management group that rode the technology bubble and then suffered heavily when the market collapsed.
TRUSTS


The next main set of institutional investors comprises the trusts, divided into unit and investment trusts. Both serve roughly the same function: to channel the funds of small investors into the equity markets.
An investment trust is a public company like any other company except that its assets are not buildings and machinery but investments in other companies. Investors buy shares in the trusts and rely on the expertise of the fund managers to earn a good return on their investments.
The origins of the investment trust movement lie in Scotland. Many of the entrepreneurs who made money out of the Industrial Revolution found themselves with surplus funds which could find few profitable homes in their locality. So they looked for advice to help them invest elsewhere and turned to their professional advisers – the lawyers and accountants. A few smart people from both professions realized that they could pool the funds of their clients and invest larger sums. That early development was complemented by the growth of Scottish life assurance companies and pension fund managers, and today Edinburgh is still a very significant force in international fund management.
Nowadays all investment trusts must be approved by the Inland Revenue. They raise money through preference shares and loan stock as well as through ordinary shares. By the end of June 2008, there were just over 450 trusts with over £94 billion in assets.
There are a few restrictions on the way in which trusts can invest. No single holding can constitute more than 15 per cent of their investments. Capital gains must be reinvested in the business and not distributed to shareholders.
Those restrictions aside, the trusts appear in a wide variety of forms. Some, including the largest, 3i, invest across the world; others confine themselves to a single country, such as Brazil, or a specific sector of the market, such as property or mining.
The structure of trusts also gives them enormous flexibility. For example, they can borrow money to finance their investments, and the interest on their borrowings can be offset against tax. This is known as gearing and relies on the rate of return on the trusts’ investments exceeding the cost of borrowing. If it does, the trusts’ profitability increases substantially; if it does not, losses multiply.
Split capital trusts use a different approach. Most trusts offer investors a mixture of income and capital gains. A split capital trust separates the two. All the revenue of the trust is paid as dividends to the income shareholders; however, they will usually receive no capital gain and, in some cases, can expect a capital loss. The capital growth of the trust is then parcelled among other classes of share: either in a safe and steady form (zero dividend preference shares); or in a more high risk/high reward form (capital shares).
In mid-2001, some split capital trusts ran into difficulty. They had borrowed money to invest in shares, but the decline in the stock market had slashed their ability to repay. Worse still, it emerged that there were a lot of cross-holdings between trusts, so that the problems of one fund were quickly communicated to others. The losses incurred by some investors are likely to dent the popularity of split capital trusts for a while.
One of the problems of investment trusts is that their shares tend to stand at a discount to the net asset value. This means that the total value of their share capital is less than the value of the investments they hold. The discount is a function of supply and demand. There are normally not enough investors wanting to buy the shares to keep them trading at asset value. This discount varies from trust to trust, depending on the nature of the trust’s investments and the reputation of the manager.
After a long period of decline, investment trusts have grown in popularity over the last twenty years. Many have introduced savings schemes, which allow investors to buy shares for as little as £20 a month, for a very low cost. Personal equity plans and individual savings accounts, which allow investors to hold trust shares tax-free, also helped.
UNIT TRUSTS AND OEICS


Like investment trusts, unit trusts bundle together the assets of small investors in order to give them a less risky opportunity to invest in the equity markets. Rather than buy shares in a company, investors buy units whose prices rise and fall with the value of the assets held by the trust. The unit trust managers earn their money through the spread between the buy and sell prices of the units and through a management charge.
Unit trusts have been one of the investment successes since the war. New trusts are being launched all the time, with even Marks & Spencer getting into the act in October 1988. In May 2008, around £454 billion was invested in unit trusts, spread across 2,237 different funds. Although the vast majority of unit trust money is invested in equities, there is a growing number of bond and money market (cash) funds.
There must actually be a trust, whose trustees are normally either banks or insurance companies. The trustees’ job is to ensure that the fund is run properly and not to supervise its investment policy. The latter task is organized by specialist managers who often are also supervising the funds of insurance companies or merchant banks.
