At least the weather in London treated us to a superb weekend. The parks are full of people, slightly underdressed for the season, who are either genuinely oblivious of the clouds gathering over the markets or choose to be so.

US lawmakers are expected to vote the bailout bill through tonight. The combined political gravitas of Presidents past and future, Central Bankers & the press are weighting hard on their shoulders. The markets staged a mini rally on Friday in anticipation. So we are clear out of the woods now, aren’t we? I apologise in advance for my slightly pessimistic views on the subject and urge you to click here if you do not wish to read my ramblings.

I do think that not passing this Plan is not an alternative right now. At the same time I view this as the end of the beginning (as Senator McCain very aptly observed at the Presidential debate). There are quite a few observations and even more arguments why it is so.

Pop (news) Charts

About a year and a half ago, market professionals were already discussing about the housing bubble and the effects thereof on credit products, the economy and corporate defaults. A few were predicting grave dangers on financial institutions’ balance sheets and profitability. Even fewer were weaving disaster scenarios of a systemic meltdown and were predicting that the over-leveraging of the previous years has stretched the system close to or beyond its limits and soon some brokers, banks, insurers were heading down. Sounds familiar, doesn’t it. Well, at that point in time, they were dismissed by most as raving lunatics and their research analysis was brushed aside while exchanges and Bank stocks were breaking records. Up to 12 months ago; then more and more started to wake up to the possibility of some serious -but not life-threatening- illnesses lying ahead.

Let’s fast forward to today…Credit Crunch, broker/dealer, subprime, Chapter 11, liquidity crisis, insolvency, etc have entered the Pop vocabulary. The common man and woman on the street, be it in NY, London or Athens, talks about the systemic credit crisis and how it may affect his/her livelihood. Popular websites. magazines and newspapers feature main articles on Wall Street events. They advise people what is the threshold of their bank savings guaranteed by the State, in case the bank goes under. There are reports of wealthy individuals withdrawing cash savings and buying Treasury bills instead. Google hits on the Texas Ratio, a rough & not terribly accurate measure of the amount of liquidity risk a bank is facing as a result of over-leveraging,  are soaring. Top 10 Texas ratio charts are compiled. I don’t know about you, but personally I get the shivers because it sounds like the beginning of a hysteria. A confidence crisis paired with a liquidity crisis is catastrophic for any Bank..

Bankers Mistrust

Banks (and all other FIs & agencies) have become something between a joke’s punch line and public enemy #1. They are in the wrong (although they are not alone, everyone is too, including you and I), they are vulnerable and they are never going to be the same again. The landscape is changing but that is not necessarily good news for everyone. We experience the (re-)birth of the Superbanks, with massive market share & lobbying power. Think of JPM swallowing BSC, WaMu (and counting), BAC swallowing MER, C ready to absorb WB. Across the pond, Lloyds TSB has acquired HBOS, controlling a third of the market! Granted, Banks are weak today, but they will bounce, and the consumer may have to deal with monsters then. Unfortunately, this is a crisis and there is little room for luxury, i.e. inefficiencies are natural. But there is a far more serious issue starting with the Banks, that is the main reason for my pessimism.

Closed for business

Banks have no-option but to de-leverage. In fact they got so badly burned already and the public uproar is so big, that new, wider and more stringent Regulation will make sure that they do that. I am pretty sure that we will have excessive de-leveraging for some time; just like a pendulum after a shock, there is going to be some time until the situation stabilises.

So why is ti bad?

Before the credit crunch, economists were warning of a recession at the gates of the USA and Europe. I think we are still going to experience it, but the crisis will make it much harsher:

• the banks are very choosy about the use of their capital now. Hey, right now they don’t even lend to each other. They’d rather preserve capital for the difficult times ahead than use it to extend credit to business and individuals. After all, if recession is indeed around the corner, they need to shore up their reserves as much as they can. So, there will be very little credit flowing through the system, meaning:
  • very few and expensive corporate lines of credit
  • high borrowing costs for the said corporates if they prefer to tap the bond markets instead
  • no private capital interested any more in supplying said corporates with credit
  • high borrowing costs for individuals, prohibitive in some cases

• Unemployment has hit very high numbers both sides of the Atlantic. So, add to the above cocktail an oversupply of skilled hands leading to:
  • lower wages
  • greater job insecurity
  • less disposable income to buy cars, houses,…even less expensive products
  • no pick-up for the housing market
  • reduced revenues for the corporate sector

This is a vicious circle: initiated by the lack of credit -the lifeblood that makes the capitalist system work and grow- leading to higher corporate and personal defaults and feeding itself this way.

What about the State, surely it is the Knight in shining armor to save us from all this nonsense?

Not necessarily. The governments and central banks have already spent billions (heading to the trillion mark in the States) to support the system. As a result their ammo is running low and they do need more, if they are to attempt to kick-start growth in a stagnant economy (because of the points above). One option is to print some more USD, EUR, GBP etc. So then we can add inflation to the mix and introduce the stagflation nightmare.

Therein lies, dear reader, our pessimism for the immediate future, notwithstanding the sign-off of the bailout plan. Basically more funds are required to flow into the system to restart the capital machine. More than USD700bn. It is not very clear where these are going to come from…And if this is not enough,

The next housemate voted for eviction

Hedge funds. Hm, not so cool anymore. It is not good to be depending on leverage and liquidity for your business model when there is none around. Those banks and brokers that have so far failed learned it the hard way. HFs face a pretty grim quarter(/year). It is rumored that on the day short selling was band by the FSA the daily P/L for the London funds was -GBP1bn. I bet you, no VaR model predicted that, no matter what the confidence interval they used. Add on top of that reduced performance in a difficult market, investor anxiety and lock-in period expiration and you get redemptions. Mr rich-investor-guy says: ‘I gave you this money to generate some superior returns. It worked well for some time and we both got richer. Now markets look awful, macro is awful, regulation seems to be getting stronger, government intervention messes up your strategies. Can I have my money back now please (this is not a question)’

I am curious how many small funds will default, since they do not necessarily have the funds to pay for redemptions -leverage, bad returns remember? There is a strategy potentially..pretty scary too. Short the market when it is allowed again, go long oil, short USD. You get the picture. Result: spiralling market crash.

Europe : ‘the final countdown’

Monday is going to be interesting.

Bradford & Bingley , a British building society seems to follow Northern Rock into nationalisation. Interestingly they were still airing ads during the Singapore F1 on ITV, while the BBC was explaining to its viewers & readers that the first GBP35k they have in savings with B&B are guaranteed by the Treasury.

Fortis is struggling, to put it mildly. It is attempting to sell itself or part of its assets (ABN) to however is interested. The bank is suffering from the idiotic, ludicrously expensive purchase of ABN Amro’s Dutch and Asset Management units last year. For a Bank that had not serious exposure to ‘toxic’ debt or bad operating model (borrow liquid short term, invest illiquid lonf term), to perish because of that is astonishing.

And a final comment for the Greek market. In Greece, the markets usually react to developments from the USA and the big european ones. The population is highly leveraged through credit cards and loans. The housing market has grown many times over the last years (a bubble, yes). I hope that the reaction to the coming events will be less on the emotional & more on the rational side. That is essential, in order to avoid sell-offs and serious pain.

Thank you for bearing with me until the end. Apologies for the pessimistic tone. I believe that it is better to think these possibilities early on and prepare for them, rather than put on our rose-tinted glasses. Either that, or it’s because I was listening to the new Metallica album.