Wednesday, October 15, 2008
bank debt guarantees: "passing the buck"
Consider: nearly 70 per cent of all US bank liabilities are now backed by government guarantee. Even unsecured lending is now effectively secured.
When thought about, it’s quite a significant financial credit market bottom. The pricing of credit instruments is - supposedly at least - based around the risk of default. There’s a ceiling on the upside for credit, so it’s the downside that counts. And there isn’t a downside anymore - not for the next three years on some bank issued bonds anyway (the FDIC’s guarantee lasts this long).
One can’t help but feel this is one of those things which may likely have an awful lot of unforeseen consequences. How do you price a credit instrument when the main thing it’s priced around is now discounted? Do all yields head to zero? On which note, to what extent did ever lower returns on investment-grade bonds drive the structured finance arms race that caused this mess in the first place? Mispriced credit is not good.
It is indeed an “engineered” bottom, as BofA says. By which one might read created, conjured or even invented.
And so we move to the major caveat in all this bottom-calling. The credit market ex-financials - and more or less all of the equity market - is still exposed and likely to suffer. An expression of that coming suffering, in graph form: ... we’ve dug up this chart which shows speculative grade default rates between 1920 and 2008.
The BofA call:Recovery means recapitalizing the banking system and weaning our corporate and consumer segments from a culture of debt and leverage. For corporates this phase means re-equitization - issuing equity to meet near-term funding requirements that debt markets are incapable or unwilling to provide while at the same time strengthening capital and reducing future default risks.
In short: stabilising financials and senior credit markets has passed the buck: to junk credit and to the equity market.
Last week’s huge falls in stock markets might just be the first realisation of that. It’s a credit crisis afterall, and equity is the first loss tranche.
i read this morning that treasury secretary paulson is calling on large banks, in the aftermath of massive forced capital injections, to start lending now. short of outright nationalization they very probably won't -- as paul de grauwe explained, banks are still facing massive future writedowns against which these captial injections will be held in reserve. the imaginable size of those writedowns is still expanding as recession (or worse) and consumer deleveraging become reality. (atop the leading indicators, see this morning's retail sales disaster -- and further, manufacturing is being catapulted into the abyss.) to start lending again now in size could be tantamount to suicide, and treasury cannot compel them to kill themselves. this is why recapitalization works to refire lending only in the aftermath of a serious delevering, not to prevent a serious delevering. indeed, contra lending, as john jansen notes this morning the likelihood will be for a particularly spartan revulsion to credit.
... [W]ith risk at every level reduced and balance sheets severely constrained, there will be a rationing of funds for productive and worthy ventures. Most revolutions end in excess and the revolutionary transformation of the economic landscape through which we are passing will be no different. Excessive restraint and caution will be the order of the day and that is not a salutary outcome for entrepreneurial initiative and innovation.
rosenberg is saying that the unintended consequence of backstopping all bank liabilities will be to force dilution and therefore delevering onto the corporate sector capital markets, where it will first smash the weakest links -- equities and high-yield. that pain started to become visible in high yield this past summer. more recently junk bonds went over the cliff (not to mention investment grade and munis). and we needn't revisit equities.
UPDATE: further commenting on corporate loss rates and the economics of bailing, the institutional risk analyst concludes:
In our view, the FDIC should combine an aggressive program to work through the troubled bank list with an enhanced regime of performance benchmarking to bolster the industry for approaching losses in 2H 2008 and 2009. Remember, just as the risk skew on the downside during 2004-2007 period was extreme, the mean reversion process now underway could take bank loan loss rates in the US well above early 1990s levels, the highest peak loss rate period since the Depression. The $250 billion in capital injections for the Friends of Hank will be just the down payment to get through the wave of loan losses headed for some of the larger players in the US banking sector. But don't forget that most smaller, better managed banks in the US will neither want nor need government assistance.
Many investors and concerned citizens around the world are showing their outrage at what the Federal Reserve has done to the American economy with their easy money policies which caused the credit & real estate bubble and subsequent global financial meltdown.
Join the thousands who are signing & commenting on the Abolish the Federal Reserve Petition at http://www.petitiononline.com/fed/petition.html
He is a former banker and retired president of a small Swiss owned investment broker/dealer licensed for business in 47 states.
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