Since unit trusts are not quoted companies, they do not suffer from the discount problem of investment trusts. Nor can they borrow money to invest. This makes them less risky than investment trusts. On the other hand, their charges tend to be higher.
Over the last decade, the unit trust structure has gradually been replaced by the open-ended investment company (OEIC). These are designed to be easier to understand since, instead of separate bid and offer prices, investors buy and sell at the same price. This does not necessarily make things any cheaper for the investor, since the initial charge (often 5 per cent) is added separately.
However, the existence of fund supermarkets means that retail investors can invest in both unit trusts and OEICs at a reduced initial charge. While this is a positive development for investors, there has been a rise in the annual charge; 1.5 per cent is now common when 1 per cent used to be standard. The extra half a per cent is used to pay advisers and brokers who sell the funds; previously, they received their money from the initial charge.
EXCHANGE TRADED FUNDS


These are the new kids on the collective fund block. Like investment trusts, they are traded on the stock market. But rather than being actively managed, they tend to follow an index such as the FTSE 100 or the Dow Jones Industrial Average. Their advantages are that they tend to have very low costs (less than a percentage point per year) and the investors do not have to worry that the manager will pick dud stocks. This has prompted ETFs to grow very quickly, with the main brand name being iShares, part of the Barclays Global Investors range.
The idea of tracking an index is not confined to ETFs. There are lots of unit trusts (and even the odd investment trust) that attempt to mimic a benchmark. As far as investors are concerned, if an ETF and unit trust are tracking the same index, they should choose the one with the lower fees.
UNDERWRITING


Traditionally, the investment institutions played a key part in the new issues and the rights issues markets by underwriting or sub-underwriting an issue. In return for a fee, they guarantee to buy shares at a set price if no one else will.
Twenty years ago, the institutions tended to be the main underwriters of such issues. That was because they had the capital while the old merchant banks did not. But nowadays, the investment banks like Merrill Lynch and Goldman Sachs can take on this role themselves. The institutions merely act as sub-underwriters, in other words as back-up for investment banks.
A classic case was the rights issue of HBOS (Halifax Bank of Scotland) in 2008. The issue flopped with just 8.3 per cent of existing shareholders taking up their rights. That was a big problem for the main underwriters, Morgan Stanley and Dresdner Kleinwort. But the two investment banks had arranged for 40–50 per cent of the issue to be sub-underwritten by outside investors. They enforced this agreement, known as the ‘stick’, thereby limiting their exposure to HBOS shares.

Hedge Funds and Private Equity


Twenty years ago, when the first edition of this book was published, hedge funds and private equity groups were too obscure to warrant a mention. Now they are so important that they deserve their own chapter.
When markets move suddenly, hedge funds are often to blame. If there is a takeover being announced, private equity groups may well be the bidder. The influence of the two sectors is generally accepted in the UK and the US, but still resented in Europe and parts of Asia. Their success has catapulted many of their founders into the ranks of the super-rich; if there is someone buying a Manhattan apartment for $50 million or outbidding a Russian billionaire at an art auction, the chances are it is a hedge fund or private equity titan.
Both industries have their roots in the US and are still more important there than in the UK. But they still wield immense influence in the City although their offices will usually be in Mayfair rather than the square mile.
Hedge funds stemmed from the idea of an American journalist, Alfred Winslow Jones, in the late 1940s. He was good at picking stocks that he thought would do well, but was not good at telling whether the overall market was cheap or dear. So he made use of a technique called shorting, one of the most controversial weapons in a modern hedge fund armoury.
Shorting allows a manager to bet on falling share prices, rather than rising ones. It involves the manager selling shares he does not own. How does he do so? He borrows the shares (at a cost) from an existing investor, promising to return them at a future date. He then sells those shares in the market. If when the time comes to buy back the shares, the price has fallen far enough to cover his costs, then the hedge fund manager has made a profit.
