06/10/08
The battle to bring the financial crisis under control
There is a famous quote from the first world war, by a French general defending Paris: "My centre is giving way, my right is in retreat; situation excellent. I shall attack!" It may seem strange to begin an edition of Global Spotlight with a military quote, but the parallels are worth examining.
Investors have felt shell shocked in the past month. As commentators such as Alan Greenspan have pointed out, the current financial crisis is the worst since the 1930s. Over 25 financial institutions, high street names such as Bradford & Bingley, investment banks such as Morgan Stanley, lesser known but significant firms such as AIG, have either been rescued by governments, fallen into bankruptcy, or forced to change their business model significantly - Goldman Sachs is now a commercial rather than an investment bank.
Why the collapse and why so sudden? The problems are highly complex. Banks and other financial institutions over-extended themselves, through mortgage lending, poor risk analysis behind credit derivatives, and large M&A deals at prices which now look too high. Global losses for the banking sector alone are approaching $600bn, with more for other investors: for example the bankruptcy of Lehman Brothers caused losses for bond holders estimated to be about $110bn. One major difference between this banking crisis and its predecessors is that the pain is much more widely spread across, and in the case of some complex credit derivatives rather hidden globally.
For the past year, banks have been desperately trying to sell assets, curtail new lending, and in particular to raise new capital - well over $450bn by early October. In recent weeks more and more financing avenues have begun to shut down. When governments rescue banks, causing losses to existing share and bond holders, it deters other investors from putting capital into the remaining banks for fear of further losses. Most worryingly, the wholesale money markets have begun to freeze - financial institutions and money market funds have become wary about lending to each other. Increasingly lending has become very short term, or required a hefty premium. The standard lending rate between UK banks is currently over 1.5% above base rates, in the US it is almost 2% higher. Banks are so fearful about lending to each other, they are depositing spare cash with the central bank. Investors are so worried about holding bank accounts that some are buying gold, while the flight into safe haven US 3 month Treasury bills forced the yield close to zero on certain days.
Banks offered loans liberally in 2006 and 2007 - now in 2008 they are in rapid retreat. The number of mortgage products available in the UK is about one quarter its previous level, with noticeably higher fees. The credit squeeze has worsened in recent days. On top of the pressure on incomes from rising inflation and higher taxes, the consumer has pulled back: US car sales in September were their lowest for several decades. Weaker domestic demand has transmitted itself overseas; business surveys showed a noticeable slowdown in new orders across the summer, and then a plunge in September.
Economic data in the past month has been bleak. All the G7 economies appear on the verge of recession in the second half of the year. Emerging economies show at best trend growth. Companies are taking more desperate attempts to cut costs: US unemployment has risen sharply in recent months. The consensus economist has faced up to reality, and now forecasts recession until at least spring 2009, possibly next summer.
Stock markets have been very weak; indeed the US equity market has fallen for four successive quarters for the first time in 20 years! The pain was originally seen in the financials sector, but more recently investors have begun to realise that the real economy will suffer weak profits too. Energy and mining shares led global stock markets lower in the past month.
The aptness of the first part of the quote from Marshall Foch may now seem apparent. Many investors are scared. Our analysis shows extremely high levels of risk aversion, shown by the levels of cash built up in accounts, or the large price discrimination between assets that differ only slightly in risk, for example the wide spreads in prices of bonds issued by different European governments.
How is the second part of the quote apt: "I shall attack"? This reflects two points. It is at times of maximum pain that the professional investor puts cash to work. Warren Buffet has invested large sums into Goldman Sachs and GE in recent days, although admittedly on generous terms! Santander, Barclays and BNP Paribas banks bought businesses for much lower prices than would have seemed possible even a few months ago.
Secondly, policy makers finally understand the dangers around them. Media attention in the past few weeks has almost entirely been on the US $700bn package proposed by Mr Paulson - would it pass or not? Our view has always been that the package is a necessary but not a sufficient condition to bring stability to the situation. Certainly removing much of the bad debts from banks will help them but a whole series of other measures are traditionally required to deal with banking crises: re-capitalisation, liquidity facilities, nationalisation.
A multitude of proposals have finally begun to appear from different governments. The UK government has announced an injection of £50bn capital into the major banks, combined with sizeable debt guarantees and liquidity facilities. The Irish and then several other EU governments have agreed a blanket guarantee on bank deposits. The French have called for talks on altering mark to market accounting rules, which would ease the pressure of bad debts on bank balance sheets. The US Federal Reserve has announced larger funding programmes both for the banks and US companies. Speeches from Mr Trichet, the ECB President, and then Mr Bernanke, the US Federal Reserve chairman turned much more dovish. This culminated in a well co-ordinated series of interest rate cuts by all the major central banks which surprised the markets. Our House View expects that interest rates in most of the larger economies will halve in the course of the next 12 months or so.
All in all, the policy response has moved up a gear, in terms of stabilising bank balance sheets and the wider economy. The battle to bring the financial crisis under control will take time. Hedge funds are still forced sellers, as they face financing problems. Financial markets will remain volatile, until they are much more sure that losses and defaults are limited and future earnings growth can be positive. Investors can increasingly find good value opportunities. Politicians face elections, and angry electorates - action will be taken!
Andrew Milligan, Head of Global Strategy at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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