The just concluded Jackson Hole conference of global central bankers and other
assorted bigwigs including the heads of International Monetary Fund and the
World Bank highlighted significant fears of underlying weaknesses.
Christine Lagarde, the former finance minister of France who succeeded the
hapless Dominique Strauss-Kahn as head of the IMF after the gentleman's career
was brought up short after a to do with a hotel maid, warned of a "dangerous
new phase" that would see a "fragile recovery derailed". Other central bankers,
including Federal Reserve chairman Ben Bernanke and the European Central Bank's
Jean-Claude Trichet, warned of risks emanating from the sovereign debt crises
in Europe and the decline of US credit ratings.
The background to Jackson Hole (or "the hole" in common slang) couldn't have
been more fraught if the central bankers had been
concerned about media coverage explicitly. Over the past few weeks, one
question has come up repeatedly given recent market gyrations - namely, are we
back to a 2008 situation for the markets. The first two weeks of August
witnessed significant spikes in volatility. The much-heralded recovery looks
not just anaemic but also poised for a reversal.
If indeed the pace of negative economic data continues - and I have no reason
to expect this not to happen - then the key question of whether 2008 is about
to repeat itself must be answered thus: no, 2011 is not 2008 but rather its
much worse. The reason is the same that a doctor would give if a patient lapses
back into symptoms of a disease after receiving treatment for a period of time:
not only does he know that the patient has a particularly virulent form of the
disease, he also understands that the disease is able to resist the treatments
he knows.
In much the same way, a downturn in economic data in 20111 comes after three
years of pump-priming by the Fed and ECB, among others. If there is no recovery
- and I have argued that for a while - then market reaction has to be
concomitantly worse than it was in 2008.
The first clue of the market's glass jaw came when Ben Bernanke refused to give
in to market hopes for another round of quantitative easing (or QE3 as it is
dubbed). After the initial market disappointment that pushed stock markets
lower, the recovery in the form of corporate earnings expectations helped to
create ideal conditions for a sell-off in gold, which tumbled over 7% over just
two days.
However, it is my view after reviewing the speeches at the hole that QE3 will
be announced by the end of September, particularly if markets continued to
drift downwards in the interim. In that event, the safest asset for investors
to hold is gold.
Poor economic data aside, the other key concern for the markets is a recurrence
of a crisis in financial companies just as in 2008. By the summer, various
companies including big investment banks (Lehman Brothers, Morgan Stanley,
Merrill Lynch), financial institutions (AIG, Fannie Mae, Freddie Mac) were
rumored to be in all sorts of trouble.
This time around, the dubious distinction has fallen at the feet of the giant
Bank of America, which saw its equity trading to around 40% of book value (a
sign of poor investor confidence in the stated figures). It did not help
matters that various folks on the Internet - who may or may not have known what
they were on about - started publishing estimates of new capital required by
the bank exceeding $100 billion. For context, the bank's stock price implied a
capitalization of $65 billion at its lowest point last week.
The famous investor Warren Buffett, aka the Sage of Omaha, after failing to
rescue Lehman Brothers in 2008 (he instead invested $5 billion each in GE and
Goldman Sachs), jumped to the rescue of Bank of America by plonking in $5
billion on preferred stock carrying a 6% coupon (against 10% in 2008 that he
charged Goldman Sachs and GE), leading to a smart recovery in the company's
share price.
On paper, the fact that Mr Buffet's $5 billion was made available for less
coupon than in 2008 is good news. However, the move itself does beg a bunch of
questions:
a. Berkshire Hathaway owns 6.67% of Wells Fargo, valued at $8.6 billion,
and has $5 billion each invested in Goldman Sachs and GE Capital. All three
firms will see their stock prices blown to bits if something happened to Bank
of America. In that context, the money may be considered more of a safeguard of
existing investments than "risky" money. In any event, with over 10% of
American deposits in its coffers, it is extremely unlikely that any government
will allow Bank of America to go bust: Mr Buffett is a preferred shareholder
rather than a common stock shareholder, therefore he will (or at least most
likely) not be wiped out by a government takeover. b. The timing of the
investment, a day after Bank of America publicly rebuked Internet rumors and
reiterated that it had no need for capital, left much to be desired; suggesting
as it did that not only was the bank in need of capital, it also could raise
rather expensive capital. c. Then came reports of the bank wanting to
sell down at least half of its 10% stake in China Construction Bank: another
sign of weakness.
All that said, it is not as if Bank of America is the only problem in global
banking today. A casual look at the LIBOR - OIS spreads for the euro on
Bloomberg shows a recurrence of the "credit / counterparty" worries that
rollicked the markets sharply over the course of 2008. (The spread between the
London Interbank Offered Rate or LIBOR and the Overnight Indexed Swap or OIS
shows the relative risk for banks to lend to each other rather than merely
exchange floating rate versus fixed rate payments. This spread, which no one in
the financial markets paid attention to before 2007, has since then assumed
great importance.)
In contrast to the widening spread in the euro, the picture for the US dollar
is relatively stable. This would suggest (all other things being equal
including the "natural" demand for a currency) that euro-domiciled banks are
poorer credit risks than US-domiciled banks.
The primary area of market concern for markets with respect to European banks
is their exposure to highly indebted European sovereigns. Weeks after a
much-heralded 135 billion euro (US$196 billion) rescue of Greece, the dust
hasn't yet settled, with a number of questions that I raised at the time still
being unaddressed.
Worse (if that is indeed possible), Greece on Friday warned it may scrap the
135 billion euro swap if less than 90% of private investors voted in favor of
the deal. Here is a borrower playing tough with its lenders who are going quite
literally out of their way to accommodate its various requests and conditions
... gee, thanks Keynes.
No wonder Christine Lagarde of the IMF at the hole over the weekend, called for
a "mandatory" capitalization of European banks, which would suggest a number of
equity shareholders are in for a bit of shock when they return from their long
European summer holidays.
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