The world of investment has changed since the end of February. Bear Stearns wasn’t the most prestigious Investment Bank on Wall Street, nor the best loved. But it was a significant front line player and its rapid departure from the scene is a shocking event.
Bear was a victim of illiquidity. It may be that it was insolvent too, but it didn’t last long enough for us to find out. Markets, especially debt markets are illiquid today because institutions that normally share their surplus balances are unwilling to do so today. Market sources of short term borrowings are not viewed as reliable and participants worry about more losses to come, so the rule of ‘every man for himself’ applies even more strictly than usual.
Bank losses shrink their capital. The maximum ratio of lending to capital is fixed, so shrinking capital means calling back loans. This deleveraging process reduces the size of the balance sheets of the Banks as liquidity dries up. But there is a further problem. In the past 15 years, Banks have ‘improved’ their business model. Instead of keeping consumer, corporate loans and mortgage loans they originated, Banks sold them on to packagers of structured credit. Structures were financed in Bond markets when the going was good, but there has been no good going since the middle of 2007. Credit markets are jammed up. As historic financings fall due, holders of structured paper become forced sellers, pushing prices lower and adding to the misery. If the pool of Structured Credit securities were not so big, it might not matter. But the nominal value of the securities outstanding in CDO’s and ABS is roughly half the size of the loan portfolios the Banks kept on their books. The overhang of these illiquid securities in the market is stifling liquidity and provoking fear. It can be mended, but, for now, the system is broken.
Sunday’s decisions on Bear Stearns provide positive answers to some important questions. The unsupervised world of Structured Credit is outside the banking system and lacks a ‘lender of last resort’, there to provide liquidity to quality assets in times of stress. In the measures announced along with the Bear rescue, there is wider access to the discount window for Wall Street firms. Sunday’s measures may not go far enough, but the key decision is to begin widening access to the facility. This will eventually improve the chances that lenders will feel able to extent short term credit to one another again. The second critical development is the decision, for the first time since the Great Depression, to use US Taxpayers money to defend the Financial System against collapse. They will do it again if they have to, no big Institutions will be allowed to fail.
Both of these decisions are helpful, but we do not expect them to be sufficient to reverse the disruptive effects of deleveraging. If the employment data are a good guide, US GDP growth is slowing and is likely to go into reverse. In the language of the British Railway Network, there is a sense in which this is the ‘wrong type of recession’ for the politicians and Regulators. They have the experience and the policy toolkit to cope with Financial Sector and Emerging Market crises (1998, LTCM and Russia and1987) and crises driven by job losses and income reductions ( The Great Depression and the 1972/3 Oil Crisis in which spending power was transferred abruptly from Western consumers to Middle Eastern States). In this case, the problem looks like an excess of leverage. And now that the excess is obvious, asset markets are falling. US housing indices are down something approaching 10% since this began. Housing is the most widely held asset going. In total, it is as large as the US equity market or twice the size of the combined Treasury and Corporate bond markets. It is also twice the size, in $ terms, of the Personal sector component of GDP. So, oversimplifying, each 1% off housing values destroys as much net worth in the balance sheet of US households as a 2% drop in income. The implications for consumer confidence and behaviour are showing through now.
What are the conditions necessary to bring the GDP decline to an end? Asset markets need to find a floor, not necessarily recover, but stop falling. In housing, this means that finance needs to be available to new buyers. The price of credit has dropped which is good, but it is availability that is critical. Lenders need to be ready to seek new business.
Whatever the pace of household creation in the US, there is no such thing as a forced buyer of a house, just forced sellers. It is hard to visualise that many buyers will press ahead while there is an overhang of foreclosed property overshadowing the market. What is true for housing is broadly true for other asset markets. If an investor is holding cash, the unleveraged return available from an asset he is tempted to buy has to rise to an irresistible level to entice him to add new risks to his portfolio. He will need a fully functional market to enable him to have confidence that he knows the price for the asset. He will take comfort if he knows that Banks will finance owners of good assets. Finally, if the asset is collateralised, he will want to see forced selling of the collateral pass its peak. These conditions do not seem likely to prevail for some months yet.
The extent to which excessive leverage is capable of destabilising other economies varies widely. Our themes reflect our assessment of those regions and industrial sectors that are best able to thrive in the present conditions. Our manager selections reflect the same endeavour to concentrate on those that have the experience and the skill to identify opportunities in adversity.