It appears free market capitalism has taken a back seat to economic socialism. For the next 30 days, perhaps it is wise to exercise the “get out of jail free card” that regulators have just given you via banning shorting.
For the next 30 days, perhaps it is wise to exercise the “get out of jail free card” that regulators have just given you via banning shorting. I’d be far more focused on using this somewhat false rally to get companies with challenged business models out of my portfolio ahead of what will be continued difficult economic times for the First World. That also should include some resource stocks if the short-covering in Australia gets out of hand in that sector.
While we will all cheer on today’s price action, let’s just make sure we take advantage of a false market and forced short-covering in names that face business model or economic headwind challenges. The next 30 days is a SELLING opportunity, not a buying one. Also, liquidity will be best in the first few days so don’t wait until day 28 to sell something.
Well, it would certainly be difficult to top the extraordinary events of the past few weeks. In fact former US Federal Reserve chairman Alan Greenspan described the recent events as part of a “once-in-a-century” financial crisis. In a very short space of time Fannie Mae and Freddie Mac have been baled out by the Treasury; Lehman Brothers has filed for bankruptcy; Bank of America has acquired Merrill Lynch; while AIG, the largest US insurance company, has been saved by an $US85 billion Fed rescue package.
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In the meantime Morgan Stanley, the largest US broker, is reportedly still looking for a commercial bank partner; while Washington Mutual, the largest US savings and loan corporation, remains in serious financial difficulty and on the brink of bankruptcy. Further, across the Atlantic, the situation is just as bad with Lloyds acquiring HBOS.
In the past, in times of severe uncertainty and financial stress, the largest institutions have always proved to be a safe haven for investors, but in the current global credit crisis, it appears the largest institutions remain the most vulnerable.
What’s happened in the US
While the failures, the bankruptcies and the mergers of the largest and most iconic US financial institutions are extraordinary, so too is the role of the US Government through the actions of the Fed and the Treasury. While investment banks have written off nearly $US600 billion in subprime-related loans over the past 12 months, over a similar period the Fed’s balance sheet has dwindled from more than $US800 billion of prime US Treasuries, to just under $US200 billion after the AIG bale-out and last week’s pledges to the Term Securities lending facility.
As a result, last week the US Treasury effectively baled out the Fed by announcing the sale of two tranches of US Treasury bills totalling $US100 billion, over and above its normal funding requirements in order to recapitalise the Fed’s ailing cash reserves. It appears no major global bank, institution, or government agency is safe in the current environment.
Consequently a complete investor capitulation, exacerbated by a healthy dose of concentrated short selling, prompted the subsequent massive sell-off global equity markets at the beginning of last week, threatening a potential systemic meltdown of the global banking system. There should be no doubt, no doubt at all, that the world financial system went to edge of the abyss of complete systemic meltdown last week.
However, enter the US Government again, and through its financial industry regulatory arm, the chairman of the Securities and Exchange Commission announced a list of 799 financial stocks on which short-selling will be banned until October. This followed a similar initiative by the UK Financial Services Authority, which imposed a four-month ban on short-selling of financial stocks. ASIC has gone a step further in Australia banning short-selling on everything for 30 days before a review. They’ve shut the gate now the horse has bolted.
However, in addition to the decision by both the US and British regulatory bodies to impose a ban on the short-selling of financials, the US Treasury has floated the idea of creating a Resolution Trust Corporation (RTC). The RTC would buy distressed housing assets, subprime mortgage loans and collateralised debt instruments to free up liquidity and recapitalise the balance sheets of the major investment and commercial banks. This plan sounds good in theory, but I believe this will be a complicated and extended process.
As a result, the US and British governments have conspired to engineer a massive squeeze and short-covering rally for global financial and banking stocks, which has been nothing short of extraordinary. The prime domestic example has been Macquarie Bank, which rose an amazing 38% on Friday and saw further short covering today. Some UK financials have risen by up to 50%. Importantly, the rally has clearly illustrated the significant role of short-selling in the recent meltdown for global financials. But does an engineered short squeeze in financials end the credit crisis?
There is little doubt that the Fed and the US Treasury had no choice but to either bale out the nation’s largest financial institutions or leave them to the mercy of short-sellers and face a systemic global meltdown of the banking industry.
Although the result has been an extraordinary rally for global equity markets, I believe two critical questions remain unanswered. Despite the abrupt change in investor sentiment, have the recent initiatives actually changed the underlying fundamentals? In addition, have the actions of the Fed and the US Treasury prevented a contagion from a financial disaster on Wall Street to a significant economic slowdown on Main Street?
I believe the answers to these two vital questions will dictate the future direction of global equity markets after the euphoria of the current rally subsides. While the majority of financial commentators have correctly observed that the current situation has dwarfed previous global financial crises, it is not fair to say that recent events are unprecedented.
