Global Financial Crisis Special: Excerpts from the Bank Credit Analyst’s Weekly Bulletin on Global Investment Strategy

October 11, 2008 by admin
Filed under: Financial Matters 

EDITOR’S NOTE: These are excerpts from the Bank Credit Analyst’s weekend Global Investment Strategy Report, dated 10 October 2008 (US time).

NO HOLDS BARRED

The world’s major central banks confronted the deepening financial crisis this week with a coordinated rate cut. The dramatic action was initiated against the backdrop of collapsing investor confidence, growing signs of a potentially vicious G7 recession and spreading bank runs in Europe. Governments and monetary authorities in the G7 have been in an all-out war over the last several weeks to stabilize the global banking system, but their efforts have produced limited results. Global stock markets have melted, credit spreads have soared and the credit market remains as clogged as ever.

There is no longer any doubt that many sentiment indicators are at pessimistic and bearish extremes, which may be an indication of some sort of selling climax. However, similar signals have emerged before, that, in retrospect, have obviously proved to be false. In the middle of an escalating financial crisis, there is no way to predict where markets will go in the short run. Irrationality is often the rule rather than the exception.

Now is the time to stay “close to the shore” and not be heroic. In other words, one needs to be extremely careful when making any macro bets. In the meantime, we cannot lose sight of the big picture. In the middle of a crisis where chaos and upheaval rein, it is always useful to step back and reflect on some of the bigger issues. The current global environment is no exception.

POLICY DISCONNECT

Until two to three months ago, the world economy still retained some lingering strength, despite the credit market turmoil. However, what strength remained has quickly been sapped, and the G7 economies seem to have caved in rather abruptly, as evidenced by the sudden plunge in key macroeconomic indicators in the U.S. and the rest of the world. The sudden escalation of the financial crisis since this summer has finally tipped the balance by choking off economic activity throughout the world in a significant way.

There is no question that the severity of this banking crisis has caught many off guard, including ourselves. Nevertheless, it is also true that policy responses to the financial meltdown have been mediocre at best, and erroneous at worst, in many G7 countries.

In our view, the U.S. authorities’ decision to allow Lehman Brothers to collapse was a grave mistake. The decision profoundly shook confidence in the U.S. banking system, leading to a complete shutdown in the interbank market. Another big mistake was allowing Fannie Mae and Freddie Mac’s preferred share prices to collapse, effectively wiping out a big chunk of “tier one” capital for many financial institutions. These two events have put the solvency state of the entire banking system in serious doubt.

It is not clear why the U.S. authorities opted to allow such high-profile bank failures to happen. There have been many strong and vocal proponents in economic policy and political circles of the so-called “liquidationist approach”– an approach that favors pure market mechanisms to cleanse excesses and prevent “moral hazard”. Another could be the pressure from Main Street, which has been calling for punishment of Wall Street’s greed. Whatever the case, the “liquidationists” have gotten what they wanted, and they don’t seem to be liking it.

Monetary response in the G7 has not been impressive either. Until very recently, most central banks around the world were still fighting the inflation battle, even though bank failures, debt deflation and recession had clearly become the key threats. The European Central Bank (ECB) was driving up interest rates as late as this past July, when the global financial system was already sinking into deepening chaos.

It is stunning to see a deeply inverted yield curve in the midst of a  potentially lethal banking crisis from the U.K. to continental Europe. Unreasonably tight European monetary policy has contributed in no small part to panic runs and bank failures in Europe.

Although the Federal Reserve and the Bank of Canada (BoC) have been the only central banks that have cut rates aggressively since September 2007, Fed policymakers were second-guessing their own reflationary actions just a few months ago. Authorities at the Fed, including Chairman Ben Bernanke, were talking up the inflation risk. As recently as August 5, the FOMC statement declared that “Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee”. Policymakers seemed to be signaling to the market that policy rates would soon be on the rise. Stock prices began to plunge anew as of May 2008 as global equity markets found themselves under simultaneous attack from rising oil prices, widening credit spreads and growing expectations that the Fed would soon reverse its rate cuts.

