Capital crisis

Starting out as sub-prime crisis, the present economic crisis is now called "credit crisis". And thats making central banks push commercial banks to begin extending credit. Presently only a moral suasion, its possible it may take form of more direct regulations soon. And this push for more bank lending (& thereby more assets) seems to be a case of "cause for disease taking the form of cure"!

But is this paradoxical solution because of the wrong name for the disease? To me, the issue is more of a 'capital crisis' rather than credit. Due to years of rather low interest rates, chase of yields, globalised flow of funds, limited regulatory supervison on capitalization & ability to get assets quickly off balance sheet - all meant that banks & instituions have put up huge amount of assets backed by limited owner's equity. And that equity has nowhere been close to sufficiency for stress losses, which is what is leaving them completely naked and inadequate now. As someone said, practically most of the western financial world is technically insolvent.

Now that high losses are happening, how do you balance the balance sheet? Someone has to fund them right? Initially, private capital did come in, as they thought sufficient first loss (expected loss) had been absorbed by the original equity holders. But unfortunately, very soon it dawned that they were only funding more losses. So that route stopped. 

And the losses continue....and someone has to fund it. Enter the Governments.....

If you look at it, due to the bubble across, all assets were overvalued. Which means correspondingly, on the other side, liabilities too were over valued. While market prices of stock can correct quickly, on the balance sheet, there is only so much equity (at book value). Which means other liability holders also have to bear the losses as well. Thats what happened to Lehman debt & bond holders. But obviously, Govt does not want deposit holders to bear these loses, as that would question the basic tenant of banking system. So, they step in to fund the losses.

As long as Govt capital is only going to fund the losses on existing assets, there is no way banks can start fresh lending. Its not a question of willingness; its a question of ability. They simply do not have sufficient capital on basis of which they can provide loans. Any impression that TARP & other governments' capital should be used for lending is an attempt to look away from the reality. And if banks are forced to do so, it would only mean they will have to capitalised again at not so distant future....remember there are losses still to be funded. 

Thats why, this is not about lack of credit. Its about lack of capital.

WorldyViews.com - the economic Chakravyuhah

As I read reports of further stimulus packages, new bank bailout plans in the US & UK etc., a shudder passes thru me.....have the Fed & Western Governments gotten themselves into a Abhimanyu situation - deep inside the Chakravyuhah without knowing the ways to escape alive?

Seems we are in clearly uncharterred territory. The massive amount of balance sheet the Fed is taking & yet the amazing rally in bonds (& fall in interest rates) are a clear evidence of this fact. Clearly something has to break. And even if rates continue to fall & bonds continue to rally, there would be some serious damage in the long term. Am not expert enough to predict what that would be, but its only logical to assume that currency will be devalued significantly since these bonds will be funded through printing of notes. And that could either result in massive inflation at a later point or a complete loss of confidence in currencies (Gold could be beneficiary).

Related Links:
http://money.cnn.com/news/specials/storysupplement/bailout_scorecard/index.html
http://www.moneymorning.com/2009/01/14/hyperinflation/

Another interesting point I noticed is how the focus in recent Bank results have turned to credit growth & amount of new loans disbursed. Seems the Fed is forcing Banks to ensure they use the govt funds to lend to various customer segments. British PM, Gordon Brown, yesterday is supposed to made a statement stating 'Lack of credit growth" is the "biggest issue today". This seems a bit puzzling to me. Its apparent Banks across the world grew extremely large on the back of very limited capital & while this is good in normal times, when the assets are turning bad, the sheer lack of capital is taking them to the doors of bankruptcy.
More than lack of credit, the clear & simple issue facing the financial industry today is lack of Capital. And that will be the topic of my next blog shortly.

cheers

WorldlyViews.com

Under this title, worldlyviews.com, shall be putting up views on the markets as I see it...

