Monday, October 13, 2008
Out-running the crisis?
The caption for the picture above should be "when I hear the word 'bank' I reach for my chequebook!" The main policy of how to save banking from itself was instigated by the Irish innovative get out of jail card to the major banks. Following the non-agreement at the EU gettogether a fortnight ago, emergency actions over Fortis, HRE, Dexia and Unicredit, Iceland's 3 biggest banks, and a few others, plus the general stock market collapse (which also shredded bank capital), plus recognition that letting Lehman Brothers collapse was a big mistake, there has been a concentration of minds around the UK's SARP (Stability And Restructuring Plan) whereby 15 EU states now agree around the British Plan that they are prepared to guarantee banks' borrowings (issuance of bank bonds) with possible partial nationalisations (if nationalisation can be partial unlike pregnancy, based on public sector buying of preference share issues a la Buffet) and noises off from the USA that Hank Paulson will also dine Buffet-style and emulate SARP more than simply try to make a big success of TARP, especially after a few problems trying to whip derivatives exchanges into line over CDS clearing. The markets clearly recognised the superiority of the SARP approach and stock exchange indices have jumped today by 5-6% across the world in early trading and double this by the end of the day (historically high rises). Gordon Brown is being acclaimed as a hero. But, we should perhaps not forget that guaranteeing banks' borrowings (the bondholders) was originally the Irish government's innovation to which the British added the Buffett preference shares investment. The cost of these initiatives will be far less in actual cash or any direct financial investment than the media imagines. But,the effect is nonetheless comprehensive for now.
Last week the equities markets collapsed and many opinion influencers raised the prospect of share values falling another 50%? Why was this? In order to look forward we can only look back for comparable conditions and in the last week the overwhelming example that the media has fixed on is the 1929 crash and the banking crises of the 1930s. Even with today's strong bounce in shares, many commentators and experts reminded us that we are headed into recession; even China's growth is slowing fast, we were breathlessly told by the BBC.
Another view is that we are already a long way into a bear market, one that began in 2,000. If 1999 is coupled with 1929 the years 1929-38 and 1999-2008 are more similar than commonly thought. Up to Friday, the S&P 500's fall for the decade was identical to the decade to the same day in 1938. The pattern of the two decades is astonishingly similar, a big sell-off followed by a prolonged rally and then a fresh bear market. The key difference is that the sell-off in this decade before the prolonged rally of 2002-2008 was less severe than in the 1930s. Similarities between the market peaks in 1929 and 2000 are compelling. Both saw wildly overvalued stock markets while economies were still growing. Measures based on cash, such as dividend yield or cash flow multiples, show that the market is now much cheaper than it was during the false bottom of 2002-03, even if overall indices are still higher. We are not, therefore, in a new 1929. Our position is more similar to that of the late 1930s. That is not so encouraging: in the next decade after October 10 1938, the S&P gained only 5%.
But at least for forecasting we have a clear historical comparison, and a clear benchmark guide for how to proceed. If you are an equity investor, do not try to to work out how long the market will take to recover or when it will hit bottom - that task is for professionals and almost impossible. Use basic balance sheet analysis methods to work out how much a stock is worth and how much it would be worth if the worst came to the worst. If that calculation leaves you with a margin of safety, then buy.
From the point of view of governments shareholder value is not the priority. Government policy is haunted by whether banks' capital can be stabilised (i.e. capital reserves restored to about 12% ratio of risk weighted assets) and looking like they might rediscover traditional banking values in time to do two things: 1. buy government bonds when they are issued, and 2. maintain a higher level of lending to small businesses and relatively poor people, higher than they would do if they merely responded to events in a short term risk averse way to recession (by cutting back on all lending, except to the rich). This is not easy for governments to impose upon the banks. But it is easier if government has large shareholdings in the banks.
Before the recession, if we think of the population divided into four quartiles, the bottom quartile has no assets and not much debt, only income, the next quartile has a lot of debt and some assets but they balance out, the next quartile has more marginally more assets than debt, and the top quartile has a lot more assets than debt (many of the very rich having no debt). When recession strikes the two middle quartiles rapidly find themselves with much more debt than assets and many of even the top quartile have only marginal net assets. The super-rich, however, have a lot of net assets and the opportunity to buy many more assets very cheaply; it is how and when most of the super-rich become super-rich. Government needs the banks to help maintain the two middle quartiles in business in order for the economy to have a chance of recovery sooner rather than later. If government can win a few months for banks to get their balance sheets back in some semblance of order then there is a chance the banks will behave positively (somewhat counter-cyclically, not severely pro-cyclically). Many economists fear that the governments' rescue of the banks may be too late; they "have lost their attempt to out-run the financial crisis" (in the words of Gillian Tett, FT).