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The Swedish solution

Created:
13 October 2008
Updated:
14 October 2008
Written by:
Jonathan Eley

Want some good news? Here it is: governments can nationalise banks and then privatise them again without the taxpayer losing his shirt. Sweden did just this in the early 1990s with a plan of action that was similar in some respects to that which Alistair Darling outlined last week. And the really good news is that stock market investors made a packet out of it, too.

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Sweden's banking crisis was caused primarily by light regulation and reckless lending against real estate (sound familiar?). By the middle of 1992, the banking system was in virtual meltdown, with the three main Swedish banks - Skandinaviska Enskilda Banken, Foreningsbanken and Swedbank - facing huge problems with bad loans and inadequate capital, compounded by a global economic downturn.

1992 vs 2008

At first, the government was reactive, as governments have been in the current crisis. It took over the first bank to hit trouble, just as the Treasury did with Northern Rock, and guaranteed deposits in the second casualty. But it wasn't enough.

When a third bank got into difficulties, decisive action was taken. The government guaranteed all the liabilities of Swedish banks, as some governments in Europe have just done. This was enough to prevent bank runs and increase confidence in the system, although at no stage did the government guarantee the equity in banks.

A support authority was set up to offer capital to banks, but as with the UK's 2008 package, it came with strings attached. Banks had to take big write-downs on bad debt and pledge equity to the government. Bank profitability was decimated for a year or so as a result. Major banks were able to offload bad loans into a Resolution Trust-type vehicle, where it was run off or written off over time.

At its peak, the bad debt problem of Sweden's banks accounted for around 12-15 per cent (estimates vary) of the country's gross domestic product (GDP). Lending to the private sector continued to contract for over two years after the intervention, and household savings soared. After the problem loans had been dealt with, the banks recapitalised and returned to private ownership, the final cost to the economy was put about 2 per cent of GDP.

Effects on the economy - and the market

Sweden's economy and its stock market were already declining before the bank crisis started, and although the economy took some time to recover fully - by the middle of 1993, unemployment was 13 per cent - the key point is that the low point came very shortly after the intervention.

Researchers at Barclays have noted that Swedish shares fell 45 per cent between 1990 and October 1992, but rallied 43 per cent the following year (even as GDP growth remained negative) and 20 per cent the year after that. Bank shares rallied 520 per cent in the 12 months after the intervention.

A crude extrapolation of these figures would have the FTSE100 falling to under 3,700 (a 45 per cent drop from its 2007 peak), then rallying to 5,270 by the end of 2009 and 6,300 by end-2010.

Caveats

The Swedes were lucky in some respects. Theirs was a local crisis, not a global one, so it was business as usual in the rest of the world, rather than the near-total paralysis that markets are currently experiencing. A general economic recovery in the mid-1990s helped, and a devaluation of the krona every bit as humiliating as Norman Lamont's Black Wednesday put the Swedish economy in a good position to take advantage of that upswing.

Conclusions

Barclays' researchers are in no doubt that parallels between Sweden in 1992 and the world right now are valid. "The lesson is that government intervention...established a sharp inflection point for equity values. Even though the economy remained in recession for a further three quarters and credit continued to contract for almost a further 11 quarters, the equity market delivered very strong returns from the month after the intervention point"

This should not be too surprising. Markets anticipate economic trends, rather than reacting to them. "The financial system moves well ahead of the real economy...the next two or three quarters should see severe declines in GDP in many economies...but the low for equity markets should be within the next three to four weeks," Barclays concludes.

But that doesn't necessarily mean it's time to pile into bank shares. Ask investors in Bradford & Bingley and Northern Rock why. Instead, Barclays believes that senior bank bonds have been sold off to absurdly cheap levels "and are a recommended purchase."

FURTHER READING...

See Dominic Picarda's recent feature on investing during recessions, Protecting your wealth in a housing slump, and Chris Dillow's Are recessions good for us?

For more on bonds, see our free Investment Guide to bonds and our weekly bond tips.

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