Friday, March 21, 2008

trash and cash

Trash and cash - it’s the new investment strategy that everyone’s talking about. Spread a rumour, buy some cheap stock, make a packet.

So, let’s try it out, shall we. I’ll spread a rumour that the Royal Bank of Scotland is in a pickle - pass it on! That it’s going cap in hand to the Bank of England for emergency cash - truly. People are trying to get their money out because it hasn’t got the cash reserves to meet its liabilities.

Now, wait for the share price of RBS to fall by 3 billion, and then buy, buy, buy. As the stock recovers, you make a fortune by selling your depressed shares at a higher rate than you bought them for. It’s a steal.

It’s also entirely legal. In fact, what happened to HBOS last week isn’t just the ploy of a few rogue traders, but the way that investment in the stock market, indeed any market works. People buy and sell on rumour - that’s what happened to Northern Rock and Bear Stearns. In both cases, the management and regulators insisted that nothing was wrong, that the bank was sound, that if people would just stop taking their money out, all would be well.

But here’s the sting: the investors who led the Rock and Bear panics were right to do so. They were vindicated by events, because despite all the assurances from the politicians and the boads these institutions, they both collapsed because people took their money out. Bear Sterns was worth £20 billion a year or so ago; last week it was sold to JP Morgan for £260 million. Northern Rock is nationalised and its shares are worth nothing at all.

And here’s another worrying thought. The rumours about HBOS last week - which led to its 20% share collapse - were not falsehoods, they were perfectly true. HBOS has indeed gone to the Bank of England for emergency cash - in fact all the big banks went to the Bank last week to ask for more money please. Depositors have been taking money out of the bank - I certainly have. And it is also true that HBOS does not have sufficient reserves to meet all its obligations to depositors. This is called “fractional reserve banking” - look it up.

The truth about banks, which we should all do well to remember in this crisis, is that their business is lending money they don’t actually have. To repeat: if depositors in any bank, however well established, all took their money out at once, the bank would collapse. Banks are only required by law to have cash reserves to meet average withdrawals - it used to be 10% but this has fallen over the years, and the average cash reserve ration of British banks is 3%. The problem arises when more than 3% wan their cash back.

So, the trash and cash merchants have a bomb proof business model here. They can spread ugly rumours about any bank they choose, safe in the knowledge that they are actually telling it like it is.

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