Keepin' It Real

One thing that separates the pessimists from the hordes of happy-talking Wall Street experts stems from how each group views the current crisis.

The optimists believe the recent upheavals are transient, akin to the fleeting gridlock that occurs when a squall suddenly rolls in and traffic back-ups as nervous drivers hit their brakes. Once the storm passes -- aided by a little help from those friendly neighborhood central bankers -- everything will then return to "normal."

In contrast, those with a more downbeat outlook feel that recent developments are only the tip of a very large iceberg and are the natural consequence of years of wanton speculation, massive overborrowing, and a hubristic disregard for myriad economic truths.

In "Banking System's Problems at Heart of the Bear Case," the Financial Times' Tony Jackson helps to flesh out, in my view at least, the more realistic perspective.

Contemplating the year ahead is, when you come to think of it, a slightly pointless exercise. It is not just that forecasts are generally wrong. More seriously, we tend to worry about stuff that never happens, while getting blindsided by events that nobody foresaw.

But financial markets are discounting mechanisms and forecasts are implicit in prices whether we like it or not. So here is my version, starting with a disclaimer.

I am naturally of a bearish disposition. This is not because I have the least aversion to wealth creation. Rather, I put it down to early training as an analyst in Edinburgh. The Scottish approach to investment is traditionally that of the surveyor rather than the estate agent: never mind the sea views, check the dry rot and subsidence.

With that in mind, the big bearish question for next year strikes me as whether the banking system's problem is one of liquidity or solvency. The central banks can fix the former.

The latter can only be addressed the hard way.

One can lead to the other, as illustrated by the case of Northern Rock. This UK bank was perfectly solvent when first hit by a liquidity crisis and is now on a taxpayer life-support system.

As to whether any big banks will go bust next year, there is as yet no saying. But sticking to the bearish theme, let us tick off some factors which make it more likely.

First, defaults are set to rise. According to Standard and Poor's, speculative-grade defaults in the US are now at an all-time low, at less than one per cent.

That compares with 10 per cent in 2001 and 12 per cent in 1990 - both recession years. But the proportion of bonds defined as distressed - that is, with spreads of more than 1000 basis points over Treasuries - is rising sharply and now stands at almost 5 per cent compared with 2.1 per cent a year ago.

That is stage one. Stage two - actual defaults - will duly follow.

Hedge fund leverage

At that point, enter one set of actors largely absent from the drama so far - the hedge funds. For years, they have been writing credit protection - in the form of derivatives - as an apparently foolproof way of getting cash flow. But as the Institutional Risk Analyst points out, they are not insurance companies. They do not have permanent capital or reserves. Instead, they have leverage.

So as the defaults come in, the hedge funds eat up their cash pretty quickly. That presents a headache to their counterparties - the investment banks. They will of course require more collateral as the situation worsens - but they cannot call in money which is not there.

On top of that, the investment banks face the continuing problem of structured investment vehicles, or SIVs. Some of those were funded by short-term commercial paper, and have had to dump assets - or get emergency funding from their bank sponsors - as that market dried up.

But according to Dresdner Kleinwort, a further $180bn-worth (£90.3bn) of SIVs are funded by medium-term notes rather than short-term paper. Some $40bn of that will need refinancing by April next year and a further $80bn by September. If the markets are still not open by then, the fire sale resumes.

Private equity bubble

There remains the separate question of loans created in the private equity bubble. Many of those are stuck on the banks' books and in due course some of them will go bad.

Granted, the pain may in some cases be cushioned by the extraordinarily lax terms on which loans were issued. When you are in default, it helps a lot if you have no covenants to meet.

It also helps if you issued a so-called PIK (payments in kind) loan, whereby you jack up the principal instead of making interest payments. But none of that helps when you are actually bust.

A slightly scary case in point is Chrysler. It insists it is not in any financial trouble after its buy-out by Cerberus.

But according to the Wall Street Journal, its new boss recently told a meeting of workers: "Are we bankrupt? Technically, no. Operationally, yes.

The only thing that keeps us from going into bankruptcy is the $10bn investors entrusted us with."

This is, as I said, a list of bear points and those of a more bullish temper could no doubt compile offsetting lists of their own. But on the basic question of the banks' solvency, we are still in the dark, for the simple reason that much of the damage has not yet been inflicted.

Then again, as I also said, the stuff that gets you tends not to be what you worry about, but what sneaks up from behind. For us bears, that is not a particularly soothing thought either.

Comments

[Contrarian Investors' Journal]

Yes, I agree with you on that. In addition, some of those optimist are those who fail to understand the concept of Black Swans and uncertainty. In "Failure to understand Black Swan leads to fallacious thinking" @ http://cij.inspiriting.com/?p=339, it quoted the parable of the turkey and ask this question:

"What do disasters such as the sub-prime crisis, probable collapse of Centro, collapse of Basis fund have in common? The common defense we hear is, “We didn’t expect it!” Those ‘experts’ often use technically sounding words like “six-sigma” to describe such unexpected events. In reality, they were just like the turkey: they think they know a lot when in reality, they know very little. That is, as what Taleb said, “compressing the range of possible uncertain states.” As a result, they were caught out by the unknown unknowns, just like the turkey. That is why economic and financial experts’ forecasts are often unreliable- in their models, the unknown unknowns do not exist and their forecasts depend on the non-existence of the unknown unknowns to be accurate. But in real life, unknown unknowns often appears unexpectedly, which serve to expose how much these experts do not know."

Many of these optimist scorned at the pessimists and label them predictors of gloom and doom. But in reality, they confuse predictions with preparing for Black Swans. To illustrate this point further, think of this: why parachutists pack a second reserve parachute? Based on statistical probability, the chances of the primary parachute failing to open is extremely slim. Does that mean this possibility should be completely ignored? This is precisely the thinking of those optimists- they jump without the 2nd reserve parachute because they only see the statistical improbability of the primary parachute failing. Worse still, those optimist thinks that by packing a second reserve parachute, a parachutist is predicting that the primary parachute will fail. Can you see the fallacy of such thinking?

Many in Wall Street are not only jumping without the 2nd reserve parachute. They are jumping repeatedly without their backup parachutes and trying out all kinds of exotic somersaults while jumping from the aircraft.