Tue, 14/10/2008 - 07:05
Resolution Asset Management investment manager Stuart Thomson says the UK bailout blueprint for the financial sector that been adopted by the rest of the world, a combination of equity injections, loan guarantees and depositor protection, is not the worst solution - it will prevent global depression - but a second worst solution that will not prevent a prolonged recession for the world's major economies.
The UK solution to the banking crisis was grounded in a Treasury Select Committee trip to Japan, where members were told that a piecemeal strategy toward solving the banking crisis would be counterproductive and nothing short of a full bailout of the banking sector would be effective.
Last week's collapse in risk appetite was exaggerated by the breakdown in market liquidity. The British option is being adopted globally, but this is not the disciplined cavalry of the Heavy Brigade, rather it is undisciplined hordes of Mongol cavalry riding to the bureaucratic conquest of the financial system. The initial objective of the G7 cavalry, stabilisation of financial markets, is likely to be achieved with the help of the big guns of central bank liquidity and the foot soldiers of financial issue guarantees.
The statement from the G7 finance ministers' meeting at the weekend laid out the guiding principles:
'1. Take decisive action and use all available tools to support systematically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitised assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.'
The absence of waffle in the statement showed that for once governments' mean business, although the 'consistent implementation of high-quality accounting standards' has been interpreted loosely, with the European Commission and Securities and Exchange Commission recommending the partial suspension of mark-to-mark accounting.
The direct injection of equity into the domestic banking will prevent failures. Once again the Japanese example is appropriate since the Bank of Japan's initial investigation into the extent of bad debts provided estimates that were only 10 per cent of the total.
The UK Treasury has spent the weekend investigating worst-case scenarios and determined that GBP37bn is required. This is GBP12bn higher than last week's initial offer of GBP25bn, with the promise of another GBP25bn if required. At this stage it is still too early to determine whether more will be required, but the odds favour another substantial injection next year.
In the US, the Treasury is proceeding with its loose interpretation of the Troubled Asset Relief Program to provide equity guarantees to the financial sector as well as the removal of their toxic debt, a factor that has been made it easier to inject excess capital by making the accounting treatment of level two and three assets more opaque. The new rules will place greater reliance upon management valuations of these assets.
The USD700bn for the TARP is still too low; the number was plucked out of the air to scare politicians and the electorate. The electorate are scared and blaming the Republicans, implying that unless there is an international geopolitical crisis over the next three weeks Barack Obama's victory is assured, but USD700bn is not sufficient to cope with the delinquency rates in the residential property market.
According to State Street, the residential property market is USD14trn and dwarfs the commercial property market, which is worth only USD3.4trn, but historically default rates in the commercial property market have been significantly higher than residential, peaking at 12 per cent in the 1990-92 recession. This would imply an additional USD200bn worth of losses if 1990-92 conditions are replicated, but the rapidity of the commercial property boom and use of financial engineering and leverage for these loans suggest that delinquencies will be higher, indicating that an additional USD225-USD250bn will be required for this sector.
Act in haste, repent at leisure. Heroic fire fighting is likely to be successful, but like the Mongol hordes, the rescue of the financial system is likely to leave economic devastation in its wake. The global bank bailout is not the worst solution; it is merely the second worst solution.
The G7 has saved the global economy from depression, but actions so far are unlikely to prevent a substantial recession followed by a sluggish recovery toward trend. Increased financial market regulation, inflation-targeting central banks and the legacy of the massive expansion of fiscal policy to bail out the financial sector and other segments of the financial system will all act as constraints upon any recovery.
There are two further problems that need to be addressed. First, you can lead an investor to liquidity but you can't make it borrow. Privately the Bank of Japan's attitude to Ben Bernanke's 2002 Helicopter speech, that in the event of a debt-deflation liquidity trap the central bank would adopt unconventional monetary policy and in extremis could literally throw money out of helicopters to encourage consumption and jump start the economy, was that it was dangerously naïve. Certainly, the Bank discovered that consumers and corporates were reluctant to borrow despite the guarantees provided to the banking system. This represented the legacy of their previous borrowing binge.
A similar scenario is likely to unfold amongst Western economies. Cash is king for corporates and consumers need to rebuild their savings rates, particularly in the Anglo-Saxon economies. The second problem facing governments in the wake of their massive bailout is one of crowding out. This is clearly evident in the UK forward interest rate market, where short-dated real forward interest rates have risen sharply over the past few weeks.
Five-year real yields deflated by forward inflation expectations are 3.5 per cent more than productive economic potential and prospective economic growth. These are excess and reflects the Debt Management Office's decision to begin funding the bank bailout in the current fiscal year. At the same time long-dated nominal forward rates have fallen sharply. This shows those investors' expectations of future inflation in 20 years' time has fallen sharply, indicating that they believe that long-term productive potential rates have fallen similarly.
Crowding out should be avoided. Government debt managers are understandably nervous about the consequences of auction failure, while at the same time are keen to reassure voters that the crisis will be of short duration and that issuance costs will be minimised. These base emotions should be resisted. The best way to avoid re-issuance risk and help bail out the banking sector is use the funding programme to help steepen the yield curve.
The resulting rise in long-dated gilt yields will also help the equity market by raising the discount rate for pension funds. The Dutch pension fund regulator's statement last week that it would not force funds to de-risk even if their solvency ratios dropped below 105 per cent was a welcome attempt to interrupt the negative equity spiral.
The economic consequences of the financial market panic will be clearly evident this week. The US retailing sector appears to have been the first to effectively cancel Christmas, by substantially reducing their orders and inventories in the wake of disappointing back-to-school sales in September. The August trade data heralded the weakness of demand in September, with the trade deficit narrowing more than expected to USD59bn and to just USD39bn in real terms (the lowest since 2001).
Imports decreased by 2.4 per cent as crude oil, autos, electronics and technology imports declined. Exports orders also declined by 2.0 per cent as the global economic weakness spread. The trade data is another sign that Wednesday's retail sales data is likely to be significantly weaker than the consensus expectation of a 0.7 per cent fall in headline sales and a 0.2 per cent decline in core sales. The latter is particularly optimistic, given weekly chain store sales, as well as consumer confidence, consumer credit, lending criteria and employment data.
We believe that economists are now as reluctant as equity analysts to mark down their estimates. This is a dangerous since it is likely to exaggerate market volatility. Volatility is likely to be driven by market illiquidity in fixed income as well as risk assets. The VAR trading models are also likely to contribute to volatility, as trailing volatility will force further reduction in leverage.
The increase in economic volatility as economic data produces a series of negative surprises over the next month is consistent with our view that any improvement in risk appetite will be tactical rather than structural and that government bonds will outperform risk assets during the first half of 2009. Citibank's US economic surprise index has already dropped precipitously from its early September high of 70 to the latest level of -6.9.
While this has a long way to go to compete with Europe's level of -70, we believe that this gap will narrow in the near-term to the detriment of the dollar in the short term. The sterling economic surprise index of 2.70 shows how the currency's recent poor performance is inconsistent with the government's aggressive intervention in the financial sector and the relatively high interest rate differential.
Once again we view the prospective rally in sterling as a tactical rather than a structural trade. This is a dead cat bounce on the edge of the cliff. Government interference will reduce productivity and growth in the medium term, while the immediate threat of recession, coupled with our massive current account deficit and understandable reluctance of overseas central banks and sovereign wealth funds to absorb their share of the government's massive issuance, will cause further currency weakness next year.
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