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Monday, 29 September 2008

TARP Day 1

The House votes today, the Senate today or tomorrow? TARP is assumed to be deeply unpopular. FTSE100 is down 2% (11am) with HBoS -10%, Europe -3%, after Asia fell 3%. In the US, Wachovia and Wells Fargo stocks are bullish, but the test will come on market opening. It seems the credibility of political and regulatory governance is being doubted. In the UK, B&B's takeover by a combination of Government (N.Rock) and Santander, and of Fortis by the three Benelux governments, and Hypo Real Estate handed €35bn credit guarantees by the German government and other banks, are discomfiting and so banks' shares are down again.
Fortis returned an excellent 2007 with ample assurances and yet has been massacred - disbelieved, shorted, rumoured to be under regulatory pressure, cash-flow weak (liquidity mismatch on assets to deposits and equity) though otherwise solvent? I know a lot more about this (and other banks) than I am legally entitled to reveal. Suffice to say such problems are not unique and Fortis is fundamentally a good and great bank staffed by honest diligent professionals who (as the CEO himself said) cannot comprehend why what is happening to them?)
All banks without exception have experienced enormous difficulties in designing and implementing systems to comply with Basel II; there is only so much true expertise available and not nearly enough to go round. Everyone has been on the steepest possible learning curve that inevitably results in errors. This is the first generation of Basel II solutions. Second and third generations will be orders of magnitude better. Similarly, the originate-to-distribute business model and all its structured credit product derivatives was a first generation nascent market that outgrew all expectations (of those who first invented it) at an unforeseen speed. Market corrections of earlier new derivatives markets were severe and some of us expected and warned that this would happen to CDOs etc. but no-one predicted the systemic scale of such a collapse.
Some of us could forecast the impact on banks' capital of economic recessions requiring up to 90% of banks' capital reserves to be replenished, but none I know foresaw that banks' equity capitalisations would fall by 70-95%!
Official figures on who is or is not experiencing recession right now have to be discounted. Core GDP data is subject to major revisions for up to two years. There is a historical pattern to the world's economic and credit cycles in terms of the knock-on lags from one to the other e.g. first the USA, then UK&I two quarters later, then the rest of Europe 6-8 quarters after that. But, equity markets and banks' liquidity risks do not walk in precise tandem with macro-economic cycles. These matters, the shocks that disrupt firms' economic capital models cannot be precisely forecast. Flawed human judgement is necessary and time needs to be bought to climb out of shock events. That is the essence of Government intervention, buying the time, not in weeks or months but years, for financial firms, their clients and customers, to win through to recovery, to regain near normal orderly markets. This requires confidence, realism and fortitude. For this, we can only rely on past recovery experience.
We know that property falls bottom out when they hit their long-run growth rates. The only reliable buy signals come from cyclically adjusted (over-the-cycle fair value, not through-the-cycle aggregate fair value, and not point-in-time or marking to market) i.e. price/earnings ratios that adjust for cycles such as profits/wages shares in the macro-economy. The US equity market is 40% above its long term fair value. Some argue this is because recession has been postponed by the governments' liquidity infusions, while others say this is belied by unemployment data i.e. equity fundamentals have already run over the cliff edge but values not yet recognised this? Elsewhere, the MSCI emeging markets index trades at an earings multiple 25% below the world index and FTSE-Eurofirst at below half the multiple of the S&P500 i.e. both much cheaper than the USA. Therefore, as John Authers (FT 27 Sept.) concludes the idea that resolving the banking crisis "will lead to a new bull market should be tested".
In my view, if TARP restores confidence in US financial assets without an equivalent intervention immediately in Europe, the dollar/Euro rate may recover its rise that began in July. Sterling today has its worst intra-day against the dollar for 15 years and the euro is also down; £ falling 2% to $1.8022 and euro lost 1.2% to $1.4346, on hopes of the TARP plan. World oil (& other commodities including Gold?) prices that rose briefly in recent days after a prolonged weakening may again soften and fall, even continuing to do so as we enter Winter demand, and thereby underpinning a fourth quarter general rise in market confidence (and Obama victory at the polls, Nov.4?), and then I expect turbulent volatility to be disruptively back in play by late January until Spring. Oil prices fell today by more than $3 a barrel while gold prices dipped and base metals retreated. But, what can I know - I was predicting a bank sector bounce, but maybe that has first to wait on TARP being voted through?

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