FYI | May 30 2008
By Greg Peel
It was Churchill who famously said “we are at the end of the beginning, not at the beginning of the end”. Standard Chartered’s chief economist and group head of global research, Gerard Lyons, who would like to believe that we are approaching the end of the credit crunch, unfortunately believes otherwise. He suggests the Churchillian reference is an apt one.
“We believe that we have finished the first phase of the credit crisis,” says Lyons, “and now we are about to enter the second phase. The first phase since last August has witnessed a period of intense financial stress. The second phase will be how this feeds into the wider economy”.
As noted in Part I of this article (published yesterday), the world has begun to believe the credit crisis which begun in August following the collapse of two Bear Stearns hedge funds ended in March with the collapse of Bear Stearns. Since the Fed rescue package was put in place confidence in the lender of the last resort has meant the return of risk appetite – albeit tentatively – and a reduction in some credit spreads previously blown out to extraordinary levels. There are now bids emerging for specific credit securities that were previously distressed and frozen. Even mortgage CDOs are finding buyers provided the extent of prime mortgages within the portfolio are enough to offset subprime risk.
Commercial banks, investment banks, hedge funds and all and sundry have been forced to mark distressed securities to “market”, when indeed there is no market, and as long as they have been conservative in this venture and taken the big hit up front the next step should be “write-ups” – at least at some point down the track. Yes – the US housing market is still in a slump, and foreclosures are growing as more reset mortgages reset, but if the worst is assumed on bank balance sheets right now then in theory the only way is up.
One is reminded that when the “subprime crisis” first hit the perennial bulls in the market scoffed at what they wanted to believe was a drop-in-a-bucket problem representing a mere 15% of US mortgages. In the context of all world debt markets, it was trivial. But the doomsayers warned of a snowballing problem which would be triggered by forced de-leveraging (margin calls by any other name) and the sudden aversion to risk. All risk assets were priced too low, and the subprime crisis was merely the butterfly that would create the tsunami.
And here we are.
Now the bulls are again taking centre stage with predictions that a bottom has already been seen and the market has reacted accordingly. Some of those bulls were bulls before, and some of those bulls were bears before. But the committed bears have never gone away.
Lyons believes that the focus must be squarely on the US and how problems in the US will continue to impact across the rest of the globe. A race is on, he suggests, as policymakers and central bankers try to stabilise the financial sector before economic problems hit in earnest. However, they will fail. The West in general will not be able to prevent an economic downturn and the financial sector will be “too fragile to cope”.
Defaults will rise and bad loans will increase, and banks’ asset quality will continue to deteriorate if property prices continue to fall. There will be a negative wealth effect and a negative credit effect. A deterioration in economic conditions will also likely see more skeletons emerge from cupboards. Already affected sectors have been diverse, with everything from credit default swaps, monoline insurers, US government sponsored lenders and even commercial real estate being dragged in to what started with a few silly mortgages.
(Another consideration in terms of diverse flow-on effects not addressed by Lyons is the oil price. Had there been no credit crisis would oil be at US$130/bbl today? While emerging market demand is an undeniable driving force for the oil price the severe drop in the US dollar prompted by aggressive cash rate slashing by the Fed is another. If the oil price remains at elevated levels the entire world is going to find economic growth a very difficult goal.)
If the world needed to learn one lesson from the credit crisis, notes Lyons, it is that the financial industry is cyclical. The headline in the New York Times read, “End of the Leveraged Era”. No more will good money be thrown after bad at ridiculously high levels of gearing. The only problem is, that headline is from 1990.
There have been eighteen financials crises in the West, post-war. Leading up to each case the famous line is quoted, “this time it’s different”, and the same line is quoted again on the way down. “The lessons from previous crises,” notes Lyons, “is that they can be long, the clean-up costs can be high, and, in the worst ones, there were many false dawns, when at some stage it may have appeared that the crisis was past the worst”.
Indeed there were different aspects to this particular crisis. Prior crises have not featured complex structured products based on originating and distributing mortgage debt. Prior crises did not feature off-balance sheet Special Investment Vehicles. However, the fundamental bases are the same – mispriced risk and a self-feeding connect between the financial market and the economy (in this case cheap and abundant credit was made available in response to the tech wreck and 9/11).
Another more individual feature of this crisis has been the foundation set by the emergence of the East. As Asian economies have grown rapidly their capital market diversity has not. The growth of steel production in China, for example, was a much more immediate desire than the reform of the old state-based communist banking system. This meant the billions in savings being generated by China had to be recycled through US Treasury bonds in order to maintain value. This provided the US with the means to spend those Asian savings despite there being little economic back-up beyond the status of “world’s biggest economy”. The same is true of Middle East income derived from a rising oil price. The world became imbalanced.
Lyons believes the US is in recession even though the first quarter GDP calculation is still holding on to modest growth. What is keeping the US economy’s head above water is the growth of exports brought about by the weaker US dollar. While this is dampening the potential for recession, Standard Chartered expects both the second and third quarters to show GDP contraction. “This is likely to be a longer lasting US downturn than has been the case,” says Lyons.
The reason is that this downturn, rooted in the residential housing market, is affecting the US consumer rather than the corporate sector. It will take far longer for consumers to “rebuild their balance sheets” as they turn to spending less and saving more. This will in turn drag the corporate sector down. The 2001 recession was short and shallow, featuring a “V” bounce from the corporate sector. Recovery from this recession is likely to be “U” shaped, says Lyons.
Rising food and energy costs are squeezing the amount Americans have to spend elsewhere, and a slowing jobs market, falling housing market and tighter consumer credit conditions are forcing consumers to “go on the defensive”.
From Australia’s perspective, Lyons’ parting words are the most ominous. “In coming months, we need to be prepared not just for further problems in the US, but also for markets to become more cautious regarding Asia.”
