FYI | May 29 2008
By Greg Peel
We hold this truth to be self-evident – when Ben Bernanke jumped in to save Bear Stearns, and then opened the Fed window to provide access to US investment banks for the first time since the Depression, on March 17, 2008, he saved the world. Ever since this much celebrated act of heroism the crisis besetting global financial markets has begun to ease.
Unfortunately it turns out the evidence suggests nothing of the sort. If share prices are any indication, we are slowly sinking back into the mire. Take Lehman Bros for example. Lehman was voted the “bank most likely to be the next Bear Stearns” back in March, but following the Fed rescue package its share price jumped from its March 17 low of US$31.75 to US$48.65 shortly afterward. However that has now fallen back to US$36.84.
Merrill Lynch was another US investment bank considered previously to be wobbling. Its share price raced from US$39.93 to US$51.75, but is now back at US$43.83. Citigroup, the daddy of them all, and combination investment and commercial bank, has moved from US$18.62 to US$26.81 and back to US$21.60. And Citi’s commercial banking rival Bank of America saw US$36.74, then US$42.45, and last night closed at US$33.87. BA shares have fallen below their March 17 low, indeed to a new multi-year low.
This all seems to have occurred with little fanfare, probably because the world has been so focussed on oil of late. But nothing gets past the London Daily Telegraph’s Ambrose Evans-Pritchard.
Pritchard notes that the cost of insuring against default on the bonds of Lehman Bros, Merrill Lynch, and other major US banks and brokerages (which are otherwise known as credit default swaps) have surged over the last two weeks, and are once again approaching levels reached when Bear Stearns faltered. At the same time spreads on the London interbank overnight rate (Libor- the rate used globally to price bank cost of funds, including Australian banks) are also back near record levels. The market had assumed once the US investments banks could borrow from the Fed, all would be well.
But there are now concerns, notes Pritchard, the Fed may be getting to the end of its US$800bn in assets it has to lend. And there remains the vexing question as where all the rest of the required credit security write-downs yet lay. Fingers have been pointed at Lehman for one, which wrote down a mere US$200m on a US$6.5bn of sub-prime debt in the first quarter, despite a quarter of those securities now having “junk” ratings.
The problem now facing the banking world is what analysts have begun to call Phase II of the credit crisis. This is not to be confused with what I have always called Wave II, which was a reference to the November-March collapse which followed the August-November rally. Waves I and II occurred within what must now be only Phase I of the crisis, if there is now a Phase II. Phase II is featuring defaults on credit cards, car loans, and new corporate loans. Notably, shares of US regional bank KeyCorp fell 10% last night after the bank announced a 50% increase in bad debt write-offs. (Not “downs” – “offs”).
Pritchard quotes a Dresdner Kleinwort analysts as suggesting “the jump in corporate bankruptcies has not yet been picked up by the usual indicators, which tend to lag the market, lulling investors into a false sense of security”.
At the same time a consortium of US banks, including Goldman Sachs, Citigroup, JP Morgan, Bear Stearns (blimey), and Morgan Stanley, has agreed to establish a guarantee fund to cover losses created in the clearing of credit derivatives. While this might sound like some sort of suicide mission, it is actually an attempt by said banks to get in before the regulators.
The fund will guarantee a central clearing house for previously opaque credit derivative contracts, due to be opened in September, which will be a joint venture of The Clearing Corporation (CCorp) and the Depository trust and Clearing Corporation of New York.
One of the problems behind the credit crisis of 2007-? is the unknown levels of risk and exposure created when two parties agree to an over-the-counter credit transaction, such as swapping the default risk on a basket of corporate debt. All sub-prime CDOs were over-the-counter, and to this day we still don’t even know where they all are. We can only trust that those parties holding such instruments have now marked their value to market. (Hello Lehman?) Global growth in the notional value of corporate debt baskets grew 81% in 2007 to US$62bn, according to the Financial Times.
With a clearing house in place, no longer will two parties need to make their own private assessments of whether the other party has the money to cover the deals, and no longer will such deals remain under the radar. The latter requires the said two parties to actually use the clearing house, but then the bank consortium is obviously assuming this is exactly what the regulators would eventually make as law. By creating their own clearing house, at least the banks are setting the goal posts themselves.
The sceptics have already said this is all just a cosmetic manoeuvre.
But while banks and regulators both move to shut several gates after various horses have bolted, those horses have now moved on to other pastures – the wider pastures of the everyman’s debt rather than just the walled enclosures of the complex credit derivative fields.
Stay tuned for Part II.
