Right, so Hank's got his TARP(aulson) and Brown has nationalised UK banking Inc. The EU is guaranteeing banking deposits up to anything from €50k to €100, depending on the member state, and Ireland is extending the bank guarantee to the Irish operations of foreign owned banks. What happens next and how do we know if its working...? Lets look at the various measures of performance that could tell us.
Recently, mainstream media discovered a prime candidate for the role of Lee Harvey Oswold for this credit crisis. Strange and shady financial derivatives called credit default swaps (CDS), which are essentially bilateral financial contracts between two parties who beg to differ with regard to the creditworthiness of a specific corporate entity, have been dragged into the streets like a heretic in midst of the spanish inquisition. A credit default swap is expressed as the exchange (or swap) of a fixed rate (like an insurance premium) in exchange for a floating future payment (the makewhole difference between the recovery value of a company's loan or bond and its original value). Basically, its an insurance policy on the loan or bond of a company, in the event of its bankruptcy, for which the buyer pays a premium. This premium is considered an expression of the probability of the company going bankrupt - the higher the premium, the higher the likelihood of bankruptcy. The index of European financial CDS premiums (iTraxx Financial) first peaked at the end of July, last year, 6 weeks before the northern rock crisis made the UK even consider the possibility of a bank failure. The CDS market is a liquid and efficient measure of corporate credit worthiness and is a far more effective and informed indicator than the equity markets. CDS has been pilloried in the press as the root of all evil when, in fact, the source of much of the global bank balance sheet toxicity was actually the off-balance sheet structures that used CDS to take exposure to portfolios of corporate entities. These off-balance sheet structures are the result of teams of financiers and lawyers in banks finding structural loopholes in global company law and accounting practices, in order to further maximise its leverage - thus magnifying the exposure to extraordinary levels. The lax nature of regulatory oversight is the root of this issue, not CDS. Credit Default Swaps are in fact a reliable early warning device and a much more informed and reliable indicator of corporate health than the equity markets. The shell-company, off-balance-sheet structures that exploited their liquidity are the tragic result of a financial industry driven to ever-increasing lengths to generate respectable returns from ever-decreasingly yielding assets. As the bull market drives prices up, their yield diminishes.
Its already well established that the equity market completely failed to recognise this credit crisis on the horizon. Most equity analysts have acknowledged their complete ignorance as to the complicated nature of the various off-balance sheet vehicles operated by the banking industry and the structured assets that were contained therein. Yet, the entire mainstream media continues to focus obsessively on the Dow Jones and FTSE indices without considering what it is actually a measure of. Equity prices are, simplistically perhaps, a measure of expected future cashflows (dividends) of a company and as such, are a consensus prediction of how big a difference a company can generate between the cost of its inputs (overheads) and the price it can get for its finished product. For the banking industry, the finished product is basically the rate of interest it can get for extending credit and its main overhead is the rate at which it can borrow money (fund itself). This current crisis has been caused by the inability of banks to source funding at a low enough cost to remain solvent. The main source of this funding is the money markets, which is a very large open market for borrowing money and extending credit over a short term (typically 1 day to 3 months). This market relies on the ability of those extending credit to treat all those seeking funding with complete trust. The toxicity of global banking balance sheets has meant that most participants with funds to extend are reluctant to loan to anyone. This has caused the global money markets to effectively grind to a halt and make most banks and financial institutions to hoard cash, rather than loan it out - UBS are rumoured to be hoarding €1 trillion of cash that they are not offering into the money markets. This results in everyone chasing a smaller amount of cash, and those anything less than 100% kosher paying through the nose for even the shortest term of loan.
The day before the Irish government announced the banking guarantee, Anglo Irish Bank were sourcing funds in the money markets at an astonishing rate of 5.5% above euribor. To put this in perspective, most current tracker mortgages in Ireland are charged a rate of between 0.5% and 1% above euribor. It doesn't take a genius to see the problem there. The first thing Hank Paulson did when he got the first block of funds from the US treasury was to buy large swathes of commercial paper (short term loans) in the money markets, in order to push the cost of funding down. In Ireland, banks were immediately funding at greatly reduced rates in the money markets after the announcement of the government guarantee. These developments have had the initial benefit of ensuring the banks ability to continue operating in a solvent manner. There are many other steps for them to take before the rehabilitation is concluded. Toxic assets must be sold off by the banks, and the amount of leverage the banks utilise needs to be reduced by a comprehensive recapitalisation of their balance sheets. Only then can they look to start generating profits again. This process will cost money, which the banks will have to pay, and therefore, this will impact their bottom line profits. Given that, the equity market can expect very little in the way of dividends for the next few years from banks.
Bank stocks are weighted heavily within the FTSE 100 and so, comprise a large proportion of its value. If banks are not likely to make much profit for the foreseeable next few years, this index is bound to suffer badly regardless of the success of the bailout plans and so, is a completely irrelevant indicator as to the fortunes of the financial industry's rehabilitation. The focus by media on the FTSE is merely confusing the matter and telling us very little. We got into this mess because of the lack of attention paid towards the basic principles of finance and the credit market in particular. We will only know if we can repair the damage by monitoring the money and credit markets. The equity market tells us nothing useful at the moment - let's stop working ourselves into a tizzy by its inevitable decline.
WNgC
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