It Isn’t Over Until the Fat Lady Sings

Big caveat: even though we have very strong opinions, we do not give investment advice. What we provide (aside from commentary) might be regarded as investment hazard warnings. You may nevertheless decide to go ahead after reading what we offer, but we hope you will proceed with caution. One thing most investors fail to realize (and we have made this mistake ourselves) is the warning from mathematician and market maven Benoit Mandelbrot: “”Markets are very, very risky – more risky than the standard theories assume.”

The thought for today is that oversold does not necessarily mean undervalued. And a second thought is that the stock market increasingly seems to serve as a quick proxy for how the economy is doing, when it has a strong propensity to give false positives.

A lot of technically-oriented investors saw the market as oversold the week before last and got in, some of them taking some punishment but now sitting on very pretty short term gains. But for mere mortals, studies have repeatedly found that short-term traders do less well than those who take a longer-term horizon (like it or not, if you take a short-term focus, you are competing with folks who have better access to information than you do. And many of them probably have steelier nerves too). Even perennial bear Marc Faber, who has only 7-8% of his portfolio in stocks (and by the sound of it, not US ones either), thinks the market was primed for a technical rally but is not keen on the long-term prospects for the US economy:

“The governments in this world have no other option but to print money. That will lead down the road to inflation,” Faber said. “You don’t need to be an economist graduated from Harvard to know we’re already in a recession. They will just put white paint on a crumbling building….

“To rebuild economic health in the United States, you need a serious recession that will last several years,” he said. “The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine.”

So whether or not the market signal is correct, we don’t see the credit/economic crisis as close to resolution. The fact that we averted a systemic meltdown is not the same as saying the powers that be found a cure. Consider the factors that have not changed in the last two weeks:

Housing has another 10-15% to fall (see here for a reminder), and that assumes no overshoot or second leg down due to a sharp increase in unemployment. And this won’t happen quickly, either. Alt-A and option ARM resets continue at high levels through 2011 (in fact, 2009 is a bit of a lull, so we might have a false sense that the crisis here has passed midway through the year).

More banks are going to hit the wall, both midsized and large concerns. The stress on this front is far from over, even if we do not revisit the panic levels of the last month. Consider these observations from Chris Whalen of Institutional Risk Analytics, who has separately said that mid-sized and small banks will see a considerable amount of distress:

Rather than resolving the crisis, the government’s plan to inject capital into big banks is “merely the appetizer and soup course” in what will ultimate be a multi-course meal, says Christopher Whalen..

So what does Whalen see as the main course? Greater government control, if not outright ownership, of the nation’s biggest banks, including:

Citigroup, which Whalen says is the “riskiest” of the group because of its exposure to consumer loans.

Bank of America, which faces more Countrywide-related litigation and keeps more of its loans in house, meaning it has “whole loan” risk.

JPMorgan, which is heavily exposed to potential defaults by businesses and is what Whalen calls an “over-the-counter derivatives exchange with a bank attached.”

Whalen, lauded for forecasting the banking crisis when most others were sanguine, believes the U.S. banking system is going to face $250 billion to $300 billion in additional loan losses in the coming 6 to 9 months. In anticipation of such heavy losses, banks are now diverting capital into loan loss reserves rather than seeking to make new loans.

The dollar has remained unexpectedly strong (that view is based on disgruntled sounds I have heard from various sources). Most expected continued dollar weakness, although a minority saw the euro taking a big hit before a dollar slide resumed. An orderly fall in the dollar would hopefully not discomfit our trade partners unduly, but a disorderly slide would.

As an aside, I was very surprised to see Bush announce a currency summit, which appears to be on for early November. First, it’s a very big move for a lame duck president, and seems particularly odd at this particular juncture (the US is currently in a position of strength via having provided unlimited dollar swap lines to the EU and bailing out AIG, which saved Eu banks from massive writeoffs. One theory is that this is merely symbolic, particularly since not much beyond very general principals could be studied and pre-approved before the pow-wow. But a gathering of this sort, particularly if not well framed, has the potential to expose rifts. The political mavens I have pinged are at a bit of a loss as to what this was about, except perhaps a sop to Sarkozy, who has been very helpful to the US.

The big unresolved issue now is that even though we appear to have avoided a financial meltdown (even Nouriel Roubini thinks that risk has passed), we are still going to see considerable deleveraging, due primarily to the fact that lenders are in no mood to take risk, but compounded by the fact that consumers and businesses are feeling plenty shell-shocked.

We have noted before that even if the Fed gets Libor and the interbank risk measures associated with it down to less stressed levels, that does not mean we are back to status quo ante. First, rates could improve at diminished levels of activity. Second, even if banks do lend to each other, that does not mean that they are going to resume extending credit on anything other than very cautious terms to customers.

