Sick financial markets – a recap(italisation)

One of our credit analysts came up to me on Friday and told me to pull my finger out and get something on the blog. So apologies for the lack of comments from mid-September. As you can imagine, things have been rather busy.

A lot has happened in the last few weeks and I thought I’d shed some light. The credit cycle has turned. Abundance of credit has given way to its utter scarcity. Companies – and people – that borrowed to grow and spend cannot ‘just refinance’ as they have done for years, but are now having to pay it back. Frequently, and increasingly, they can’t pay it back. In companies’ cases they can no longer issue new debt to repay old debt, so they have to sell assets. Depending on the nature of those assets, it could be terminal. People haven’t saved, and in a similar way to companies, those that relied on debt to keep going are not able to borrow any more.

The market was very wrong about some very important beliefs: banks and systemically important financial institutions can default. Not even investment banks that managed to survive events such as The Great Depression and the failure of Long-Term Capital Management are safe this time. A few weeks ago we had four independent broker dealers operating in the US; we now have none (since the only two "going concern" broker dealers are registered as bank holding companies). Even the larger regulated deposit-taking institutions can get into trouble and need protection for their depositors (WaMu, Bradford & Bingley). Some governments are coming out and putting their own names behind the entire banking liability structure (Ireland, Denmark). Oh, and as for any doubters about the globalisation or not of financial markets: big, systemic, deposit-taking institutions are failing or being bailed out all over the western world. The prognosis, for now at least, is that the disease is rapidly spreading: last week alone we saw the failures or rescues of more than 10 financial institutions.

The market was very wrong about another thing. There was a saying I heard long ago: "Banks don’t fail; they get cheap". If a bank started to perform badly, its valuation fell and the bank would be bought. Thus, equity holders might lose some value, and then exchange their old shares for ones in the new purchasing company. Creditors, both senior and subordinated, would just get consolidated into the new, bigger entity. Not any more. Barclays refused to resuscitate Lehman, and then bought its US operations for a bargain price the day after its failure. All senior and subordinated creditors got carried out. WaMu also showed that this ‘rescue model’ could also be applied to deposit taking institutions – all of WaMu’s group debt was left in a shell company containing none of the assets that previously supported that debt (they’ve all gone to JPMorgan). Bail-outs, though, as some used to think of them – equity holders lose and creditors are made good – do still take place: HBOS needed saving, and Lloyds was given huge regulatory and governmental support to take on all of the businesses of HBOS. But gone are the days when it was ‘safe’ to buy senior debt and to avoid subordinated debt and equity.

Lots of other things deserve comment, but one of the most violent events of the past couple of weeks was the equity and credit market sell off when it became clear that the much anticipated and much needed TARP program in the US had become embroiled in partisan issues. The markets very clearly needed this package to be passed, so the House worked around the clock to make sure it happened. The TARP was passed on Friday. And the markets relapsed. Perhaps the markets will only be happy once the banking system is nationalised with taxpayers’ injections of equity? $700bn in bail-out money is enough to buy the 10 biggest US banks at current market prices, but it is not the dose of medicine the market originally thought it would be.