More Bank Bailouts to Come, So Keep Selling Sterling

By: MoneyWeek

Hmm. I'm not sure that Gordon Brown got the result he hoped for yesterday.

After the first Great British banking bail-out, Mr Brown thought he had saved the global banking system – the "world", no less. And plenty of pundits were happy to indulge his fantasies.

But yesterday, the Great British Banking Bail-out (GBBBO) Mark II revealed that he hadn't even saved the UK 's banks. £37bn of real money (as opposed to promises or guarantees, we're talking cash that's been spent) later, and the economy's still in deep trouble and we're no closer to knowing just how bankrupt the banks actually are.

The markets now seem to expect that a GBBBO Mk III, involving large-scale nationalisation, is just around the corner. But can we afford it?

Uncertainty means investors will plan for meltdown

Royal Bank of Scotland 's share price demonstrated just how impressed the markets were with Gordon Brown's new bail-out plan. It dived by more than 60%. The bank's market capitalisation is now just £4.5bn, compared to £78bn a year and a half ago. Investors, realising that the Government is now on course to own 70% of the bank, are almost pricing in full-blown nationalisation.

The trouble with the new bail-out, with all its fiddling about with insurance and guarantee schemes, is that we're no nearer to knowing just how much dross is on banks' balance sheets. Until investors know what the worst-case scenario actually is, they'll plan for a meltdown, and rightly so. Barclays, for example, which is doing its very best to remain free of government control, saw its shares take another pasting yesterday. The bank says its profits for 2008 will be "well ahead" of forecasts but the trouble is, no one believes it.

There's a fear that it still has a lot of dodgy assets on its balance sheet, and that if it's forced to take a long, hard look at these by the Government, then we'll see hefty write downs.

The longer the uncertainty continues, the longer it'll be before markets can be sure that a floor has been reached. As CLSA's Christopher Wood points out in the FT this morning, "the ultimate endgame in countries such as the US and Britain is still likely to be full-scale nationalisation of the banking system," but it would be better done sooner rather than later, "since it would accelerate resolution of the financial crisis."

Bank of England to start printing money

The other big news was that the door has been opened wide for the Bank of England to embark on quantitative easing (that's Bank-speak for "printing money"). The Bank will get £50bn to buy assets such as corporate bonds. The idea is that by buying corporate debt, it will drive down yields (yields fall as prices rise) and so cut the cost of borrowing for companies.

It also means, of course, that the Bank is on the hook if its purchases go bad. But while an ordinary investor would lose money in that situation, all that will happen with the Bank is that the Treasury – ie the taxpayer – will cover it. Spending other people's money, with no comeback if you lose it, is not a great incentive to do proper due diligence – just ask anyone whose asset manager gave their money to Bernie Madoff.

For now, the Treasury will issue short-term gilts to give the cash to the Bank. That means that we're not quite at the full-blown money-printing stage – this is money coming from private investors, via the Treasury, to be invested by the Bank in assets which no one else on the market wants to buy. But it's easy enough to move to the money-printing phase (as the Federal Reserve has already done in the US) – rather than raising the money via the Treasury, the Bank just hits a computer key and creates it out of thin air.

Sterling took another beating yesterday

Given all that, it's small wonder that sterling took another beating on the foreign exchange markets yesterday. The pound fell by more than 2% against the dollar, and 3% against the yen. As Audrey Childe-Freeman of Brown Brothers Harriman told the FT: "The fact that the UK needs another banking package after £37bn was pledged only three months ago is very worrying… it's negative for sterling because investors start to think: can the British government really afford all these measures?"

There'll be plenty more worries ahead for sterling in that case – because we certainly haven't seen the end of the banking bail-outs.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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