The price of everything

The Twelve Days of Crisis

On the first day of Crisis the markets sold to me
A sub-prime bankruptcy.

On the second day of Crisis the markets sold to me
Two structured notes
and a sub-prime bankruptcy.

On the third day of Crisis the markets sold to me
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the fourth day of Crisis the markets sold to me
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the fifth day of Crisis the markets sold to me
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the sixth day of Crisis the markets sold to me
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the seventh day of Crisis the markets sold to me
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the eighth day of Crisis the markets sold to me
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the ninth day of Crisis the markets sold to me
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the tenth day of Crisis the markets sold to me
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the eleventh day of Crisis the markets sold to me
Over-hyped underwritings
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

On the twelfth day of Crisis the markets sold to me
Central banks succumbing
Over-hyped underwritings
Hedge fund Boards all leaving
LBO refinancing
Eight salesmen bilking
Seven ‘bonds’ accruing
Six fleeced investors
$500 gold calls
Foreclosure loans
Three French funds
Two structured notes
and a sub-prime bankruptcy.

..all of which does omit, of course, “hysterical overblown relief rallies by equities”; “a craven capitulation on the part of monetary authorities to Wall Street’s narrower interests”; “disconcerting weakness at the long end of bond markets”; “rising inflationary pressure”; “the dangerous vulnerability of retailers to deteriorating consumer spending”; “flimsy fiat currencies”; “a scary succession of non-American national property markets waiting to soften, including but not necessarily limited to Australia, Belgium, Britain, Denmark, France, Ireland, Italy, Spain and Sweden”; and “defensive investing becoming paramount” – but then none of these coinages is particularly susceptible to rhyme.

Easy money

“Neither a borrower nor a lender be; For loan oft loses both itself and friend;

And borrowing dulls the edge of husbandry.” – William Shakespeare.

 

Time was when all that was needed to rectify banking problems was a raised eyebrow from the Bank of England Governor. Now it is the actions of that same Governor that are causing eyebrows to be raised throughout the markets.

 

At the 20 September Treasury Committee, Mr. King’s defence began with acknowledging, albeit with some prolixity, that “the impact on the confidence that people have in the banking system generally could have been shaken by the scenes that were seen on television”. From personal observation, the queues of Northern Rock depositors in North London last week threatened to be outnumbered by TV cameras. Reporting on the crisis was of course wholly legitimate; but the media treads a fine line between reportage and fuelling panic when the subject matter is as sensitive as this.

 

Part Two of the King defence amounted to attack: “the interaction between four apparently unconnected pieces of legislation prevented us from carrying out the operation that we wanted to do”. The (widespread and often vicious) criticism of Mervyn King for his role in the Northern Rock debacle looks unbalanced by comparison to the roles played by the FSA and the Treasury. What is now clear to all is that a tripartite system of banking regulation, oversight and support amounts, in extremis, to costly confusion and an even more costly environment of unaccountability. And we may never know the true degree to which a nominally independent Mr. King was leant on by politicians. But the Bank of England is not a lawmaker, whereas the members of the Treasury Committee are. As Mr. King pointed out, an old-style banking bailout of Northern Rock was made impossible by recent legislation: the Takeover Code prevented a rapid change in ownership, while the 2005 Market Abuses Directive prevented covert action on the part of the Bank as lender of last resort. The Bank of England was cowed by a tangle of New Labour-introduced red tape.

 

What does the Bank of England require to ensure that history doesn’t repeat itself ? “We now require a serious reform of deposit insurance, of the administration of banks, of the clash between the wish for transparency of companies to their shareholders, the tension between that and how it applies to banks when in difficulty, and the length of time it takes to deal with transfer of ownership of banks. Those four things are fundamental. If any one of those had not been there, there would not have been the problem with the lender of last resort operation.”

 

Chancellor Alistair Darling has already exceeded his authority in “guaranteeing” bank deposits with money that, underwritten by taxpayers, was never his to begin with. Evidently the Financial Services Compensation Scheme is going to be overhauled; the figure of £100,000 as a maximum level of deposit guarantees keeps floating about. Logic suggests that the banking regulator and lender of last resort should be one and the same entity. And when flawed business models run into the buffers, politicians should be forcibly reminded to be less eager to throw public money at the problem – what amounts to socialism for the rich, if you will.

 

But knee jerk reactions to otherwise unprecedented events have been remarkably commonplace over recent months. And when it comes to knee jerk reactions and a craven capitulation to powerful lobby groups, Pavlov’s dogs have nothing on Wall Street faced with the ringing of an easier money dinner gong. The response by equity markets to last week’s 50 basis points cut in Fed Funds was shockingly predictable: off to the races, again. An indiscriminate relief rally like this deserves to end in tears for at least some of its members. For the prosecution, see the house price data published in the September 15 issue of ‘The Economist’. Between 1997 and 2007, US house prices (the Case-Shiller national index) rose by 120% (OFHEO data suggest a 103% rise). Only an optimist could foresee anything other than disappointment ahead for existing US homeowners. But consider the rises experienced in other countries over the same period: Denmark 121%; Belgium 131%; Sweden 138%; France 139%; Australia 149%; Spain 189%; Britain 211%; Ireland 251%. There are obviously differing factors that moderate the rises: the role of rising real incomes and population; declines in real interest rates, and the pace of homebuilding. But the essential indication seems stark: a “bubble” in US property has triggered, one way or another, a crisis in international financial markets. There will be other national housing market shoes to drop. And lower rates on their own may do very little to boost both sectors – we have seen first hand the impact of a sharp decline in confidence on the savings system. Tighter lending standards, the reversal of 'teaser' rates and wider credit spreads may see many borrowers perversely watching their costs increase even as headline interest rates fall - let's see politicians explain that. Equity markets are in denial. Not everybody gets out of this room alive.

