Don’t bank on it

“If we didn’t have bonuses, we wouldn’t have had anybody working for us.”

-      Drexel Burnham Lambert spokesperson, explaining why the company gave over $195 million in bonuses just before it filed for bankruptcy.

Time was, any self-respecting bear had to rummage hard through the financial papers to find evidence for their base case scenario of looming financial sector implosion. Admittedly, such venal conduct is frowned on by the behaviouralists, who call it “confirmation bias”, which is evidently a bad thing (even if the apparent “bias” turns out to be correct). The point being, all a self-respecting bear has to do nowadays to find evidence of imminent armageddon is simply: open the paper. Wednesday’s issue of the Financial Times was a case in point. Gillian Tett published another report from her consistently excellent coverage of the credit crisis (“Draining away – four problems that could beset debt markets for years”). Any reader who survived that account only had to turn the page to read Martin Wolf’s related discussion of the current financial crisis: “Why banking remains an accident waiting to happen”. One can only take issue with the tense: banking as accident has already happened, although admittedly it can and probably will get worse. Equity market investors can in any case no longer use the excuse that credit market problems weren’t entirely in the public domain – try and read any broadsheet without stumbling upon ever lengthening coverage.

Readers who would like to take issue with any of the above will have their work cut out but are wholeheartedly invited to do so – there is altogether too much confirmation bias going on. Perhaps the only saving grace from the current financial débacle is that, in time-honoured fashion, the ‘nouveau riche’ have stepped up to the plate to bid for assets that anyone with any taste or discernment has quietly abandoned. And so we read that Middle Eastern and Asian sovereign wealth funds have “invested” roughly $37 billion in shares of western financial companies this year. This could yet be akin to those Japanese purchasers like Mitsubishi Estates in 1989 who “invested” capital in trophy assets like the Rockefeller Center in the late 1980s - at a level that nobody else was willing to pay - just in time for them to file for Chapter 11. Or perhaps ADIA’s $7.5 billion emergency cash injection into Citigroup will prove an astute investment into a fundamentally sound business rather than into an uncontrollable leviathan with unquantifiable junk exposure employing 327,000*; and perhaps China’s $3 billion investment into private equity group Blackstone this summer won’t prove ex post facto to be the top of a secular bull market in leverage and indiscriminate risk-taking.

Adding fuel to the fire of the deflationary crisis is CLSA’s Christopher Wood, whose latest ‘Greed & Fear’ newsletter draws attention to the worrying dichotomy between government bond yields (shrinking) and interbank lending rates (rising). This is worrisome because it points to a simultaneous flight to quality and from corporate and particularly interbank risk. Quite how long this lasts is an open question, but it seems a reasonable assumption that current credit market conditions have never been experienced by those charged with navigating their firms through them, let alone by those looking to surf them for material gain. Wood suggests that

“The unwinding of structured finance is causing an accelerating global credit crunch which threatens not only US consumption but also the vigour of the current global economic cycle. Meanwhile, the risk of market-moving financial accidents is rising daily, as shown by Citicorp’s desperate sale on Tuesday of $7.5 bn worth of equity units to the Abu Dhabi Investment Authority.

“All this is why it is only a matter of time before the Fed cuts interest rates again and why there will be, sooner or later, coordinated interest rate cuts which will include the Bank of England and the ECB and maybe (horror of horrors) even Japan.”

Sceptics would be tempted to ask why, therefore, the equity markets have been surprisingly resilient ever since the credit market’s long hot summer of hate first bubbled up to the popular consciousness. The answer, as Christopher Wood and others have increasingly pointed out, is that stock markets are much more stupid than bond markets.