Finally, G7 central banks have misplaced their priorities. Most G7 central banks have been preoccupied with finding various measures or mechanisms to inject liquidity into the financial system. Although this is a necessary step to reduce short-term funding pressures, it does not address the critical problem that has been plaguing the banking system: the escalating solvency risk of lending institutions as a result of eroding asset values. Libor spreads have been held at extraordinarily high levels, even though many billions of dollars of liquidity have been injected into the financial system.

Stock markets around the world are not impressed by the $700 billion U.S. rescue plan either. We suspect this may also have to do with the fact that the package does not address solvency concerns. For instance, under the current plan, if the Treasury offers too much for distressed mortgage-backed securities (MBS), the bailout cost could literally skyrocket, and the market is not convinced the Treasury would be able to assemble an additional $700 billion package. If offer prices come in too low, then the solvency risk for lending institutions remains. This may also explain why the interbank market remains frozen solid, even though many European governments have taken actions to either guarantee bank deposits or increase insurance on them. These actions are aimed at preventing a run on the bank, not outright bank failures.

On a positive note, some European governments seem to have finally realized the magnitude of the problem and begun to tackle the core issue directly. Last week, five European banks were taken over by the government. This week, the British government announced a 50 billion pound plan to partially nationalize the banking system. This is a very important step. By becoming a shareholder of the banking system, the government not only protects taxpayers by giving them a chance to make profits once the stock market recovers, but also reassures depositors by effectively guaranteeing the solvency state of lending institutions.

Our sense is that, in the end, many G7 countries may have to nationalize big chunks of their banking systems. Indeed, the White House on Thursday confirmed that the Treasury is considering doing just that. Either way, it is unfortunate and disappointing to see that the Bush Administration has been ill prepared for the banking crisis from day one: It has never properly explained and sold the package to the public, the Congress nor the market.

All of this means that it may still take some time for the market to return to definite stability. The Treasury needs to convince the financial market that it will address the solvency issue head on. Meanwhile, most central banks are still way behind the curve and need to catch up quickly.

The Fed needs to drop rates to below 1% in order to maintain a 350 basis-point yield curve spread, which is always required when banks are under stress. If the bursting of the tech bubble drove the Fed funds rate to 1%, the current shock should probably move the equilibrium rate to 0.5%, if not zero, especially given the recent sharp spike in the U.S. dollar.

Other central banks are even farther behind the curve: The ECB’s policy rate should be 2% at most, according to our Taylor rule: It stands at 1.9% for December. Short rates in the British Isles remain at 4.5%, and the country’s banking crisis is just as intense as that of the U.S. Policy in Australia and New Zealand can be characterized as either tight or extremely tight, although authorities are rushing to drop rates.

Bottom Line: We are still in the window of maximum vulnerability. Nevertheless, it seems that authorities are beginning to get their act together, as stock markets around the world have been discounting a truly gloomy outlook for the global economy. Forced liquidations abound and investors are in severe distress and panic. Hopefully, these are signs that the market could soon regain some composure.

LESSONS TO BE LEARNED

There are many important lessons to be learned from the unprecedented financial crisis that has gripped the global marketplace for over a year now, and some of these lessons could be very useful in guiding us through future episodes of financial instability.

First, stocks do not often properly anticipate the full ramifications of a real estate meltdown. For instance, residential real estate prices in the U.S. peaked in July 2006, but share prices continued to climb until October 2007, creating a false sense that the market downturn would be a localized shock with limited implications on the wider economy.

A similar phenomenon was also true in the Savings and Loan (S&L) debacle. For instance, commercial real estate prices began to tumble in October 1988, but the stock market did not go into a cyclical bear market until July 1990, when the S&P 500 began to discount a recession.

The lesson seems to be that all major downturns in real estate, historically, have always led to severe disintermediation in the banking system. This is because a real estate market cannot sustain a boom without the participation of lending institutions. By the same token, the solvency state of the banking system is always implicated when a real estate boom turns into a bust.

