THE GREAT FINANCIAL PIT OF CARKOON
By Thomas J. Donatelli
Signature Capital Partners, LLC
We must dare to think about unthinkable things because when things become unthinkable thinking stops and action becomes mindless.
-J. William Fulbright, U.S. Senator
By the time you are reading this, it is very likely that at least one money center bank here in the United States will be on its way to being nationalized, despite pronouncements to the contrary from Washington. Given the “doublespeak” that is so common to politicians, they may even say that they aren’t nationalizing as they do it. It will most likely be a creeping, incremental nationalization but whatever words you chose, that’s where we are heading. In addition, and contrary to the vigorous protestations by Jean Claude Trichet and other financial Eurocrats, the entire European banking system will have been finally exposed for the disaster that it truly is with, by some reports, as much as $15-$20 trillion in toxic assets rotting on bank balance sheets throughout the EU. Even as I am writing this, it has already been disclosed that several large sovereign credits in both Eastern and Western Europe, hang in the balance. There is also the potential that a sovereign central bank may fail at some point in the coming months. Markets are even starting to entertain the possibility of a full-blown Euro crisis. What is so remarkable is that all of this is occurring in the face of coordinated and massive liquidity injections by global central banks that have been going on, by the way, for quite awhile. It’s just not working.
In trying to conceptualize the size and seriousness of this current credit mess, one is reminded of that image of the “Great Pit of Carkoon” from the movie Return of the Jedi. For those of you who haven’t seen that movie, it was a massive hole hiding a ravenous and horrific looking monster. As C-3PO described it, inside that pit “you will find a new definition of pain and suffering as you are slowly digested over a thousand years.” Sort of sounds like the global financial system, doesn’t it? And with each passing month, and with each new liquidity injection or credit facility that feeds this monster, the pain diminishes briefly only to return with even greater vigor and intensity. Today, the damage to the American economy has been well documented:
$9 Trillion in losses from housing, and counting
$10 Trillion in loss from the stock market, and counting
$14 Trillion in outstanding consumer credit, and counting
Big numbers to be sure, yet none of this even includes the ongoing and ever-expanding exposure of our Treasury and the growing potential threat this poses to our currency. And yet, the economy continues to decelerate, unemployment continues to accelerate and overall consumer activity has literally hit the wall. Buckle your seatbelts for a wave of big name, high-profile retail bankruptcies that will reverberate and rifle through the commercial real estate market as well. This, of course, doesn’t even include the impact on the industrial economy. The monster in this pit is voracious, indeed. Europe will be next, likely to be followed by China.
To date, policy makers in both the Treasury and the Federal Reserve have tried to address this problem by mischaracterizing it as a liquidity problem. In so doing, they have created the justification for their ongoing and, I would argue, misguided course of action by continuing to ply the financial system with liquidity (in the form of debt) in the hope that they will jumpstart the credit market and, with it, the velocity of money (i.e. the “multiplier effect”). If they can do this, so the thinking goes, we will be back to the races, credit markets will reopen, equity multiples will lift and the housing market will stabilize. Some have even gone so far to argue that the markets are not functioning properly because they are irrationally undervaluing or “mis-marking” the credit instruments held by the banks. If we would just replace “mark-to-market” with historical cost accounting practices, so it is argued, viola! our problems would be solved. This sort of reminds me of Kevin Bacon’s plea of “be calm, all is well!” at the end of the movie Animal House just as that peaceful little college town of Faberville descended into complete chaos. By the way, I don’t seem to remember anyone questioning valuations “on the way up” no matter how demonstrably excessive or absurd things became. Do you? In any event, it is very naïve to believe that an arbitrary accounting switch would deceive the market at this point. The proverbial “cat is out of the bag” and all of the information to establish market value resides outside and beyond the control of the Government or the banks - and that is how it should be. Unless, of course, people really want to see investor capital flee the banking system permanently.
No, with all due respect to Messrs. Geithner and Bernanke as well as the CEO’s of many of our larger banks, what we are confronting is not a liquidity problem but a plain, old-fashioned solvency problem and a big one - regardless of how politically unpalatable or painful it is to admit. The solution to this mess will ultimately come when we finally get honest with ourselves and accept this fact.
Let’s look at the “big picture” for a moment, shall we? In 1982, interest rates were hovering at just over 20%. Over the ensuing 25+ years, they slowly eroded to 0% (actually even less than 0%) in real terms. Over that same period, credit creation grew inexorably. As such, home prices inflated, as did just about everything from equities to bonds to commodities – you name it. More recently, say over the past 10 years, this massive creation of credit was literally turbocharged by what is now euphemistically referred to as the “shadow” banking system: securitizations, swaps/synthetics, investment banks, captive finance subsidiaries (GE Capital, Textron Finance, etc.), stand-alone asset based lenders (i.e. CIT), hedge funds, private equity funds, specialized insurance products and on and on.