Remarkably, Anna Schwartz, who with Milton Friedman, was the author of the pathbreaking monetary study of the Depression that concluded the worst would have been averted had central banks injected more liquidity, said in an interview with the Wall Street Journal that the Fed was using the wrong remedy to this crisis, and was treating it as a liquidity crisis when it is in fact a solvency crisis. Indirectly, that bolsters the view that the relief in the interbank markets may be limited despite the extreme measures taken:

Credit spreads — the difference between what it costs the government to borrow and what private-sector borrowers must pay — are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. “The Fed,” she argues, “has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.”

So even though the Fed has flooded the credit markets with cash, spreads haven’t budged because banks don’t know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is “the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue….

. Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”

“Why are they ‘toxic’?” Ms. Schwartz asks. “They’re toxic because you cannot sell them…” The only way to “get rid of them” is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson’s original proposal to buy these assets from the banks was “a step in the right direction.”

The problem with that idea was, and is, how to price “toxic” assets that nobody wants. And lurking beneath that problem is another, stickier problem: If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized, and a number of banks would probably fail.”… [H]e’s shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. “They should not be recapitalizing firms that should be shut down.”

Anna Schwartz is arguing for something pretty close to the Swedish model: figure out how underwater various banks are. liquidate or sell the worst ones, recapitalize the ones that are impaired but are strong enough to pull through (the Swedes nationalized them; it might be possible to keep them private, but with with substantial government oversight and upside participation), and spin bad assets off into a Resolutions Trust type liquidation vehicle.

So not surprisingly, with an economy on the downturn, even if banks do decide to become freer with lending to their peers, evidence is mounting that they are not going to be as accommodating with their customers. From Andrew Ross Sorkin at the New York Times:

“Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital,” Mr. Paulson said in a statement Monday. “And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people.”…

But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels.

“It doesn’t matter how much Hank Paulson gives us,” said an influential senior official at a big bank that received money from the government, “no one is going to lend a nickel until the economy turns.” The official added: “Who are we going to lend money to?” before repeating an old saw about banking: “Only people who don’t need it.”

From Robert Reich:

The Dow is see-sawing but the reality is that the Bailout of All Bailouts isn’t working. Credit markets are largely still frozen. Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing. It’s not flowing to distressed homeowners. It’s not flowing to small businesses. It’s not flowing to would-be homeowners with good credit ratings. Students are having a harder time borrowing for their tuition. Auto loans are drying up.

Why? Because the underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.

Roubini now foresees a deep recession of at least two years’ duration. That does not appear to be part of the newfound stock market cheer. Given Roubini’s success in calling this credit crisis, I’d be loath to take a long-term bet against him.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

55 Responses to "It Isn’t Over Until the Fat Lady Sings"

  1. Yves   October 21, 2008 at 11:21 am

    One of the fundamental macroeconomic imbalances in the US economy: the dismally low savings rate.The righting of this imbalance will have to take place sooner or later, and it means lower consumption, higher exports, etc…Spending their way out of this crisis will do the trick only in the short term, and actually worsen the fundamentals.

  2. C   October 21, 2008 at 11:27 am

    Yves, you spake the truth.Oversold does not necessarily mean undervalued. Yet, it doesn’t seem to register with the investing public that the formerly higher price of a stock meant that it was OVERvalued and may still be even at a currently lower price. And, averting the financial meltdown did not equate to a cure, as you say. Anecdotally, it kills me that the very same people who think their houses are still worth the high values of the market peak would expect to buy that very same house today at a much lower price. Go figure. I’d also like to add, I saw testimony of Bernanke just last night in which he asserted that the banks who have received capital and are not lending it are missing out on profit opportunities. Maybe, but they could also be avoiding losses. Just as no one ever gets fired for recommending IBM, no bank is going to get “fired” for not lending money, at least not in this market.

  3. JohnRyskamp   October 21, 2008 at 12:13 pm

    “The risk has passed.” What nonsense! All Roubini and his cohorts have done is temporarily appeased the appetites of our corporate fascist leaders for more theft.How could he collude in all this theft? And what is the result? Check out the Baltic Dry Index for a look at economic facts on the ground, as reality is played out, instead of Nouriel’s idiotic notions of “systemic risk.”Next corporate consolidation in order to avoid “systemic risk.” After that austerity in order to avoid “systemic risk.” Next cartels and boards a la Hitler and Mussolini in order to avoid “systemic risk.” Next lebensraum in order to avoid “systemic risk.”The only real systemic risk is that Roubini and his cohorts are still around.

  4. Nkirv   October 23, 2008 at 12:57 am

    Isn’t the stock market just Brownian motion?BTW, did anyone notice this besides me: Benoit Mandelbrot bears a striking resemblance to Yoda!