To give an example, say the manager borrowed shares from an investor for three months at an annual interest rate of 8 per cent. He sells 100,000 shares at £6 each, netting £600,000. After three months, the shares have fallen to £5 each. So he buys back the same amount of shares at a cost of £500,000, pays £12,000 of interest to the lender (£600,000 at 8 per cent for three months), and nets a profit of £88,000.
Shorting upsets companies because it tends to drive their share prices down. Short-sellers have been known to spread rumours about a company in an attempt to push their position into profit. At the time of the September 11 attacks on New York and Washington, there was even talk that the terrorists had sold the market short in advance of the event. In the summer of 2008, when bank shares were falling fast, regulators in the US and the UK moved to restrict the ability to sell short their shares.
To go back to Alfred Winslow Jones, he realized that if he bought one group of shares (went long in the jargon), and went short of another group of shares with the same value, he would be protected against market movements. If the market rose, he would lose money on his short positions but make it on his longs. If the market fell, he would lose money on his longs, but make money on his shorts. His position was hedged. The hedge fund name flowed from that basic idea.
However, this idea needed another twist. Even if Winslow Jones was a very good stock-picker, his long positions might only beat his shorts by 4–5 per cent a year. That differential would not be enough to attract outside investors. The same is true today of a lot of hedge fund strategies. So the fund uses borrowed money to enhance returns. But this is a double-edged sword; leverage enhances losses as well as profits. In 1998, the hedge fund Long-Term Capital Management (LTCM), run by trading legends from the Salomon Brothers investment bank and backed by two Nobel-prize winning economists, needed rescuing after its bets on bond markets went wrong. It had levered up thirty times; in other words, its capital was just 3 per cent of the assets it controlled. Only a small move in markets was needed to cause it trouble.
This use of leverage can make hedge funds risky but it would be wrong to say that all hedge funds are huge risk-takers. Many are very sophisticated about the way they seek to control risk; the volatility of their portfolios will be a lot lower than that of, say, a technology fund. The big blow-ups of recent years have tended to involve funds that invested in riskier assets. In 2006, Amaranth lost 35 per cent in a month after making bad bets in energy futures; in 2007, two Bear Stearns funds lost all their value after investing in securities linked to the subprime mortgage market. In both cases, investors knew they were making such bets, and should have been prepared, if not for the scale of their losses, at least for the possibility of their occurrence.
Another area of hedge fund risk relates to the way they are structured. They are usually registered in an offshore haven like the Cayman Islands to give them tax privileges; they have much greater investment freedom than a mutual fund. But this also means they are very lightly regulated. In the UK, the Financial Services Authority looks after the fund managers, rather than the hedge funds themselves; in other countries, there is very little oversight at all.
There have been several examples of fraud, usually when the managers lie about the nature or the value of their investments. The Bernard Madoff case is a slightly unusual one. Technically speaking, Madoff did not run a hedge fund, but hedge funds did give him money to invest. The failure to spot the fraud reflects very badly on those funds that did do so: the authorities try to restrict the damage by limiting the type of people who can invest in them; only the very rich and institutions like pension funds and university endowments can qualify. The idea is that such people can look after themselves.
Gradually, however, hedge funds are becoming open to the wider public. One or two individual funds have listed on European stock markets; once quoted, there is nothing to stop widows and orphans buying shares in such funds. Quite a number of funds-of-funds have listed on the London market.
A fund-of-funds should be less risky – a specialist manager groups together a portfolio of individual hedge funds, having (in theory, at least) weeded out those run by fraudsters or which are taking wild risks. The Financial Services Authority has also suggested that retail investors should be allow to invest in vehicles (so-called FAIFs, or funds of alternative investment funds) that will contain hedge funds within their portfolio.