These doyens of high finance were the pyrotechnic force behind the multiplier effect that ballooned every bank balance sheet and which, in turn, drove the global financial system to the absolute brink. If anything, the Fed set the table for all of this moral hazard by taking rates to zero and then stepping aside to let these financial alchemists to ply their trade. And did they ever! In virtually every instance, they grew ever more dependent on one or a combinations of strategies all involving significant amounts of leverage that led, in turn, to more unbridled credit creation. Credit default and interest rate swaps create credit as do leverage buyouts, collateralized debt obligations, mortgage back securities, hedge fund, etc. There was also the tendency by many managers to avoid accurately marking their books in order to promulgate the illusion of success. Another dirty little secret was that underwriting standards also deteriorated markedly. Securities were intellectually and structurally flawed when they were first conjured together in the basement of the Wall Street Sausage factory. They were then shamefully mis-rated by the rating agencies. Finally, they were served up to investors whose desire for a few more basis points of “return” clouded their better judgment. And thus the monster in our great financial “Pit of Carkoon” was born. As it was pointed out in the New Republic (November 5, 2008, p.15), “an illusion had developed on Wall Street that this generation of investment managers possessed a new kind of genius, but, in truth, the only thing these managers did differently was to apply more leverage to the same old strategies in a bull market. When the laws of investment gravity brought the markets back to earth, their spaceships crashed on the rest of us.”
What was once the exclusive provenance of the Federal Reserve System became an unregulated, unmonitored and uncontrolled global high-speed credit-manufacturing machine in the hands of the “shadow” banking system with, ironically, much help from the Federal Reserve. Today, as a result of this unfettered financial “innovation” we have, in effect, crossed the credit Rubicon, an inflection point if you will, where the last dollar has been lent. The velocity of money literally went parabolic via iterative acceleration in the credit markets. There is now simply too much debt supported by too little real income globally and, sadly, that income is continuing to shrink. We are now looking at a secular reversal of a multi-decade trend of credit expansion and are most likely entering a protracted period not just of credit stringency or contraction, but outright credit rationing. This will have negative implications for all asset values for the foreseeable future as the world devolves into one massive pending restructuring transaction. Unfortunately, our elected officials seem hell bent on ignoring this reality and are, instead, trying to deal with the problem by applying the very same policies that created it in the first place. They are acting like malpracticing physicians treating a patient’s symptoms while ignoring the disease as it metastasizes.
Through their continued policy missteps, our officials are acting like they think the mechanism for the transmission of credit is broken so they are trying to “fix” it by forcing more liquidity into the system. It isn’t working and it won’t work either. Market participants have, indeed, amended their opinions and, therefore, their behavior with respect to credit but this is more a sign that sanity is returning, not the other way around. What is, in fact, happening is that investors worldwide are re-pricing risks to rationally reflect the dramatic changes taking place in the global economy. This re-pricing is taking the form of change in both time and liquidity preferences. During normal periods of banking stress, when momentaryor unjustified fear overtakes the market, “runs” on assets can and do occur. When this happens, investor time preferences rapidly attenuate and their liquidity preferences dramatically expand. This all happens within a compressed time series. In these situations, the Federal Reserve can inject liquidity into the system, permitting the system to return to equilibrium as investor fear subsides and things return to normal. But during a solvency crisis (like the one we are in), all of the liquidity in the world will not change the fact that the underlying asset quality is decisively if not irredeemably flawed. In that circumstance, the investor will not return in the same way and his time and liquidity preferences will readjust to that new reality. The current readjustment is a convulsive one and has not finished playing out.
So why is this happening? Why are policy makers having such a hard time dealing with what’s really going on? Why is there this apparent denial with respect to the actual problems in the financial system? Why isn’t this continued model of “Open Bank Assistance” (i.e. “feeding the monster) being tossed out in favor of the more appropriate model of receivership? The answer lies not in the facts of this situation but in the politics of it. What is often forgotten is that banks finance themselves not just with deposits or equity capital but also by the issuance of bank bonds. The predominant owners of these bonds tend to be other banks – domestic banks, large global banks, even sovereign Central Banks – who tend to treat these bonds as high quality, investment-grade paper with no reserves “booked” against them. Given their limited (or fractional) capital positions, these banks are not in a position to take a loss on these bonds without being forced into insolvency themselves. So it is probably a very good wager that banks from the U.S. to Europe to China are imploring, possibly even demanding, that our Treasury officials prevent this at all costs. The result? We continue to feed the monster.
And so we have come full circle. The losses in the global banking system are very real and very large due to the seismic shift that occurred in the model for credit creation. Investors, finally recognizing this fact, have now radically reset their time and liquidity preferences in response to this new secular trend. What’s the proper solution? As painful as it might be, it is time for everyone to accept the fact that a full scale global restructuring of bank balance sheets must occur. Equity holders in many large institutions will likely be wiped out and the bondholders will have to, at a minimum, be willing to take a “haircut” and in some cases a very significant one. Some may even be wiped out as well. Until everyone accepts this, the global financial system will not heal, the multiplier effect will not return, taxpayers will be forced into subsidizing equity and bondholders for years to come and the monster in our financial “Great Pit of Carkoon” will never be sated.