FYI | May 21 2008
By Greg Peel
Where’s the rest?
This has been a question often asked with regard to the write-downs of credit security valuations ever since the US subprime implosion turned into the global credit crisis. It took a while before US banks began to make realistic write-downs of their exposures. At first this was because many initially believed the subprime crisis would prove inconsequential, but when that appeared not to be the case US banks were able to hide behind lax accounting laws even if it was just to buy time. This changed last November when the US accounting rules were tightened, and as a result forth quarter write-downs became much more substantial than third quarter write-downs. As the credit crisis worsened into 2008, first quarter write-downs were even more severe.
With each step along the path Wall Street became more confident of the “kitchen sink” nature of write-downs. There seems to have been more than one kitchen, and if now infamous bank analyst Meredith Whitney of Oppenheimer is correct then there’s a few more stoves, ovens and range tops that have to be thrown out as well. The large US banks have now put aside a further US$25bn for ongoing credit-related problems, but Whitney suggests that figure will rise to more like US$170bn by the end of 2008.
Nevertheless, global banks have to date written down some US$250bn in valuations of credit market securities, such as mortgage-backed CDOs. The US has represented the bulk of the write-downs, the UK has done its bit, Japan has stuck its hand up for some of punishment and even China has admitted being caught. But various calculations have put the total figure required to be written down at more like US$500-700bn. So if the US has thrown out the kitchen sink, where’s all the rest of it?
Eyes turn suspiciously to Europe.
Aside from the likes of the globally active investment banks such as Germany’s Deutsche Bank, France’s Societe Generale or Switzerland’s UBS or Credit Suisse, the rest of the myriad of European banks have been very quiet. Yet exposure to US subprime securities and other exotic high-yielding instruments has been universal. They have turned up in every pocket of the world.
Mind you, while banks across the world have also posted significant operating losses, “write-downs” do not necessarily mean “write-offs”. Write-downs simply mean a mark-to-market revaluation of uncrystallised positions. As the market for toxic securities had frozen, one could argue that “mark-to-market” should mean “mark-to-zero”, but the reality is these securities are still worth something and they have just now started to trade, tentatively, once again. There are still plenty of AAA mortgages tied up in these complex instruments that will quite happily reach maturity fully serviced. Vultures have begun moving in to relieve stressed balance sheets of that which banks would rather just offload.
It won’t be that long before we will see the first “write-ups” – further market calamities notwithstanding.
The US financial sector hit bottom on Bear Stearns Day and as soon as the Fed opened the discount window to investment banks Wall Street called an end to the crisis. The US stock market has rallied ever since, with financials in the front line. The Bank of England has taken similar measures, and UK banks have performed in a similar fashion. Shares of European banks have also rebounded. But what has the ECB done?
The ECB has pumped billions of euros of liquidity into the system, and it did rescue Germany’s IKB Bank early in proceedings just as the BoE was stuck with Northern Rock. But the ECB has not shifted its 4% cash rate one iota, even as the Fed has slashed its rate and the BoE cut as well. Moreover, the EU is not all of Europe.
The analysts at GaveKal suggest, “European banks have rebounded alongside the US banks, but the credit crunch in Europe has hardly even started and the size of the damage is not remotely discounted in European bank shares.” Part of the problem lies in “peripheral” European countries.
[A quick clarification here: The European Union is made up of 27 member states including the UK and Ireland but not including Switzerland or Norway. It includes most of Eastern Europe but not Russia, Belarus, the Ukraine or anything further east (which is Asia anyway). The “Eurozone” includes those members who have chosen to and are permitted to use the euro as a common currency. There are 15 of these but the UK, Sweden and Denmark have opted out. Some non-Eurozone EU members peg to the euro.]
Latvia, for example, is running a current account deficit of more than 13% of GDP. Latvian foreign debt has been growing in excess of 40% year-on-year since 2006 and now stands at nearly five times GDP. Eastern Europeans have borrowed heavily in foreign currency, mainly euro or Swiss francs, given much lower interest rates than local currencies. As the euro, in particular, has risen steadily, GaveKal notes this must have caused “considerable pain”. Hungarian officials have issued a warning about borrowing in yen – the currency favoured by carry-traders at an interest rate of only 0.5%.
Even larger European economies have caused the Eurozone strife, including Spain and Italy which have also run up massive debts and which threaten to destabilise the euro as a currency given the disparity between, say, Italian bonds and German bonds. Spain spent all of 2007 selling gold.
The US is possibly in a recession, given what measure you chose, and there is little doubting its housing crisis is still in full swing. However, it does seem that the worst of the liquidity crunch has past. Despite the potential for more hiccoughs, US banks have written down assets, slashed dividends, raised vast amounts of capital, and have even begun to lend to each other once more. The worst of the subprime fallout has probably past and the US bond market is no longer pricing in further Fed rate cuts.
In Europe, the situation has all seemed to remain rosy despite the “global” credit crunch and despite the strong euro, which undermines export earnings. First quater GDP growth was better than expected. But there is a growing belief that, as GaveKal puts it, that this was “the last flicker before the candle goes out”. A just-reported 1.4% slump in March construction output might be a sign.
GaveKal warns that while the last great trade was the shorting of the US banking sector, the next great trade will be the shorting of the European banking sector. At particular risk are Austria and the Scandinavian countries who are big lenders to Eastern Europe.
