The rally in equities and other risk assets is based on the view that the market can see the end of the tunnel for losses in the financial sector. And so, as in past recessions, as confidence returns, so will the strength of the real economy. Thats how the argument goes.
But history is no guide this time. First, markets have failed to recognize the big impact that losses among financial intermediaries will have on credit creation. Also, the credit bubble is both a mirror of and a means to finance global imbalances. If the credit machinery that allowed the imbalances to burgeon is dead, so the imbalances will disappear. But this implies a far longer and more painful workout than the markets expect.
Earlier this year, I reckoned that total sub-prime and other larger credit losses would reach $1 trillion-plus. And give or take a few billion, the IMF now agrees. Half of these losses will accrue to banks. The rest will visit non-deposit financial intermediaries (NDFIs).
Banks have already acknowledged losses amounting to about two-thirds of the total they will have to recognize. So, the argument goes, the market now knows the rest. Time to buy!
But the $500 billion of losses accruing to NDFIs are still not acknowledged and are not understood by the market. The reason they are so important is two-fold. First, the liquidity created by NDFIs is uniquely asset money and therefore affects the pricing of financial assets even more than a contraction of bank liquidity.
Second, the NDFIs balance sheets are notoriously cyclical and, when they contract, they set off a vicious circle of tightening liquidity. This is because NDFI lending uses securities as collateral. When lending shrinks, this forces the sale of more securities. This triggers asset price declines that, in turn, trigger more credit contraction as the value of collateral falls.
Far from being factored into market prices, this process has only just begun. The reason why markets have not come to terms with the impact of NDFIs losses is that in previous credit contractions they didnt matter; their balance sheets were 10% or so of those of the banking system. Now they are 40% of the size of banks balance sheets. For this reason, history is no guide.
Global credit crisis
Cost and losses to date
Source: Independent Strategy
The credit excesses that we are now struggling with were originally the means of financing economic imbalances whose core is the lack of thrift and the unearned consumption of a large proportion of the rich worlds households not all of them in the US.
This excessive consumer leverage resulted in global economic imbalances such as the US current account deficit, the China bubble and so on. For a decade or more, people were conditioned to spend what they earned plus what they could borrow on their rising asset prices. Those rising asset prices were themselves the result of excess leverage and liquidity. So there was excess leverage at two stages of the process: in hefting asset prices and in financing consumption.
The financing model that supported this is now broken. This is not because financial institutions have lost $500 billion of their risk-free capital. After all, the banks have nearly $2 trillion of the stuff in the US and Europe. While tragic for their greedy managers, the losses are by no means fatal for the financial system.
No, the model is broken because the whole system depended on the banks business model of loan origination and distribution. That allowed a bank to make a loan and then sell it off its balance sheet together with any subsequent responsibility for its quality, which, perforce, progressively deteriorated. The result was that the bank used up precious little credit capacity to make loans, which is why banks balance sheets (and total credit) exploded. That sort of lending is now over. Regulation and a return to prudent banking practice, including adequate reserves for all credit, will see to that.
If the credit machine used to finance real economic imbalances is dead, so will be the imbalances. As the imbalances are vast, it means that dragging the US and other OECD consumers back to solvency and thrift will take a very long time. As the consumer accounts for 70% of GDP, that means that the workout will also last a very long time. That does not warrant optimism about a short, sharp downturn followed by a quick recovery in the US or OECD economies.