While hedge funds may be registered in the Cayman Islands, their offices are usually elsewhere. In America, a lot of hedge funds are based in Connecticut, the other side of the Long Island sound from Manhattan; in Britain, the centre for the industry is Mayfair, convenient for the theatres and expensive shops of the West End and a short commute for those who live in Chelsea or Notting Hill. Style tends to be more casual than in the City; it is more common to go without a tie than to wear one.
The hedge fund world is intensely Darwinian; in 2006, while 1,500 funds were set up, some 700 folded. The managers regard themselves as smart people, pitting themselves in daily combat against the whims of the markets. They resent criticism and dislike publicity about their pay packages or their mistakes. But they are not above using the press to promote their positions, particularly in bid situations.
This can lead to a lot of resentment, especially when so-called activist funds start to lobby against the decisions of company managers. The Children’s Investment fund, or TCI, is one prominent example. It campaigned against the Deutsche Börse’s bid for the London Stock Exchange, arguing that the German exchange would do better to return cash to shareholders. Not only did the bid fail but the Börse’s chief executive Weiner Seifert was forced out. Then TCI took a 1 per cent stake in the Dutch bank ABN Amro, sparking a bidding war that ended with the bank’s purchase by Royal Bank of Scotland.
In Europe, where shareholders have traditionally been seen and not heard, this kind of activism was distinctly controversial. Hedge funds were accused of being reckless speculators, only interested in short-term profit and not in the long-term health of the companies they invest in. There were calls for their activities to be restricted. The debate on the issue was much more restrained in Britain, where there is a much longer tradition of corporate takeovers and foreign ownership of big companies. It may help, of course, that Britain has a thriving hedge fund sector.
Another worry about hedge funds is that they might bring the system down; this concern inspired the rescue of LTCM in 1998. The fear is that hedge funds will not be able to repay the money they have borrowed when markets move against them. Since they normally borrow the money from banks, they might bring a bank down with them. This fear was reawakened during the credit crunch although that episode showed the banks (in theory highly regulated) could collapse of their own accord.
The main link between the banking sector and the hedge funds is the prime brokerage arm of banks. These offer a wide range of services; from lending the funds money, to keeping records of their trades to setting up the funds in the first place. Hedge funds are fantastic customers of the investment banks, since they trade frequently, earning big brokerage fees. But they are also competitors of the banks; they are trying to make money out of the same markets as the banks’ trading desks. Most of all, they compete for staff; a lot of hedge fund managers were former investment bank traders.
Regulators can find the prime brokers quite useful as a means of keeping tabs on the hedge funds. If the hedge funds are taking too many risks, then the prime brokers, as their main lenders, should notice. But the risk works both ways. When hedge funds borrow money from a bank, they are obliged to put up assets as collateral for the loans. When worries surfaced about Bear Stearns in March 2008, hedge funds worried about the safety of their collateral; so they cut positions with the bank, weakening its capital position. One can see it as sweet revenge for the way that banks, by trading against its positions, brought down LTCM. The credit crunch caused a shrinking of the hedge fund industry, with nearly 15% of all funds closing during 2008. The industry’s assets dropped from $1.9 trillion to $1.4 trillion.
TYPES OF HEDGE FUNDS


By 2008, there were around 10,000 hedge funds in existence with some $2 trillion of assets under control. Some were of the basic Winslow Jones model – being long and short of individual shares in the hope that their stock-picking skills would prove superior.
But others were much more sophisticated. One group, known as arbitrage funds, tried to profit from price discrepancies in particular parts of the market, such as convertible bonds. Others, so-called distressed debt funds, specialized in the bonds issued by struggling companies. A third group used powerful computers to try to spot patterns in the market.
So one needs to beware of newspaper stories that say ‘hedge funds are buying this asset’ or that stock. The funds are so ubiquitous these days that they are probably on both sides of most trades.