(Just to add some more discordant notes to the mood music surrounding stocks, Craig Karmin for the Wall Street Journal suggests that a number of North America’s most powerful investors are planning or considering making substantial reductions in their US stock holdings, including the New York State Teachers’ Retirement System, the New York State Common Retirement Fund, the Teacher Retirement System of Texas and the Florida Retirement System Pension Plan, which in total control more than $500 billion in assets. Russell Read, Chief Investment Officer for the California Public Employees’ Retirement System (Calpers), suggested that the $250 billion fund might enhance returns by moving assets from US to foreign stocks, taking US equities from 40% to 24% of its portfolio – which would mark the fund’s lowest allocation to US stocks in more than 20 years. Calpers is due to consider the measure later this month. While this would represent a zero sum game for equity markets as a whole, it is difficult to see how huge withdrawals from the US market would leave foreign markets unchanged.)

On a related issue, given the sensitivities around the importance of banking in the modern economy, let alone around individual banks’ still opaque exposure to unexploded ordinance, the tit-for-tat assaults on banking competitors masquerading as research are a more than usually conflicted and  loathsome excrescence from Wall Street. Brokerage “research” – if issued from an investment bank with enough clout – can easily become a self-fulfilling prophecy, and even faster when markets are as badly dislocated as they are today. So it wasn’t much of a surprise that shares in Citigroup fell sharply after Goldman Sachs cut its rating to “sell” with fresh predictions of as much as $15 billion in writedowns relating to CDOs. That downgrade might have looked even smarter if it had been issued, say, when Citigroup was trading at $50, when Goldman’s opinion was “in-line / neutral” (whatever that means), rather than the $32 at which it was actually released to a no doubt grateful world. The writers of ‘Long or Short Capital’ have a wicked line in brokerage tit-for-tat downgrade parody:

“In November.. Citi downgraded E*Trade and set a 15% chance of bankruptcy. Goldman Sachs downgraded Citi to a sell, forcing Citi to later downgrade Goldman from a strong buy to a mild buy.. Merrill Lynch has made plans to downgrade Goldman because of its heretofore unrevealed defence pact with Citi, but they are looking internally for a way to resolve it in the context of their downgrade non-proliferation treaty with Lehman and Goldman. Bank of America has been skating by nicely, but has its downgrade silos “hot and ready”. CSFB, in a defensive move, has.. been firing downgrades at all comers.. JP Morgan is sitting on the sidelines, just happy no one has noticed how ****** they really are. Bear Stearns has been downgraded to the point of not actually existing..”

But downgrading rivals – even in an environment of heightened investor doubt – remains childish compared to the damage that banks have managed to inflict upon themselves (and their shareholders, always the last constituency amongst any financial institution to get fed). As Martin Wolf writes, the combination of generous government guarantees (as lenders of last resort) with rampant profit-making¹ in inadequately capitalised institutions is an accident waiting to happen again and again:

“Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies.”

Shareholders in Northern Rock, and investors in equity markets wondering what all the credit market fuss is about, please take note.

*as at 31.12.2006. Whether this is a good deal for Citi or for ADIA has been covered well and extensively elsewhere. Suffice to say that we prefer to stay on the sidelines with regard to financials, even those deemed “too big to fail”. They said that about The Titanic, didn’t they ?

¹Something banks were apparently doing until the subprime crisis broke.

Comments

[ian]

couldn't the move by the big pension funds to allocate their money away from US blue chips into alternatives and international be considered a contrarian indicator? I mean, these guys tend to get very excited about what has been working, not what might work in the future.

[Charles Butler]

Tim,

OT (but not very far off, I don't think)...

Newmont's decision to re-float Franco-Nevada which will use the 1.3 bn (oversubscribed 3x, BTW, adored as it was on the TSX) to purchase the ex-parent's in house royalty portfolio? A person can think of various interpretations, some of which might arise from royalty stocks' inability to reach May highs during the most recent runup in gold, aside from Newmont's stated desire to concentrate its efforts on mining.

Cheers,

CB

[tim price]

Not so familiar with the royalty interests composition, but from what I read, there is spillover from oil and gas revenues and the new focus is evidently on gold as a pure-play, which might account for some of the performance lag ?

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