“The market can stay irrational longer than you can stay solvent”
John Maynard Keynes
Fully six months have passed since our January 2011 Banking Outlook article appeared. Has the global banking system collapsed? No, it hasn’t. Are the developed countries’ banking systems still in trouble? Emphatically yes, and it’s not getting better; witness the US, UK and European stock markets’ valuation of the their respective banking systems.
I cite Keynes’ famous remark about stock markets because it’s equally true when discussing the world’s financial system, credit markets or central bank policies. I’m a firm believer that in the end the fundamentals always prevail. But, 40 years of investment experience have taught me that in the short to medium term, the fundamentals, no matter how compelling, can be overwhelmed by the irrationality of markets, regulators and governments. Predicting crisis is difficult but hardly impossible: predicting the timing of crisis is a losing propostion. Witness:
- A couple of years ago the esteemed Economist magazine repeatedly ran cover articles predicting an impending crash in house prices in the UK and the US. After a year or two of continuingly rising or stable house prices the Economist, perhaps feeling they looked a a bit silly, gave up the ghost and stopped publishing articles about housing bubbles. About 18 months later we had the financial and housing crisis of 2007-2008. Right on the fundamentals, wrong on the timing.
- A number of US and some UK equity analysts repeatedly warned their readers of an impending banking crisis starting around 2004. Much to their credit they never backed down from their views but undoubtedly many of their readers and investment clients wearied of hearing about and preparing for a crisis that never seemed to come, but it came and it was severe. (Academic studies have repeatedly shown that more than 95% of professional and non-professional investors are unable to time successfully investment market directional changes no matter how dramatic those changes are.)
Where are we now?
- The Greek debt crisis / the “PIIGS” problem goes from bad to worse. We are now entering bail-out No. 2 for Greece This bail-out is larger in money terms than the initial bail-out, and in the interim Greece has made no progress in fixing their fiscal, monetary and economic problems.
- More significantly the Greek crisis has now evolved into a clear and present danger situation for the European banking system, whose major and medium size participants are heavily exposed to Greek sovereign debt.
- As many readers will know now the exposure of the European Central Bank (ECB) to Greek sovereign debt is a problem – any restructuring of Greek debt that involves sacrifices by the private banking system (including in this case the ECB) could end up involving write-downs by the ECB in excess of its capital. The ECB is estimated to hold Euros 400 billion of PIIGS’ debt and it estimated to be leveraged 23 to 24 times its capital - a leverage level it no longer wants to allow the private banking system to take on.
- The ECB with the help of its national shareholders can worm its way out of any problems that might impact its capital levels. The real problem is that French, Belgian and other European private banks will not be able to circumvent the problem without massive infusions of capital from somebody and based on current market conditions that somebody is most likely to be the taxpayer.
- In the US we have America’s massive budget deficit problem; it’s huge overseas debt problem and clear signs that the world is shifting away from the US dollar as it “reserve currency”. The loss of reserve currency status will leave the US with little leeway for resolving its budget and debt problems simply by raising its debt level and printing more money. The Federal Reserve is now the largest holder of US Treasury bonds - the debtor is now his own biggest lender! Can this system be sustainable?.
- The US’s problems are huge and complicated. So-called quantitative easing, versions I and II have not stimulated the US economy, official unemployment is 9.1% and unofficial and far more realistic estimates of unemployment run at around 16%.
- A big question now is “will there be QEIII?” and what will happen if there is no QEIII? Will credit markets and the equity market adjust to the end of hyper-inflationary stimulus, negative real interest rates and constant government fussing with the economy, mostly to no useful end?
- The US banking system is not doing well. In our January article we talked about the “extend and pretend” process of extending troubled real estate loans while pretending that the collateral value of the loans were still at non-default levels. Bank of America, among other major US banks are foreclosing on properties in record amounts. But they are also continuing to maintain real estate loans not in severe arrears at 2007 valuations. If the valuations of the underlying mortgaged properties was brough current to 2011 a number of major banks would face write-downs of 25-35% of the prudential capital.
- Weiss Research, for many years a credit and rating analysis service for banks, now estimates that at least 12 major international banks are sitting on impaired assets where the aggregate value of the impairments that should be written down in value.
- The drag that repossessed properties places on the housing market is in great part the cause of continuingly falling house prices, sluggish new and existing home sales, and the concommittant negative “wealth factor” feeling and unemployment dogging the US economy. But it's not only the US. It’s also large parts of the UK, Spain, Portugal, Greece and the UAE.
On a global basis major economies and the international banking system are storing up ever larger problems. Referring back to the Keynes’s quote: with government intervention this storing-up of problems process can be extended for several more years. But the longer it is allowed to grow, the greater the reaction will be when the critical economic fundamentals come to the fore.
China knows it has an inflation and housing bubble problem, but like the US it also know it has a range of social problems and worker expectations that have to be managed.
The real estate markets in the UAE have not recovered.
Political unrest in the Middle East is going to keep markets on edge and oil prices high and will significantly impact Saudi government policies. Several commentators now describe Saudi as being in the center of a socio-political “ring of fire”.
Europe’s Euro problems are going to get more critical. Germany and the Netherlands are now demanding private sector participation in any restructuring of Greek or Irish debt; that principle is divisive within Europe but will get extended to Portugal, Spain if necessary and beyond.
Conclusions: In January we advised as follows:
§ We urge our banking clients to keep a close eye on international market conditions as they evolve over 2011 and to make contingency plans now for dealing with a possible second round financial industry crisis.
§ Among the actions that should be considered are:
- A what-if analysis of market conditions with special attention to the organization’s areas of vulnerability: market risk analysis is critical
- Take the tough steps needed now to improve your balance sheets and solvency ratios while capital markets and regulatory policy are accommodative
- Take corrective action on troubled assets now – explore strategies for so doing and develop action plans
- Tighten up credit standards and credit skills among your staff – undertake business risk reviews
Our advice remains the same but with some added considerations:
- Remain vigilant and do not cease taking the preventive and corrective actions needed to strengthen your institution
- Don’t think the urgency to act or the possibility (if not probability) of a major credit crisis has gone away because it doesn’t materialize over the next three or six months of this calendar year
- Politics aside, the ability of governments to manage the way out of the problems we face without taking radical, painful corrective actions has proven historically to be nil
- It is also worth noting that history demonstrates that there has never been a “fiat money system” (a national currency based on trust and not backed by hard assets) that has not collapsed, completely or temporarily
- Banks and bank managements that have prepared their organizations to respond to market crisis from a position of knowledge, strength and readiness will succeed and the failure of other institutions will create opportunities for the those who are able to seize them
(A follow-up to Bank T&D Consulting's January Global Banking outlook)
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