Savings & loans… a replica
In fact, a quick look at history reveals that an almost identical situation occurred in the US just 20 years ago and the regulatory response was an exact replica of last week’s events. As a result, I believe it is worth recounting the events surrounding the US Savings & Loans crisis in the late 1980s and early 1990s because I think this provides a playbook for the answers to the two critical questions that will determine the sustainability of the current recovery.
The Savings and Loans (S&L) or thrifts, were regulated community-based institutions for savings and mortgages. However an act of Congress in 1980 designed to help the S&L industry retain its deposit base and to improve its profitability, granted all thrifts the power to make consumer and commercial loans and to issue transaction accounts.
As a result, after deregulation, thrifts were allowed the same powers as banks. In the real estate boom of the 1980s, they lent beyond their capabilities and expertise, to fund unprofitable home loans and risky ventures. However, further deregulation allowed them to sell their mortgage loans and use the cash generated to seek better returns. Sound familiar?
The major Wall Street firms were quick to take advantage of the S&L lack of expertise by buying the assets at 60% to 90% of their value and transforming the loans by bundling them as government-backed bonds by virtue of guarantees from Freddie Mac and Fannie Mae. Sound very familiar? Even worse, the S&Ls were the major group buying these bonds, holding $US150 billion by 1986, and being charged substantial fees by the investment banks for the transactions.
The result was a real estate crash, with more than 1000 S&Ls and banks failing. At the height of the crisis in 1988, with the failure of the large Silverado Savings & Loan, the Fed initiated a bailout that cost taxpayers $US1.3 billion. In October 1990, the Fed cut interest rates aggressively and offered open-ended support for distressed assets. Sound even more familiar? The ultimate cost of was estimated at $US160 billion, which included a $US124 billion cost to taxpayers after a Fed bale-out.
Consequently, between 1986 and 1991 the number of housing starts dropped from 1.8 million to one million, the lowest rate since World War II. It is amazing that some things never change; just last week the latest official housing figures reveal that housing starts fell to below 900,000, the lowest rate since the Great Depression.
The magnitude of the thrift failures bankrupted the Federal Savings & Loan Insurance Corporation, or the federal insurer for the thrift industry, so after the collapse and bake-out of Silverado, the government announced the formation of the Resolution Trust Corp (RTC). The RTC’s role was to close bankrupt thrifts, which totalled over 1000 by 1994, and liquidate the real estate assets and mortgages, which amounted to $US394 billion over the course of the next decade.
Obviously, the S&L disaster has some remarkable parallels to the current crisis. However, it is worth noting some very important issues. Despite the height of the S&L crisis being officially recorded as the failure of Silverado in 1988, history has a way of compressing time. The reality of the S&L crisis reveals that the housing industry remained in a protracted slump and mortgage losses persisted until 1993.
In addition, the losses of the RTC were finally unwound a decade later. Further, the bale-outs resulted in the massive US budget blowouts of the early 1990s, where the budget deficits ballooned to nearly 5% of GDP. More importantly, the weak housing market resulted in a sharp contraction of consumption spending and the US economy entered a recession over the course of 1990-91.
An analysis of the S&L crisis reveals that the recovery process from today’s “credit crisis” is likely to be protracted with a significant risk of a US recession. As a result, I feel no necessity of calling the bottom for financials. In addition, I remain wary of the sustainability of the current global financial rebound, which has been basically engineered by a short squeeze and a massive short covering rally.
Uncle Sam to the rescue
I believe the extraordinary relief rally has been driven by two issues; government intervention and government bale-outs. The common denominator is the Government and that basically means printing paper money to replace physical assets and real capital lost in the wake of the financial meltdown. In addition, the new short-selling rules open a Pandora’s Box. Where does it end? What happens to the auto sector? The airline sector?
The role of Henry Paulson, the Treasury Secretary, has been very interesting over the past 12 months. Last year Paulson and President George W Bush vehemently rejected government intervention to support distressed financial institutions. However, Paulson is now spearheading a bake-out that has already cost US taxpayers $US1.1 trillion, with the prospect of another $US700 billion for the latest rescue. There is no short-term fix here; the magnitude of this issue is nearly beyond comprehension.
Alan Greenspan views the recent crisis as a once-in-a-century event, and the consensus view is that the current situation is equal to the Great Depression and significantly worse than the S&L crisis. Considering the extended duration of the recovery process for both previous crises, I have trouble believing the current relief rally marks the end of the great 2008 global financial meltdown or more importantly, the bottom in global economic growth.
The underlying problem is that the operation of global credit markets has become dysfunctional. As a result, banks refuse to lend to other banks. The reason is simple; the major global banks realise the quality of impaired assets on their respective balance sheets.
