There has been an upsurge of optimism about the credit squeeze and its implications for the world economy since central banks made it clear at their get-together in Rome that they will adopt radical strategies, if necessary, to solve the crisis.
Meaning: throw unlimited money at the problem, relieve irresponsible banks and funds of their dodgy credits, and prevail on governments to spend their way out of trouble. This will happen largely at the expense of the blameless – taxpayers, fixed-income investors, and banks facing unfair competition from state-guaranteed rivals.
Some stock markets are already rallying strongly. Gold and other commodities have seen their prices fall sharply. Even that goliath of the currency world, the euro, is starting to weaken in yen terms.
My friend and great analyst David Fuller speaks about “stunning technical action” on the European and American stock markets that “validates bullish sentiment indicators.” He suggests “the ranging chart patterns that we see look like base formation development prior to upside trending action.” In other words, he thinks the bear phase is probably over, and the bulls will soon be charging again.
Shares of the Swiss banking giant UBS jumped strongly after it announced a stunning $19 billion write-off in the value of its US mortgage-related investments and a $15 billion fully-underwritten rights issue to boost its capital. The markets liked the Swiss willingness to face up to the nasty problems and act convincingly to restore financial strength. But is the end of the credit crisis really in sight?
The fundamental reasons why this isn’t the end of the crisis
One of the strongest arguments for believing that investment markets generally are at or near their trough is that advisers are overwhelmingly negative, which in the past has been a great indicator of market bottoms. David Fuller is caustic about those who say it’s “different this time.” I rarely disagree with him, but I have two problems with this argument.
One is that if advisers are so overwhelmingly negative, why are equity valuations still so high relative to what they were at the bottom of previous bear markets, with the majority of analysts continuing to forecast that corporate earnings will grow, rather than contract?
Equity markets are valued well above their long-run averages relative to cyclically adjusted earnings and the replacement cost of their assets. The housing market in the US and some other major economies remain expensive relative to earnings and rents.
Secondly, things really are different this time in the sense that this is the worst broad-based financial crisis in nearly 80 years. This could mean that sentiment gets even worse before the markets hit bottom – relative to the dangers, the pessimists may still not be pessimistic enough. It just doesn’t feel like the end of a bear market. Nor do the fundamentals support that argument.
The effects of decreased spending
Notwithstanding the current outburst of optimism, the credit squeeze is getting tighter and has much further to run. It is starting to destroy economic growth, and I fear the worst is yet to come.
The key negative is not lack of confidence in the credit markets – that will slowly be resolved – but the certainty that banks will continue to move towards much more restrictive, low-risk and low-yield lending under the hammer blows of political and regulatory punishment, shareholder and client anger, mammoth write-offs and painful capital and human-resource restructuring.
The crisis had its origins in ‘sub-prime’ – the foolish lending of money for property purchase to Americans who were clearly highest-risk borrowers, as they were without income, employment or personal assets. But sub-prime debt is a tiny part of global debt – so why are rising defaults by those borrowers having such widespread consequences?
Why sub-prime matters
Sub-prime and similar high-risk credits were added to investment packages consisting mainly of low-risk assets such as the bonds of semi-government agencies, to enhance their yield. This was like injecting deadly viruses into otherwise-healthy bodies.
Those securities were sold-on by banks to long-term investors such as pension funds. More dangerously, they were also sold to hedge funds and other speculators who borrowed cheap money from banks to buy large quantities of these higher-yielding assets.
It’s now become clear that supposedly reputable “investment” banks have often borrowed as much as 97 per cent of the money they invested in such assets. It only takes a fall in the value of those assets of more than 3 per cent, for whatever reason, to wipe out the banks’ own investment.
The packaged investments lack transparency. It’s extremely difficult for those who lent money to the speculators to value their assets. How much sub-prime and similar high-risk credits are contained in those assets? And how can those assets be valued when there are no markets for them? There are no buyers, because buyers are too frightened by the financial risks of ‘catching a falling knife.’
Fear about the safety of sub-prime-related investments has infected confidence in the vastly greater and more important derivatives sector -the market in risk – which also seriously lacks transparency.
Markets have behaved in ways that were quite unexpected. When banks and funds suddenly needed lots of cash to meet an avalanche of exiting lenders, they found they could not dump their lowest-quality assets because there were no buyers. They had to sell off the only assets in which a liquid market remained – their highest-quality securities.
Regulation spreads more panic
Regulation has also had totally unexpected consequences. After Enron and similar scandals, regulators and auditors insist that assets such as the above-mentioned packages have to be ‘marked to market’ when accounts are produced.
In markets where values are in any case falling, this puts values under additional pressure to fall. And where markets have dried up, auditors have no choice but to value very conservatively, so huge losses have to be ‘taken to book,’ further spreading panic.
Central banks are seeking to contain the global crisis by cutting interest rates, flooding the system with money, and starting to transfer risk from the private sector to the state – lending to financial institutions against the security of dodgy assets, guaranteeing such securities, and nationalizing banks. That process has much further to go.
It can be argued fairly, as the policymakers do, that they have no alternative but to go to the rescue of the bad boys – because the global financial system is so integrated that the failure of a major player could trigger seizure of the entire system, with catastrophic consequences.
Central bankers ought to ride to the rescue of responsible players, not the ones who took greater risks and showed the greatest irresponsibility to boost their corporate profits and executive bonuses (Bear Stearns in the US, Northern Rock in the UK).
Insolvency not illiquidity
Unfortunately, that is not always possible because of ‘systemic’ risk – the danger that the collapse of the most irresponsible major players could have such widespread consequences that it could produce a ‘financial nuclear winter,’ destroying a system that is essential to all modern economies.
I was amazed to see that other financial institutions’ exposure to Bear Stearns – their counter-party in derivatives contracts – was $10 TRILLION.
Central banks’ panicky measures do address the problems of illiquidity, and in time will succeed, as they can print unlimited amounts of their own currencies. But they won’t do much to deal with the problems of insolvency. Illiquidity in the credit markets is about perceptions. It’s when people become reluctant to lend because they fear their loans won’t be repaid. Insolvency is about reality. It’s when borrowings cannot in fact be repaid in full, because values of assets have fallen below those of debts.
Asset values have fallen, and are continuing to fall, for several reasons. The boom in real estate is over. Mortgage borrowers are reneging on their debts. Owners of fixed-income securities of all kinds are selling them to raise cash and reduce their exposure to financial risk.
‘Debt,’ says The Economist, ‘is now a four-letter word.’ Governments and central banks, acting together, can solve problems of illiquidity if they are prepared to provide money and/or guarantees without limit to financial institutions – especially the irresponsible ones whose practices have raised the greatest fears they will default. They seem to be preparing to take that route.
But they cannot solve the problems of insolvency unless they are prepared to pay off the debts of borrowers – especially those who have taken on the greatest debts relative to their assets and income-earning potential, through greed or gullibility.
By Martin Spring in On Target, a private newsletter on global strategy