Monday, December 31, 2007

Banking system’s problems at heart of the bear case

(Tony Jackson - Financial Times) Contemplating the year ahead is, when you come to think of it, a slightly pointless exercise. It is not just that forecasts are generally wrong. More seriously, we tend to worry about stuff that never happens, while getting blindsided by events that nobody foresaw.

But financial markets are discounting mechanisms and forecasts are implicit in prices whether we like it or not. So here is my version, starting with a disclaimer.

I am naturally of a bearish disposition. This is not because I have the least aversion to wealth creation. Rather, I put it down to early training as an analyst in Edinburgh. The Scottish approach to investment is traditionally that of the surveyor rather than the estate agent: never mind the sea views, check the dry rot and subsidence.

With that in mind, the big bearish question for next year strikes me as whether the banking system’s problem is one of liquidity or solvency. The central banks can fix the former.

The latter can only be addressed the hard way.

One can lead to the other, as illustrated by the case of Northern Rock. This UK bank was perfectly solvent when first hit by a liquidity crisis and is now on a taxpayer life-support system.

As to whether any big banks will go bust next year, there is as yet no saying. But sticking to the bearish theme, let us tick off some factors which make it more likely.

First, defaults are set to rise. According to Standard and Poor’s, speculative-grade defaults in the US are now at an all-time low, at less than one per cent.

That compares with 10 per cent in 2001 and 12 per cent in 1990 – both recession years. But the proportion of bonds defined as distressed – that is, with spreads of more than 1000 basis points over Treasuries – is rising sharply and now stands at almost 5 per cent compared with 2.1 per cent a year ago.

That is stage one. Stage two – actual defaults – will duly follow.

Hedge fund leverage

At that point, enter one set of actors largely absent from the drama so far – the hedge funds. For years, they have been writing credit protection – in the form of derivatives – as an apparently foolproof way of getting cash flow. But as the Institutional Risk Analyst points out, they are not insurance companies. They do not have permanent capital or reserves. Instead, they have leverage.

So as the defaults come in, the hedge funds eat up their cash pretty quickly. That presents a headache to their counterparties – the investment banks. They will of course require more collateral as the situation worsens – but they cannot call in money which is not there.

On top of that, the investment banks face the continuing problem of structured investment vehicles, or SIVs. Some of those were funded by short-term commercial paper, and have had to dump assets – or get emergency funding from their bank sponsors – as that market dried up.

But according to Dresdner Kleinwort, a further $180bn-worth (£90.3bn) of SIVs are funded by medium-term notes rather than short-term paper. Some $40bn of that will need refinancing by April next year and a further $80bn by September. If the markets are still not open by then, the fire sale resumes.

Private equity bubble

There remains the separate question of loans created in the private equity bubble. Many of those are stuck on the banks’ books and in due course some of them will go bad.

Granted, the pain may in some cases be cushioned by the extraordinarily lax terms on which loans were issued. When you are in default, it helps a lot if you have no covenants to meet.

It also helps if you issued a so-called PIK (payments in kind) loan, whereby you jack up the principal instead of making interest payments. But none of that helps when you are actually bust.

A slightly scary case in point is Chrysler. It insists it is not in any financial trouble after its buy-out by Cerberus.

But according to the Wall Street Journal, its new boss recently told a meeting of workers: “Are we bankrupt? Technically, no. Operationally, yes.

The only thing that keeps us from going into bankruptcy is the $10bn investors entrusted us with.”

This is, as I said, a list of bear points and those of a more bullish temper could no doubt compile offsetting lists of their own. But on the basic question of the banks’ solvency, we are still in the dark, for the simple reason that much of the damage has not yet been inflicted.

Then again, as I also said, the stuff that gets you tends not to be what you worry about, but what sneaks up from behind. For us bears, that is not a particularly soothing thought either.

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