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Monday, December 22, 2008


merrill: downside yet to come

via ft alphaville -- merrill's banks analyst stuart graham:

Mr Graham believes that the current consensus view of recovery in the second half of next year is misplaced. Yes, action by the authorities could provide a surprise on the upside, but in this analyst’s view a credit bubble has to be followed by a credit contraction. Period.

And that contraction clearly has some way to go. Merrill Lynch reckons large banks have so far shed €800bn of the €5.5 trillion necessary.

So far the declines in Europe are zero. Although not our base case, we see the risk of negative loan growth in the UK, Spain and Ireland possibly for the next four years.

Just to reinforce the sense of gloom, Mr Graham has a “hypothetical downside scenario” where European banks could require a further €123bn of capital, meaning that anyone trying to spot value by looking at current book values is probably wasting their time.

Here come the bad debts. Lead indicators point to a severe deterioration in asset quality. We see commercial real estate, shipping and CEE as particular hot spots. We forecast provisions of 115bps in 2009, rising to 123bps in 2010, with our stress test based off 159bps (a re-run of 1992’s 152bps).

Funding pressures remain a concern for CEOs. Maturity profiles have shortened and it is not clear to us how banks can be weaned off government guarantees and central bank repo lines. All banks are targeting retail funding but this is becoming more expensive in a very low interest rate environment.

Political risks are very high. The sector faces unprecedented political and regulatory scrutiny. Pressure on deposit spreads would normally lead to wider asset margins but can the banks put through such price increases? The threat of nationalisation hangs over some institutions.

even though that €800bn is perhaps less than 15% of the final estimated need for writedowns, one must remember that in a full-regulatory-velocity fractional reserve lending system (which is certainly what we had and more in early 2007) it probably underpinned some €8tn in potential loans. is it any wonder there is a credit crunch? and is it any wonder that the efficacy of contrived and inappropriate government efforts seems worthy of derision?

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GM-- I have to agree with this. The financial market collapse has been witnessed (though we will hit deeper lows in 2009, for sure), but the full economic collapse is only beginning. All those layoffs have yet to fully impact consumer spending, for example; there is a difference between fearful retrenchment of consumer spending and consumers literally having no money, or a few hundred bucks a week in unemployment checks.

That said, a slightly off-topic question for you: don't you think oil at this price is a no-brainer? The downside is perhaps 50%. The upside is a four bagger. Right?

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depends on your holding period, m, is my guess. i wouldn't be surprised to see oil reach further down than most expect -- is $25 out of reach? i don't think so.

the age of oil scarcity is coming, and if you can hold for the land-export model to come into effect i think you'd make some scratch. problem is, i'm not sure how global depression delays the demand development of oil exporters -- except to say that it will, probably significantly.

i've been mulling the explorers and developers, actually -- it's death for them right now, and probably for the next couple years as projects get delays and canceled. but after the storm they will be needed, and there will be a time in here when one will be able to buy them for nothing. they are essentially a levered play on WTIC, and headed through peak oil you'd think there's going to be value among the survivors of this vicious reversal and rout.

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