Jan 13th....there are ominous signs as seen in Oct /Nov period, when dow fell to 7500 levels....led by strains in the financials, 4th quarter results are expected to show how bad the economic scenario in the developed markets are & could form the basis for massive selling & new lows in the markets......
markets tested the 9000 levels & various views were getting formed that markets were forming a positive foundation & with Obama coming in & announcing a new stimulus, the markets could gain in the short term.
That positive formation is definitely broken.....markets could not hold onto the 9000 levels & momentum has decisively turned around...
Last time around, markets just about held to a huge support level - 7800 on the Dow & 750 on the S&P....With further bad news from Banks (watch our JPM cues, there could be -ve surprises), Autos, telecom & Retail companies, markets could test those previous lows.
These levels ofcourse are huge support levels....if they break, it could really be a free fall. I would bet that such a scenario would happen sometime this year. Not sure if it would happen so early in the year - maybe a fresh Govt policy whether stimulus plan or other Fed solution may help in holding to these levels. If not, then brace for some huge falls in the market.
USD/EUR could hit 1.24 & if that breaks, it could really march towards parity. And possibly good to buy Gold as well below 800.

Trading views for now.

cheers

Y 2009 - Stage is Well Set - Part 1

Hi,
Wishing everyone a very happy, healthy & joyous Y 2009. This is my first blog for the year & I propose to summarise the state of global markets & what would be my predictions for the year.

2008 has been moved into the books of history. And phew, what a year it was! An action packed year, it commenced with a US economy that was badly bruised, with alternating opinions between a serious injury to a downright cancer; the emerging markets on a heady high, seemingly operating in a different world; & popular calls were for interest rates to drop across & dollar to gain due to flight to safety.
In the end, the US disease turned out to be a big cancer, a malaise spread deep & far, needing amputation of the "Investment Bank" out of Wall Street & whose reach ensured the entire global economy was afflicted with a massive slowdown; emerging markets were brought down to earth & realised they were part of the same world; and rates did come down & dollar did gain due to risk aversion, but in-between for a period, commodities & food prices roses to such levels that Central Bankers were left fighting an inflation battle & then had to do a 180 degree turn-around with massive urgency to address growth issues in the latter part (some like Trichet are yet to recover still from the inflation hangover).

Before I move onto the expectations for this year, let me say that among the many happenings in 2008, 2 stand out in my view & will define the year -
1. It brought Credit back into fashion; a generation of professionals understood the existence and meaning of "credit risk" in the financial vocabulary;
2. Global Banking changed big time; between national bailouts of large western banks & guaranteeing of deposits by various governments around the world, international banking rules & consequent easy cross-border flow of funds changed significantly in 2008. We will see the impact of this in years to come (this is actually a topic for another day).

So whats to expect in Y 2009? Lets look at how the stage's set -
1. everybody agrees there is deep recession in the western world; & meaningful recovery is expected only in y 2010; not much bets on equity.
2. if the cause of the disease was low interest rates & easy liquidity, it also perversely seems to be the medicine for cure; so we have had more of it;
3. oil has collapsed to drastically low levels & seems due to demand destruction, commodity prices will be soft;
4. while fed fund rates are at near zero, expectation is for rates to fall especially in emerging markets;
5. & finally on currencies, its a real conundrum - with its economy in shambles, zero interest rate & high deficit, USD should be the last thing you want to hold. Yet, the world wants to keep its cash in US treasuries, since nothing else is trusted. So you have the USD climbing to healthy levels in 2nd half of the year.

