Saturday, March 08, 2008

Giving the markets the finger ... of instability

OK, one more before the "road".

Danny John and Jacob Saulwick have tried, in the SMH, to come to grips with the Big Squeeze in the markets, primarily the credit market but that is not too far removed from the equity bone.

Here are some excerpts from the story they write:
Bond traders with decades on the floor; bankers bruised by innumerable sharemarket tumbles; financiers hardened by the graft of years spent rustling up cash. All describe the scale of the present crisis as entirely new to their experience.

A career banker who spent 30 years with HSBC before taking on the leadership of Australia's third largest bank last October, [ANZ CEO Mike] Smith recalled the words of Wells Fargo chief executive John Stumpf as he addressed the Australian British Chamber of Commerce yesterday: "It's interesting that the industry has invented new ways to lose money, when the old ways seemed to work just fine."

WHAT BEGAN with pockets of the American lower-middle classes not being able to pay their mortgages - better known as the subprime crisis - has escalated into a full-blown global liquidity crunch. Every day, the headlines get worse as yet another obscure part of the vast subterranean market for debt starts to implode.

Sean Keane comes from the centre of the maelstrom. For more than 20 years the regional head of short-term interest rate trading for Credit Suisse, he has bought and sold the financial instruments that now have the world's attention.

"The extent to which the market has needed liquidity, and the speed at which credit has disappeared, is something I have never seen in any previous crisis," says Keane.

What has made the present crisis worse than any he has seen before is the scale of the markets for complex financial products that have now become paralysed.

"These markets have become so very large in the last five to 10 years," he says.

Until recently, this had been a great blessing. A vast array of new-fangled credit products allowed banks and other investors to spread the risk of borrowing and lending across a wide range of participants. The lower perceived risk had emboldened lenders, strengthened the hand of borrowers, and driven deal after deal after deal.

During the good times, all of this debt was spread far and wide to banks, hedge funds, superannuation funds - even local councils across NSW. This, says Keane, has been one of the great developments in markets that's allowed them to grow. "But what's happening now is that part of that model is being unwound very quickly," he says. Investors are no longer willing to buy the financial contraptions that have enabled the spread of risk. They want cash. And cash is now very scarce.

More broadly, questions are being asked about the business model of companies that depend on low interest rates and climbing asset values to support a flurry of deal-making - in short, the Macquarie model.

Most assumed that it would not come to this. Even as the subprime meltdown began to undermine the citadels of US banking, the global financial services industry was saying as recently as Christmas that this was an American phenomena and was almost ring-fenced. Normal service would soon resume. "Everyone was hoping that January 1, you'd come in, and things would be different. But here we are in March and things are as bad if not worse," says Febo. Initially, the major Australian banks thought they would largely escape the direct impact of the crisis and the subsequent flow-on effects through specialist debts sectors such as the mortgage securitisation market.

The low interest rates that followed the 1997-98 Asian financial crisis and the 2000 "tech wreck" helped drive what became five years of powerful and seemingly unstoppable growth for the banks and their customers.

In the euphoria, Centro Properties, Allco Finance and ABC Learning, to name but a few, came up with ever more fanciful forms of financial engineering. It worked but it required ever more leverage. Debt, though, was easy to come by and even easier to sell to investors eager to join in the profitable binge.

But debt came back with a bang last October after the subprime crisis became a wider liquidity issue. The US investment banks, which rose a boom writing loans to people who could not afford them, had their balance sheets turn to mush. Write-offs and losses have since hit an estimated $US400 billion ($430 billion) and everyone thinks more will come.

WHAT BEGAN as a loan crisis in the US has since closed debt markets, drying up the supply of money throughout the world. Spreads - the difference between official interest rates and those that markets and banks charge to lend among themselves - have blown out to astronomical levels.

Even the spread on the most secure forms of debts - senior bank loans which, if they went bad, would take the bank and possibly the whole financial system with them - has jumped five-fold.

Other forms of corporate leverage have risen to a level where lenders are charging 100 basis points - a full 1 per cent - above official cash rates set by central banks. Meanwhile, troubled companies looking to refinance their existing facilities face crippling rates of 500 to 600 basis points.

For the banks, the possibility of a bad debt problem had started a slide in their share prices in mid-October. From the top of the bull market when the ASX200 hit 6800 points in November, the index of leading companies has since slid inexorably towards 5258 points, where it finished yesterday.

Five months ago, banking industry leader Commonwealth Bank was trading around $60. By the end of this week, at just $39.52, it had shed nearly $27 billion in market value.

The rest of the sector has suffered just as badly, with market capitalisation losses totalling a further $75 billion for the likes of Westpac, ANZ, NAB and St George.

And while Australia has largely escaped the "bloodbath" seen in the global financial capitals of New York and London and as described by the ANZ's Michael Smith last month, the crisis has certainly started to ooze into the major banks' balance sheets.

Is this a blip or just the beginning?

PUT THAT same question to seasoned observers and the answer is the same. They just don't know.

Deutsche's David Backler believes part of the answer lies with the banks, particularly those globally that have had massive write-downs, with the prospect of a lot more to come.

"The market is still dealing with the new liquidity conditions in real time and it will be a while before things settle and people start acting less reactively." And that probably means, he argues, more re-adjustments and possible asset write-downs.

His colleague, Marla Heller, who heads Deutsche Australian and New Zealand leverage finance division concurs. "This credit dislocation has affected the banking sector much more than was originally expected." It "has significantly altered the fundamentals of the sector resulting in a recalibration of pricing and terms".

For Curt Zuber at Westpac, the landscape of doing business has changed. "Liquidity has been redefined," he states baldly. "Duration that was there yesterday is hard to come by. Volume that was there yesterday is evaporating," which presented challenges both for borrowers and investors.

Many in the market "found that securities previously very liquid can't be sold in stressed conditions. Credits that normally could be bought and sold with a quick phone call at a fraction from mid-market, are no longer trading, at any price. And perhaps just as importantly, market intermediaries are no longer holding large inventories. This has greatly reduced secondary market trading and pressured primary market performance."

With the US staring into the abyss of recession, what we have seen already could indeed just be the start. Smith said yesterday the global economy was weakening on the back of an international financial system in turmoil.


What they fail to note is that many, many people far more "au fait" with the workings of these things have for years now been identifying many fingers of instability in the system that have contributed to the current landslide of liquidity.

As each such finger was mentioned, the financial geniuses of this age poo-pooed the very notions and the markets careened ever higher.

Guambat has not come up with one of them, himself, but has, over the last couple of years, passed along his observations that others have made.

It is an unsatisfactory smugness knowing that these geniuses are now having to pony up their margin calls. But having had to pony up margin calls of his own on the bet that this would unwind sooner than it did keeps that little spirit of revenge-at-last dancing on Guambat's shoulder.

But to put those base emotions to one side, and avoid an "I told you so" taunt, it is worth going back to that central model of instability mentioned by Guambat 2 years ago to obtain a less panicked perspective on the "international financial system in turmoil".

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