Plenty of blood on the streets now ... another ugly close in the US last night (S&P down 4.7%, Nasdaq down 5%) has driven an equally horid session in Asia where markets are down 5-6% as I write. Morgan Stanley came under attack yesterday, its shares falling as far as 44% at one point, before closing around 20% lower. The criticism following the Bear rescue, and then that of the GSEs clearly hurt the US authorities and allowing LEH to go to the wall, and helping out AIG only on stringent and distressed terms was a very deliberate attempt to draw a line under the moral hazard problem. Unfortunately, it now appears as though the whole structure is build on moral hazard. It feels like we just had the rug pulled from under the financial industry ...
... of course, the authorities presumably knew this would happen and the situation may yet stabilise without any intervention. They will feel they've done a good thing and they'll be right. But we don't know yet if this gamble will pay off. The reality is the wholesale credit markets are closed and there is no liquidity. Without that the entire financial sector, and eventually the real economy, is paralysed.
Of the five bulge bracket firms last year only two are left, but how long will Morgan Stanley and Goldman Sachs last? This morning the talk is of Wachovia hooking up with Morgan Stanley, along the lines of BoA and Merrill ... the structural problem built into the broker-dealer model is that these guys rely on wholesale markets for the funding of long-term assets and those markets have dried up. There is a basic flaw in the model which is being painfully exposed.
Might it be even worse than that though? Stansberry and Associates wrote a few months ago that over the last three years, Goldman Sachs reported net income totaling $19.6 billion but produced a cash flow of negative $93.6 billion - a $113.2 billion disparity. Even when factoring in the returns from its investments (which produce negative operation cash flow), they end up with a net negative number of –$800 million. They concluded "I've got no doubt that Goldman has the world's smartest accountants. In fact, I wonder how many of them used to work at Enron ... "
Back home it looks as though Lloyds have agreed to take out HBOS for 2.32 with regulatory competition restrictions waived. Once in a lifetime market share opportunity for Lloyds, but can't see anything yet on ring fencing HBOS's toxic "assets."
Russia suspended trading on its exchanges for a second day yesterday as the ruble denominated Micex fell by 10% in less than an hour, despite the CB injecting $20bn into the money marketsand the Finance ministry offering $44bn to fund the country's three top banks. KIT Finance, a brokerage, went the way of the Lehman and banks are now no longer lending to one another. What a familiar sounding mess.
This is serious on a number of levels though. It has become common to benchmark current situation against the 1930s depression. Everything is the worst, the toughest, the most serious ... fill in the blank ... since the 1930s. And its true that there were many similarities between what's happened now and what happened then - the availability of cheap credit, the dangerous dependence on that credit to fund the purchase of consumer goods, stocks and fixed investment ... but there are many differences too.
Firstly, the policy response was different. The Fed believed that allowing bankrupties was the right economically and even morally as it had been warning on the dangers of reckless lending in the preceding years. As the banking system was engulfed in panic and the money supply contracted by one third the Fed sat idly by. Milton Friedman believed that this alone was the difference between what should have been an ordinary recession and the depression which ensued. The rest of the US government was similarly inactive, failing to respond with any sort of fiscal stimulus until Roosevelt's new deal in 1933. Indeed, in the meantime, the government enacted the Smoot-Hawley Act which put up trade barriers and set off a chain reaction of similar responses around the world causing a collapse in world trade.
Compare that to the central bank liquidity provision, the monetary and the fiscal stimulus we've already seen so far and the current downturn shouldn't be anywhere near what was seen in the 30s. There is no legislating for the utter stupidity of politicians of course, and there are increasingly autarkic noises emanating from the US (autarky as a policy of economic independence and non-trade was born in the 1930s incidentally) but with such a strong trading ethos throughout Europe and Asia it is difficult to imagine the world lurching back into the isolationism of the early 1930s.
But there is one more aspect to the 1930s crash which is less widely discussed - the US was then the world's biggest creditor nation. When its domestic economy hit the skids it pulled that foreign capital home, badly destabilising the countries it had invested in (most notably Weimar Germany). This time round we have seen the opposite. The creditor nations of the world in Asia and the Middle East have stepped up their investment in the US and played a pivotal role in the recapitalisation of the financial system.
Russia hasn't been a big player in that respect, but neither is Russia the only EM to be in meltdown. The Chinese stock mkt is now down 60% from its peak and its real estate market is looking dangerous indeed with home prices as much as 25% lower in major cities and annecdotal evidence of white elephants all over the country. In other words, the collateral backing of China's banks' balance sheets may not be as robust as it appeared during the upturn. Any fix will likely include their massive foreign reserves which would require a repatriation of the capital currently invested in the US. You could come to a similar conclusion looking at the Gulf states, where authorities appear to be trying their best to prop up domestic share markets while the suddenly softer oil price is reducing inflows of dollars by the day ...
Yesterday the US treasury announced it would give the Fed another $100bn to restore its balance sheet following the AIG loan. Where does the Fed get the money for all those treasuries? The printing press. The ultimate solution to this mess will be the monetisation of dodgy collateral, which may or may not lead to another sort of mess further down the line. Interestingly, gold started its staggering 10% intraday rise almost immediately following that announcement breaking its hitherto tight correlation with the dollar. The dollar this morning though, is weak ...
A study by National Bank Financial says an oil sands mine, including upgrader needs a price of $85 to be economic. Meanwhile, the financial bust is going to make it harder for firms to raise the $179bn the industry expects to need for investment over the next ten years. That's worth bearing in mind as commodity prices sink. The EIA estimated that in the next 25 years the world would need to invest $30tr to satisfy its energy needs. Estimates of the required infrastructure in clean water provision over the same period take that number up to $40tr, or $1.6tr per year. That's more than the annual run rate of the current global financial crisis, for twenty five years ...
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