However, it usually takes some time for the financial disintermediation to intensify and finally impact the real business sector. At this stage, stocks start to tumble. It is always a prudent strategy for investors to run for cover on the first signs that real estate prices are starting to fall. Usually, there is sufficient time for investors to offload shares because a peak in real estate often leads a top in stocks, with a substantial time lag.

Second, a crisis in the banking sector cannot be viewed in the same light as a recession in the normal business sector such as auto or steel. Banks are built on public trust, and credit is the lifeblood of the capitalist system. Trust in the entire banking system can easily be broken by one or two failures, leading to the immediate seizure of credit flow. The experience of the 1930s as well as of the recent crisis shows that any major interruption of credit flow can have devastating results.

Therefore, authorities should never flirt with the “Austrian school” solution or be concerned about “moral hazard” when dealing with a banking sector fallout. This is because allowing any major lending institution to fail can unleash panic runs that are often lethal to the entire banking system, creating a domino effect that cannot be easily contained.

It is both unfortunate and undesirable to have a banking system operating on the principle of “too big to fail” or of being protected by government at times of financial crisis. However, the world has never seemed to be able to find the perfect solution of encouraging free competition in the banking system while at the same time protecting public interests, whenever there is a confidence crisis. Maybe proper regulation and supervision are the only way to deal with the financial sector reform in the future.

Third, central banks are always late in combating deflation. This is partly due to the fact that inflation, rather than deflation, has been the main problem throughout postwar history. Most G7 central banks have shown a clear common tendency of being quick to raise rates but slow to cut, even though there has been a clear long-term trend of falling inflation since the early 1980s.

It is not an exaggeration to say that slow reaction in central bank policy often aggravates the intensity of a financial crisis at the early stages. It seems that only once central banks are forced into a panic reaction do financial markets start to turn around.

Another important point is that central banks seldom allow policy to target asset prices. This is fine when economic conditions are normal. However, when a banking system is in crisis, monetary policy must focus squarely on lifting asset prices. This is because a continued fall in asset values can make a solvent institute insolvent, leading to a vicious downward spiral of bank failures, debt deflation and forced deleveraging. A central bank must prevent this nightmare scenario from occurring by reflating asset prices as early and as aggressively as possible.

On a positive note, the steep drop in global share prices this week has clearly made central bankers blink and has brought about coordinated rate cuts. This is the first hopeful sign that all major central banks are finally on the same page and are willing to fight debt-deflation collectively.

Finally, banking sector bailout packages do not guarantee the immediate return to stability or the resumption of rising share prices. The Resolution Trust Corporation plan was unveiled in February 1989 (made into law in August 1989), but share prices did not come through their bear phase until October 1990. However, the Swedish experience was one where the announcement of the nationalization of the banking system triggered a nearly immediate turnaround in stocks.

In other words, there is no fixed pattern in terms of financial market reaction. However, the common  attribute of banking crises is that, in the end, they all lead to the socialization of bad debt by creating large public borrowing requirements. However, financial market consequences of previous examples of fiscal bailouts are very different. In smaller countries, the large public sector debt load is often monetized, leading to a collapse in the local currency.

In others examples, such as in post-bubble Japan, the financial consequence has been a prolonged decline in stock prices, combined with a steady decline in bond yields. In the S&L bailout, the U.S. government appears to have had a “free lunch”: Stocks eventually soared after a brief bear market between July 1990 and January 1991, while bond yields declined. The dollar only had a brief period of weakness, lasting from July 1990 to March 1991.

It would be very interesting indeed to see how financial markets would adjust, discount and react to an unprecedented socialization of bad debt in the entire G7 economy –- a scenario that looks increasingly likely.

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One Comment on Global Financial Crisis Special: Excerpts from the Bank Credit Analyst’s Weekly Bulletin on Global Investment Strategy

  1. What Others are Saying About Global Financial Crisis? « Barrygardens’s Weblog on Mon, 1st Dec 2008 6:26 am

    2. [...] Global Financial Crisis Special: Exerpts from Bank Credit Analyst … – There are many important lessons to be learned from the unprecedented financial crisis that has gripped the global marketplace for over a year now, and some of these lessons could be very useful in guiding us through future episodes of … [...]

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