Not quite so wonderful

MEDIUM CLOSE SHOT –– More people have crowded around the counter.

Their muttering stops and they stand silent and grim. There is panic in their faces.

 

GEORGE

Now, just remember that this thing isn't as black as it appears.

 

As George speaks, sirens are heard passing in the street below.

The crowd turn to the windows, then back to George.

 

GEORGE (cont'd)

I have some news for you, folks. I've just talked to old man Potter, and he's guaranteed cash payments at the bank. The bank's going to reopen next week.

 

ED

But, George, I got my money here.

 

CHARLIE

Did he guarantee this place?

 

GEORGE

Well, no, Charlie. I didn't even ask him. We don't need Potter over here.

 

Mary and Ernie have come into the room during this scene. Mary stands watching silently.

 

CHARLIE

I'll take mine now.

 

GEORGE

No, but you . . . you . . . you're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house . . . (to one of the men). . . right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?

 

TOM

I got two hundred and forty-two dollars in here, and two hundred and forty-two dollars isn't going to break anybody.

F     - From Frank Capra’s ‘It’s a wonderful life’ (writing credits: Philip Van Doren Stern, Frances Goodrich, Albert Hackett, Frank Capra, Jo Swerling and Michael Wilson)

It’s difficult to write objectively about the current money market crisis, perhaps because so many greater fools have been revealed to be swimming naked. Investment banks colluding with ratings agencies and packaging liar loans and salting the vehicles with leverage and then selling the structures on to investment funds and hedge funds and.. and then all of a sudden banks aren’t willing to lend money to each other, which seems about as bad as free market capitalism can get until the banks actually start falling over, which some of them presumably will.

The Austrian school would presumably prefer to see judgment being meted out to the guilty parties. But I am increasingly minded, albeit reluctantly, to concede that a severe money markets crisis transcends plain morality when the normal functioning of those same markets is jeopardised, as it surely is today. As my friend Warwick Lucas of South African brokers Imara SP Reid puts it:

“In the middle of a shooting war, if you get philosophical about man’s inhumanity to man, there is only one outcome. You die.

“Moral hazard is something that should be assessed when a banking system is lending busily, not when it is on the ropes.”

As things stand, one plausible future looks as follows: monetary authorities implement emergency rate cuts; the dollar declines further; precious metals rally further (“fright to quality” being one of the current crisis’ better coinages); one or two pretty big lending institutions are unable to survive the liquidity drought; institutional vultures circle; risk aversion continues its belated rally; and the desperate monetary pumping starts to sow the seeds of the next debacle.

From an equity investor’s perspective, only the foolhardy (and complacent insiders, which might be the same thing) step in to buy financials here. While the Knight Vinke agitation will be music to the ears of HSBC shareholders, HSBC is, one presumes, among the category of banks too-big-to-fail. And in any case, UK depositholders will be well served by refreshing their familiarity with the maximum compensation levels from the Financial Services Compensation Scheme:

(http://www.fscs.org.uk/consumer/key_facts/limitations_of_the_scheme/compensation_limits/)

Outside HSBC, Standard Chartered looks like one of the west’s better longer term bets; as Eric Knight points out, the world’s economic centre of gravity is shifting eastwards.

Also from an equity investor’s perspective, previous recessions have by and large shown which sectors perform least worst: utilities; food groups; brewers; tobacco; consumer staples; healthcare. Energy has historically been a poor performer, but one suspects that this time round, the dynamics of the demand pull / insufficient infrastructure spend in the hydrocarbon complex will ensure a different outcome. A random array of the sort of equity holdings that should outperform the broader market in the event of a more developed economic slowdown would include, for UK investors at least, the likes of United Utilities; Unilever and Reckitt Benckiser; Diageo; British American Tobacco; GlaxoSmithKline and AstraZeneca. Insert your own national favourites here. And on the basis that Asia and other emerging markets somehow manage to pick up the slack left from a softening US (and Europe ?), the diversified mining groups (including Anglo American, BHP Billiton and Xstrata) should continue to benefit from the secular bull market for resources notwithstanding their higher market betas. (Gold, of course, is one of the most ‘special situations’, but should continue to do well as Armageddon insurance despite the sporadic sell-offs triggered by delusionally bullish behaviour on the part of the speculative community.)

Equities, of course, are not the only game in town. But when the ‘alternatives’ only trade with visible prices once a month or less, it’s so much more enjoyable to play the casino on a day-to-day basis, and see other people’s misery in real time.

“As calamitous as the sub-prime blowup seems, it is only the beginning. The credit bubble spawned abuses throughout the system. Sub-prime lending just happened to be the most egregious of the lot, and thus the first to have the cockroaches scurrying out in plain view. The housing market will collapse. New home construction will collapse. Consumer pocketbooks will be pinched. The consumer spending binge will be over. The US economy will enter a recession.” – Eric Sprott, Sprott Asset Management.

And to revisit an old favourite from earlier this year; as Countrywide CEO Angelo Mozilo outspokenly suggested:

“I’ve never seen a soft landing in 53 years.”