A "V-Bottom" is Possible
(October 16, 2008)
Dear Subscribers and Readers,
With the promised US government equity injection of US$250 billion, the tangible equity ratio of the US banking sector is projected to rise from 7.5% to about 9.0% - the highest since the Great Depression. Even prior to the promised injection, the tangible equity ratio of the US banking sector was at its highest level since the early 1960s. Meanwhile, the average Tier 1 capital ratio for the initial group of capital recipients is projected to rise from 8.2% to 10.7%. Note that any bank with a Tier 1 capital ratio of over 6.0% is considered “well-capitalized.” Even should we experience a deeper-than-usual recession going forward (i.e. unemployment rate of over 10%), the capital base of much of the US banking sector is still strong enough to withstand credit losses and concerns. Make no mistake: With the recent global equity injections and coordinated monetary easing, both the liquidity and credit concerns of the US banking sector should dissipate in the coming weeks.
In our August 30, 2007 commentary, I remarked that the current credit crisis is analogous to the “Panic of 1907” in a very important way – a watershed panic that led to the creation of the Federal Reserve in 1913 (see the following 1999 Federal Reserve Bank of Atlanta's paper “Why Didn't the United States Establish a Central Bank until after the Panic of 1907?” for some background).
Quoting our August 30, 2007 commentary:
Finally, at this time, there is good reason to believe that both the major central banks and investment banks of the world still don't have a clear view of where all the subprime or leverage exposure is, even though all their risk books are, for the most part, consolidated. Remember, as of the end of June, the total amount of money controlled by hedge funds around the world amounted to a range of US$1.7 to US$2.0 trillion. Utilizing a leverage ratio and an annual turnover ratio of 4-to-1 (which is very conceivable since half of all trading on the U.S. stock exchanges and more than one-third of all bond trading are done by hedge funds), the amount of hedge fund “efficiency capital” rises to a whooping US$27 to US$36 trillion, or nearly three times U.S. GDP. How could the world's central banks make policy (or even more of a stretch, provide specific solutions) if they (and their contacts at Goldman, Morgan, etc.) have no idea what half of the financial system is doing? In the Fall of 1998, many folks in NYC know that the problem was LTCM – today, not only has the problem gotten bigger, but it has spread to many more, heterogeneous, participants as well. In this way, the current crisis is analogous to the “Panic of 1907,” as during the “Panic of 1907,” much of the crisis had initiated in and spread around the NYC trust companies, as opposed to the national and NYC banking system, who were members of the New York Clearing House. Indeed, the Panic of 1907 was one of the most serious liquidity squeezes in US history, mainly because of 1) the explosion in NYC trust companies and assets in the 10 to 12 years prior to 1907, 2) the fact that they were not members of the New York Clearing House, and thus no legal or regulatory responsibility to hold sufficient reserves in order to stave off a general run, and 3) members of the New York Clearing House, who were lenders of the last resort in 1907, were reluctant to “bail out” many of the trust companies since they had never disclosed their books. Moreover, while trust companies were relatively conservative at first, they gradually evolved into more speculative institutions as the owners of the trusts “discovered” that they were able to invest in more risky assets, such as real estate and stocks, unlike banks who were strictly prohibited from doing so. The hedge fund industry today is analogous to the trust companies in 1907.
In retrospect, not only was the hedge fund industry analogous to the trust companies in 1907, so was most of the investment banks that are not under the regulation of the Federal Reserve. In fact – as it turned out – the majority of the speculation in illiquid/low-quality assets were centered in the investment banks – akin to many of the trust companies in 1907 who speculated in real estate and other hard-to-sell assets. More importantly, the Panic of 1907 began with liquidity concerns and quickly spiraled into a full-scale panic as investors and trust company depositors questioned the solvency of much of the US financial system. It also ended with John Pierpont Morgan and other commercial bankers quickly intervening to “bail out” the trust companies and to restore nationwide crisis – as well as to stem solvency concerns going forward. Following is a daily chart chronicling the events leading to the Panic of 1907 and its aftermath:
The Panic of 1907 ended with Morgan arranging the sale of Tennessee Iron & Coal to US Steel – in order to prevent the collapse of a major brokerage firm, Moore & Schley, as much of its loans were collateralized by its holdings of the company. The US stock market (as per the Dow Industrials) would eventually bottom on November 15th – and from there, it never looked back, although the stock market continued to experience sizable volatility over the next few months. Similarly (unlike the lack of write-downs and bank recapitalizations of the Japanese financial system in the early 1990s), given that both the US Treasury and most of the world's developed countries are now bailing out their financial institutions (note that with the bailout, all the major global financial institutions are now highly capitalized) – and given that we have already written down most of our mortgage holdings – this should go a long way towards alleviating solvency concerns, even should we experience a global recession going forward. While many analysts are comparing the current bear market to other US bear markets in recent years, my sense is that the closest analogy we have is the market action in the aftermath of the Panic of 1907. Assuming this is the case, the stock market should have already bottomed, although a retest is quite possible. As I discussed in our latest weekend commentary, I also expect a significant rally leading into Christmastime.
Finally, there is now no doubt that the vast majority of asset classes in the world today is hugely oversold. Even crude oil prices – which just recently peaked three months ago – have experienced a dramatic crash not seen since 2001 (when much of our nation's economy and transportation system stumbled in the aftermath of the September 11th attacks). The following chart of the daily spot price of crude oil vs. its 200-day moving average shows this perfectly:
The spot price of WTI crude oil is now trading at more than 34% below its 200-day moving average – or its most oversold level since November 2001. Should crude oil prices continue to sell off in the coming days (i.e. to $70 a barrel or below), it would be at its most oversold level since late 1986. Given that the much of the world's central banks and governments are now working overtime to pump money into their systems, the current global liquidation of all asset classes (aside from the government bonds of developed countries), are now long in the tooth. Again, I expect the US and global equity markets to rally sooner rather than later and for the rally to extend into Christmastime.
Henry To, CFA