The diversity of these strategies is part of the hedge funds’ appeal to clients. The idea is that when they invest in the sector they get a different kind of return, one that is not dependent on the stock market. Indeed, the hedge funds claim they are focused on ‘absolute return’, producing a positive outcome regardless of market returns. Until 2008 the worst year for the hedge fund index was 2002, when the average fund lost just 1.5 per cent. The industry’s near 20 per cent losses in 2008 dented its reputation.
Hedge funds can use a lot of leverage, which makes them risky at the individual level. So investors need to own a bunch of them to get the potential benefits. Furthermore, the best hedge funds are often closed to new investors, because the managers worry that having too big a fund will reduce performance. The new investors may end up choosing between smaller managers without a long track record.
The biggest problem of all may be the costs. The managers claim superior skills, so they charge higher fees; 2 per cent annually and a fifth (20 per cent) of all returns. Those that want a diversified portfolio of managers may opt for a fund-of-hedge-funds, which will charge another 1 per cent annually (and 10 per cent of performance) on top. That is a big hurdle to overcome.
Worse still, the high performance fees may encourage hedge fund managers to take risk. After all, it is the performance fees that have turned some managers into billionaires; if you manage $10 billion of money, and the fund returns 20 per cent in a year, that is a performance fee of $400 million. If the fund subsequently collapses, the managers don’t have to pay the performance fee back.
Clients have some protection against these problems. Performance fees are only paid if a ‘high water mark’ is passed, representing the previous peak in the fund’s asset value; otherwise, a client could be paying twice for the same return. And managers often keep the bulk of their investments in their own funds; so they will lose if the clients do.
Nevertheless, the size of the fees is causing many people to look for alternatives. One possibility is to use computers to mimic hedge fund returns, at much lower costs. These ‘replicators’ or ‘clones’ may prove a threat to the long-term growth of the industry. The idea behind the clones is that hedge fund returns are driven by a few factors, such as movements in the US stock market or corporate bond yields. Mix the factors together in the right proportions and, in theory, you can get the same returns. Whether this will work as well in practice remains to be seen.
PRIVATE EQUITY FUNDS


The private equity industry is smaller than the hedge fund sector but equally controversial. Its critics argue that the industry makes itself rich by taking over firms and sacking workers, that it consists of asset-strippers who damage the long-term health of the economy. Its supporters claim that private equity represents a superior model for doing business, in which the interests of managers and shareholders are much better aligned than in the traditional quoted company sector.
The debate is muddied by the fact that many people confuse private equity with venture capital. The latter also invests in unquoted businesses, but at a much earlier stage. Venture capitalists are trying to find the companies that will be the Microsofts and the Apples of the future. They tend to have many more failures than successes but they hope that the gains on the latter will outweigh their losses on the former. Since innovation and small businesses are undoubtedly good things for the economy, it is rather unfair that venture capital gets dragged into the private equity debate.
Private equity, by contrast, invests in existing companies. Normally, funds will take over the entire company, attempt to improve its performance, and then sell it, either to the stock market or to a corporate buyer, a few years later. They will usually fund this purchase with a lot of debt, hence the original name for private equity funds was leveraged buyout funds. Often, the management of the company will be incentivized with equity stakes, which will make them rich if the value of the company rises sharply.
Loading up a company with debt is risky; if the business is unable to meet the interest payments, it will go bust. So private equity groups tend to look to buy companies with two characteristics: strong cashflow and a lot of assets. The cashflow can be used to meet the interest payments and surplus assets sold to pay down some of the debt. The theory is that the need to pay off the debt will concentrate the managers’ minds and lead them to control costs and avoid wasteful projects. One way of controlling costs, however, is to sack workers; another is to limit spending on research and development. Hence the criticism that private equity groups run businesses for the short, not the long, term.
The industry has argued that, on the contrary, it is interested in growing the businesses it buys, since eventually it has to sell them again. A slash-and-burn policy would thus be counterproductive.
Various academic studies have looked into the issue (some funded by the private equity industry) with mixed results. One of the most authoritative, prepared for the World Economic Forum in 2008, cleared the industry on the issue of stifling innovation, on the basis of patent records. It did find the industry partially guilty in terms of job destruction, saying that more jobs were lost (compared with similar businesses) in the first two years.
