By GRAHAM FROST 22/09/2008
I was amused by a comment a little while ago by a lady who, when asked to comment on market volatility, said ‘I’ve never seen anything like this since I began trading three months ago’. With no amusement at all I can tell you I have never seen anything like this in over 20 years of investing.
Just to re-cap the middle weeks of September:
Lehman brothers, a large US investment bank, went bankrupt. This sent the message that the US would not support every bank in trouble and created market turmoil. Credit spreads – the amount of interest over the treasury rate that lenders require for risk – increased dramatically and equities were dumped across the board. On the positive side, the US Treasury effectively nationalised Freddie Mac and Fannie Mae, the mortgage giants and then AIG, a giant insurer. Government injected a reported $275bn capital into them. Central banks also announced a globally coordinated injection of capital of $180bn into the banking system to help alleviate cash shortages and, in the US, a $50bn guarantee programme for money market funds. In addition, authorities in the US, the UK and Australia banned short selling (selling stock you don’t own in the hope of buying it back cheaper later) on a number of financial stocks. A spate of bank mergers saw Merrill Lynch being absorbed into Bank of America, and Lloyds TSB proposing a takeover of HBOS. Finally, the US announced a proposal to provide $700bn in a government fund to buy the bad assets banks are holding in the mortgage market. At the same time investment banks Morgan Stanley and Goldman Sachs agreed to become normal banks and be regulated by the Federal Reserve. The era of high leverage is over.
Markets rallied as a result of all this with a variety of equity markets, including the UK, registering gains of 8% or more on Friday 19th September. Has the market bottomed? There are encouraging signs – a big spike in the volatility indices, forced selling by distressed holders, flight to safety of treasuries with no yield, and large cash positions seen in institutional accounts – often coincide with a market bottom. Past banking crises illustrate that massive intervention can work, provided the political will is there and the process proceeds speedily. What about now?
The takeout of the big mortgage providers has already driven down mortgage rates by 1% to 5.3%.The big plan is the $700bn, requiring approval by Congress, with which the government will buy illiquid mortgage assets from banks at discounted prices. The idea is to put a floor under the downward spiral in house prices and the economy, by getting banks to start lending and trust each other again. Clearly there are some hurdles to overcome. How will the price for toxic assets be determined? How will home owners with negative equity be incentivised to keep up payments? Will it force more bank write-offs and deter investors in much needed new capital? As the credit crunch has spread to other illiquid assets, will more money be needed? Will the ballooning in the US budget deficit call the dollar’s status as world reserve currency into question? Will other countries adopt the Fed’s model to bail out their own banks?
All things considered, we may have seen the turning point in the financial crisis but its fallout will last for some time in terms of slowing growth. Current pricing of equity markets indicates a lot of bad news has been priced in, but markets are likely to need a sustained period of consolidation – and further interventions – before investor confidence is fully restored.