Here's what I would predict for this year - (will restrict this blog to Equities) -
US Equities: Markets seem to have absorbed a lot of bad news, including the prospect of big financial & auto companies failing, US economy in official recession, & the highest jobless data for decades (possibly since WWII). So, markets are rallying on positive news & in the short term, any new Obama fiscal package could be the catalyst for a decent rally. However, any rally will be short lived, & weak economic data & a continuing bad economy will ensure there is no runaway bullish trend reversal. So expect a range bound to positive market for the first 2-3 months (8200-9600 levels).
what could make the market go higher? - as in good times, when its difficult to find reasons for markets to collapse, in bad times its difficult to find reasons for markets to zoom up. One catalyst could be a sharp fall in value of USD, leading to a rapid growth in US exports & that could lead to a quicker recovery (infact we saw a bit of it around Q2 in 2008 with good export story masking the underlying carnage in the real economy for sometime). With the impact of the massive rate cuts trickling into the economy, it could help get some stronger economic data, leading to a good move up in equities. Its a possible scenario, but don't think it would be very probable. Because of my views on USD - USD will collapse eventually but 2009 may not be the year (I'll explain in subsequent blogs).

how about on the downside? - markets can see a 2nd round of shock this year, with last year lows being broken. what could cause this scenario? simple, a continuation of 2008 will definitely lead to this scenario. Just step back & recall the massive policy responses to this crisis - the Fed & Govt have thrown everything at it so to say to save from total collapse. And they have been doing this for sometime (think of the first time they allowed Banks to borrow against illiquid collateral around the weekend of Bear Sterns collapse, the 75 bps emergency rate cut I think in May or June, coordinated rate cuts on a single day by 6 central banks around the world, TARP & other new accronyms, Banks bailout, cutting Fed funds rate to zero, subscribing directly to CP of corporate etc), with each measure being more drastic throw of the dice than previous. And each time its needed something more desperate, more ingenious, & more dramatic to keep things working. What makes us believe we are done with it & thrown the right dice finally? Infact, in truth what we are done with is monetary policy measures. There isn't much the Fed can do from here. So, people are focusing on fiscal stimulus & hoping that would help spur the economy.
The likely possibility is that there is a massive deluge & we are using some measure or other to block the breaches & preventing the tidal wave from engulfing us. And each mend has worked for a brief while, before there is a fresh breach requiring a larger mend. And while there have been significant casualties already, there is a possibility that there is not much stopping the deluge. So fiscal stimulus could be another mend. But Y 2009 could be the year of the great deluge & massive collapse of economies & markets. I would put some good probability on this because -
- the paradox surrounding the US consumer is not resolved - his massive spending & burgeoning debt has created this massive demand & asset price bubble; yet policy efforts are addressed to let him continue spending. In reality, US consumer won't be able to spend much this year & that would lead to continued & probably more demand destruction this year & no stimulus can help;
- Chinese & other emerging markets are not going to step in for the demand destruction of the US & developed economies; & the fear psyche & savings mindset of consumers in these markets will make them save more rather than less;
- deleveraging is still continuing; while there's lots of money sitting on the sidelines waiting for opportunities & those could create short term rallies, the inability of banks to lend due to shortage of capital will mean we are always on the edge & even small bad news will create panic reactions;
- what these rate cuts & fiscal stimulus will do is ensure government takes some of the tab & gives some money back to its people, to substitute partly for the massive loss in personal wealth & balance sheets.
On the balance, I think we would be lucky to escape with the lows of 2008 as the bottom. The effects of the massive rate cuts & government bailout & fiscal measures could help hold the bottom. That would be best case scenario. However, the excess of recent years & wide spread nature of the malaise could be so large that it does lead to a deflation if not depression. That would create new lows for the market this year. Only such an event would truly roll back the perils of the past & create ground for rebuilding the economy on the strength of the right pillars of investment & exports. In summary, enjoy the rallies but watch out for this scenario!

Emerging market equities - very closely tied with the US markets. Only that rallies could be sharper here, because of flows chasing better returns. After a year of massive outflows, Y 2009 could witness larger flows into emerging markets, especially if the deluge does not break through. Emerging markets too have undertaken massive rate cuts & fiscal measures & that should help keep them afloat as well for sometime. It would result in currency gains as well.
But again sell into the rallies. Higher commodity prices or the deluge break through could kill them for this year.
Better to invest in Korea, China, Singapore, India rather than Russia or Brazil.

Thats good for now. Will talk about bonds & currencies in separate articles over the week!

ciou,