I am reminded of a sign I saw as a kid on a wall in a country shop, which said: “In God we trust, the rest pay cash.” Unfortunately the global banking system is in the same shape. Banks are hoarding cash despite nearly $US500 billion of liquidity injections by world central banks. Credit is a dirty word and cash is king.
The announcement of a $US700 billion facility similar to the RTC of the early 1990s is not a silver bullet but it is certainly a step in the right direction. The crux of the issue comes down to complexity. The securities industry has changed dramatically since the early 1990s. The widespread use of credit default swaps has resulted in a current global market estimated at about $US45 trillion. In addition, many of the credit swaps have involved the use of mortgage-backed securities as collateral for counterparty risk.
The formation of a similar type RTC will be difficult. Unlike the 1990s, the current problem is not merely real estate assets. Considering the size of the credit default swap market, not only would the entity have to decide exactly what mortgage paper qualifies, but it may also have to decide the implications to the system.
There is no doubt some paper would not qualify, and others would have to be bought at such a discount that the losses would result in releasing limited capital for the banks defeating the purpose of the initiative. In addition, an incurred loss form a sale to the government facility would have to be reported immediately, with further ratings consequences and immediate credit downgrades.
More importantly, as Paulson commented, the key would be to ensure stability and recovery in the housing market, which remains the root of the current problem. However, Congress may be forced to consider regulating the opaque and unregulated market of credit default swaps. This would be a nightmare, substantially increasing the risk and the cost of the rescue package.
When will the recovery come?
The three main issues required for a sustained recovery in the US equity market, particularly financials, are; an end to the downward spiral of US house prices, the recapitalisation of the bank sector to promote lending again, and for a recovery in household balance sheets.
Unfortunately, all three are inter-related and despite the renewed intervention by the US Government, I believe the recovery process will be protracted. In addition, considering the waning influence of the fiscal stimulus, there is still a very good chance that the US economy will slip into a recession or at the very least economic growth remains very sluggish for the next few years.
The other issue is my belief that the US financial system is facing an increasingly tough regulatory environment, which is expected to complicate the speed of the recovery process. The magnitude of government intervention is unprecedented.
It appears free market capitalism has taken a back seat to economic socialism.
I believe this is a particularly disturbing development for the US and global credit markets. There’s no doubt that the events of the past two weeks have completely, and in some cases, irrevocably changed the economic and financial landscape.
We have essentially witnessed the end of the independent US investment banks. This has important and long-lasting implications for the cost of debt. As a result, the end of cheap and abundant credit through securitisation is finished. Consequently, business models predicated on a low-debt environment are redundant.
In addition, the recent extreme volatility will undoubtedly herald the demise of a significant number of hedge funds, which will crystallise further losses for the major global banks and financial institutions. I also believe that private equity could be another “elephant in the room”, which markets are not currently considering.
Even more importantly, the total cost to the US taxpayer is now close to $US2 trillion, and Congress is expected to pass legislation to increase the Federal debt limit to $US11.6 trillion. I believe current events will almost certainly signal the end of the global leadership for the US economy and the US dollar as the world’s “reserve” currency. This is an historic event.
I believe the actions of the Fed and the US Treasury have underwritten the long-term gold bull market. It is interesting to see the recent strength of the US dollar beginning to fade as the significant cost to the US taxpayer is revealed. As a result the Australian dollar gold price is now at record highs, and the domestic gold majors are completely unhedged with 100% exposure to the upside in physical gold.
Despite the change in short term sentiment for financials, we do not believe the recent events have significantly altered the fundamentals; I expect further US and global bank failures.
As a result, I am recommending investors use this financial short covering rally to rotate to the highest end of the risk curve. In addition, I believe domestic banks will suffer further writedowns and increased bad debt provisions as the economy slows. As a result, I feel uncomfortable with the global price/earnings premium for domestic banks and expect further multiple contraction through time.
In addition, I expect the nightmare on Wall Street will translate to a significant and extended economic slowdown on Main Street, with a US recession a very real prospect. Despite the strong underlying drivers for Australia, I don’t expect the domestic economy to escape the slowdown with domestic demand expected to remain weak. Further, while the long-term urbanisation and strong commodity demand theme remains firmly intact, there is no doubt China is slowing due to the Olympics and restrictive fiscal and monetary policy.
Considering the current uncertain environment, I feel no necessity to attempt to call the bottom for global equities. In fact, I believe such a call is basically a coin toss. I feel more inclined to highlight the emergence of value in sectors that have suffered in the broad compression of price/earnings multiples.
There are long-term positives emerging with the fall in the oil price and the positive valuation impact of falling bond yields. Our focus remains on companies with strong cash flows and earnings transparency in an environment of continued volatility and uncertainty.
Charlie Aitken is a director of Southern Cross Equities.
This article first appeared in Eureka Report