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In this last Weekly of 2007, may we leave you a question to ponder on over the break? Can a massive loosening of liquidity solve a solvency problem? Obviously the question itself implies a view, viz., that the immediate underlying cause of the current prices is the fall in US (and UK) housing prices and the terrible performance of mortgage-backed securities. This immediate cause is a manifestation of the USA’s living beyond its (considerable) means. |
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It is worth recalling that the housing crisis is the underlying cause, as a return to healthy financial markets can only be achieved when the US housing market stabilises. Until then, insolvency will be hitting house owners and the holders of mortgages and mortgage-backed securities. Every attempt to bail out the victims of falling house and assets prices puts off the evil day when the mess must be cleared up, but will not prevent it. Our view is that the powers that be should let the write-offs and bankruptcies happen so that the deck can be swept clean and the extent of the damage seen, following which a fresh start can be made. Thus our own answer to this key question is, “Liquidity injection is necessary to alleviate the lack of inter-bank trust, but alone it will not solve the overall financial problem.” That will require time (months, possibly years) to allow the level of house prices to return to their trend line of steady growth, household indebtedness to be cut, and lenders’ balance sheets to be recapitalised. |
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The very fact that the EUR 350 billion “cheap” money from the ECB was taken up by banks of just about all sizes and types suggests that the funds were very welcome. However, it was interesting that 75% of the £10 billion of 3 month loans auctioned by the BOE was placed at 5.36% (UK Base rate is 5.50%, 3mth Libor yesterday was 6.39%), and the cover ratio was only 1.09, compared to an average of 2.3 for the last four monthly auctions (the highest rate at which money was placed was 6.6%, suggesting at least that somebody badly wanted the funds). The real impact of this concerted liquidity drive by central banks will be seen only next year, as in any case markets are almost frozen for bond trading as market makers close their books. The auction system adopted by central banks has overcome the fear of ignominy banks feared in using the “discount window” or its equivalent. In principle, if banks have so much cash available at a low cost, they should start lending more freely to each other, although the caution will remain until all the skeletons are revealed in all the cupboards. |
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The conduct of the banks is now becoming clearer: |
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- Move SIVs back to balance sheets
- Accept foreign investments for increased equity
- Announce new provisions for asset write-downs once the new financing is ascertained
- Sell them off slowly at massive discounts over several years, the loss on sale having already been taken on the P& L with the setting up of provisions
- A variant on the theme is to sell the doubtful assets now to a separate entity as per the proposed “super-SIV” (M-LEC) being established by several banks led by Citi and ready to buy written-down assets (it is not yet certain, however, that M-LEC will be realised)
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In this way, the disaster of a vicious circle leading to total collapse will be avoided. Here in Geneva, we happen to have lived through a housing and credit crisis starting in 1989 which lasted ten years. Yes, it took that long for house prices to start to rise again. Operating health was returned to the Cantonal Bank by massive write-offs and transfers of the assets to a separate fund which gradually sold off the repossessed properties over time. The parallels with “M-LEC” are obvious. |
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Rarely has a stable door been closed so long after the horses have bolted, as with the Fed’s current tightening of sub-prime mortgage rules! Rarely shall we witness central banks bowing to market and political pressure, preferring “to save the economy” to fighting inflation. Stagflation is a growing threat. |
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While the eurozone is just coping with the upward pressure on its currency, European countries outside the zone, notable Switzerland and the UK, are positively benefiting from currencies which are rather weak against the EUR. |
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Our consistent recommendation over the last months has been that the best place to search for extra yield was sovereign bonds in emerging market currencies. Only Mexico has let us down, although South Africa may yet do so. This recommendation holds for the New Year. |
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The next Weekly will be on the 9th of January. We wish all our readers a very happy Christmas and New Year. |
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Focus |
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(!) USA: “headline” CPI now above 4%. Greenspan has lifted the probability of recession to 50%. SocGen sees Fed rate lowered by 100 bps in 2008. Stagflation threatens. |
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(?) Rebalancing: expanding exports reflecting cheaper USD is helping the US economy possibly at expense of rest of world (we see this as a positive step in rebalancing) |
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(+) ECB: the EUR 350 billion injection at 4.21 %, which has lowered LIBOR |
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(+) Switzerland: 2007 GDP growth estimated at 2.9% for 2007 and 2.1% in 2008, led by strong industry. |
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(–) South Africa: the election of Zuma has put the ZAR under pressure |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question |
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