Critics of the industry also focus on two other issues. The first is the lack of transparency. Because businesses owned by private equity groups are not publicly quoted, they do not receive the same level of scrutiny from outside investors or from the media. However, the industry would argue that being out of the limelight allows the businesses to make better decisions, without the pressure to meet short-term profit targets.
The second issue is tax. Debt is tax-deductible in both the UK and US systems. This can mean that a highly-indebted business can end up paying no corporation tax. As more and more businesses move into the private sector, this could erode the tax base.
In an ideal world, the tax system would be neutral so it would not matter if a company funded itself with equity or with debt. But removing the tax deductibility of interest would penalize public as well as private companies, and might send the weakest companies to the wall.
A more telling criticism was that the partners in private equity companies were allowed to class most of their profits as capital gains rather than as income. For a while, the lowest rate of capital gains tax was 10 per cent. This meant, as Nicholas Ferguson, a private equity veteran, confessed, that he was paying a lower rate of tax than his cleaner. This remark seems to have inspired the move by Alistair Darling, the chancellor, to raise the minimum capital gains tax rate, from 10 per cent to 18 per cent in 2008. However, the move caused much resentment, as it penalized small businesses as much as private equity bosses.
Like other fund managers, private equity groups have a portfolio of investments made up of the companies they backed. The managers of private equity groups are called general partners; the investors in the fund are known as limited partners. The latter will normally agree to invest a set amount in the fund and to tie up the capital for several years; this gives the general partners the freedom to dispose of the underlying businesses when conditions suit. When they arrange a leveraged buyout, the private equity funds will use the capital subscribed by the limited partners as the equity capital for the deal, and then raise the rest of their money (in the form of debt) from the banking sector.
Like the hedge fund industry, private equity groups are motivated with performance fees, usually a fifth of all returns. Annual management fees of between 1 and 2 per cent will also be charged. But the managers claim that their high returns justify the payment of such high fees.
This is another subject of much debate. It is possible to show that private equity funds have beaten the stock market over extended periods. But the funds use a lot more borrowed money and, as a result, are more risky. Academic studies suggest that, once this risk is controlled for, private equity funds perform no better than the market. One quirk of the figures, however, is that the best performing funds are consistently ahead of the pack (something which does not seem to be the case with unit trusts).
That raises a couple of questions. The first is, if it is possible to identify the best performing private equity funds, why does anyone give money to the below-average performers? The most likely answer is that the best managers limit the size of the funds, so that not all investors can get a slice of the action. They end up taking a punt that some less renowned manager can achieve similar returns.
The second question is what drives the returns of the exceptional managers? One reason was cited earlier in the book: lesser liquidity demands greater reward. Because investors are locked in to private equity funds for a period of years, they demand high returns to compensate.
Another potential explanation is that private equity investors have superior skills in selecting the right companies to back, and are better at motivating the managers they employ. A further possibility is that this is a financing trick, driven partly by the tax break given to interest payments (see above) and partly by a long period of low and falling interest rates since the 1980s.
In the early 1990s, when the UK did slip into recession, private equity suffered from a very difficult periods as buyouts of retail outfits like Magnet and MFI got into trouble. In the US, the best-known deal of the era, the takeover of tobacco-and-food group RJR Nabisco, delivered very poor returns for its backer KKR.
That episode reveals another potential problem for private equity funds – the feast-or-famine problem. When the asset class is popular, the funds have lots of money to invest. But when those conditions occur, the funds end up bidding against each other for control of attractive groups. That forces prices higher and future returns down. Conversely, when economic times are hard and share valuations lower, investors are less enthusiastic about giving money to private equity managers. Early indications are that deals made in 2006 and 2007 will be very unprofitable. The Boston Consulting Group predicted in December 2008 that 20–40% of private equity firms could go out of business within 2–3 years.