The banks
The big banks have lost a lot of money in the credit crunch. The utterly engrossing live transcript of FT Alphaville's Chat on November 1st, when the big banking losses started to scare the stock-markets, shows all the gallows humour of a truly bleak picture for UBS, Merrill Lynch, Citi, etc.
We're not quite sure how bad it is, because the assets the banks hold don't currently have a price: no one will trade them. Gillian Tett, in the FT, has an alarming article: she points out that the banks' auditors, remembering Enron, are now getting nervous about how the banks are reporting losses. Assets that were considered valuable safe bets one day are turned into highly risky, devalued paper the next.
Tett's article really is alarming. The ABX Indices which have plunged are at the heart of the market on which a vast trade in Credit Default Swaps (CDS) was based. When banks bought some securitised mortgages--AAA Northern Rock, let's say, they would then go to a hedge fund and buy insurance against the value of that asset falling. The hedge fund would construct an instrument based on trades in the ABX indices. and pocket a fat commission on the sale of this thinly understood construction. The banks will start to call-in their CDS's, but the plunge in the value of the ABX indices will lead the hedge funds to default. The auditors will require even further write-downs of assets from the banks. Expect banks to hang on to all the liquidity they can get their hands on.
Here is some gallows humour from Alphaville:
PM: NO ONE - but no one - believes these write-offs are finished NH: and that’s why the market has tanked this afternoon PM: There has been no kitchen sinking cos the banks worried about their core capital position PM: No wonder they wouldnt lend to each other! \ldots SMI: We’re seeing downgrades of 5, 10, 15 notches, from AAA to junk. That can’t be going down well with pension fund investors PM: In one hit!? SMI: Yep - there’s one CDO that was rated AAA in april and slashed to rubbish this month PM: Nice one
The auditors are trying to get their clients to recognise the extent of losses. If they don't, and the banks go like Enron, the audit firms will be blamed once again. You have to realise that when any business holds large stocks of not very liquid assets, changes in the value of those assets can make a huge difference to accounting profits. This is what is leading UBS to offset $2bn one day and $8bn two weeks later. No one really knows how much more there is to come. And this is what cost Citi's boss his job: even worse--to your board and to the market--than making losses is giving the impression that you are not in control. (Of course, you never are in control, but leadership is there precisely to have a sacrificial fall-guy when things go wrong; the myth of control is essential to modern management's leader-centrism).
The authorities
Bernanke has been the bankers' friend again, reducing US interest rates by another quarter point. It is nice, in a tight spot, to have the cost of your main raw material (liquidity) reduced like that. Nouriel Roubini, however, thinks that to neutralise the full effect of a 20% fall in US home prices would require a full 2% cut in interest rates.
Even the quarter point cut added to the dollar devaluation. The mechanism is pretty straightforward: if you had dollar bonds in your savings (maybe through your pension fund) and were happy with your holding before the interest rate cut, you must want fewer dollars after the cut--so you go and buy Euro, or Swiss Franc of Sterling bonds.
Devaluation is great for those who owe dollars and earn foreign currency--it makes the debt so much easier to repay. It won't help most of the Consumers and home-owners caught in sub-prime.
The regulatory implications of the credit crunch are getting clearer. In a very persuasive article, Paul de Grauwe argues that central banks should control asset price bubbles just as they should control inflation. Banks--and banking regulation--create bubbles; central banks mop-up the aftermath of bubbles; so they should be actively engaged in trying to stop them occuring. Makes sense to me.
The Real Economy
There have been surprisingly up-beat real economy headlines. US jobless figures continue to fall, personal insolvencies in the UK are down, BA has never made more profits than last quarter ...
One would expect pretty mixed signals in the real economy. Low and falling interest rates mean that there is huge liquidity in the system--what do you do with cash? One thing is that cash is absorbed in inflation--dollar liquidity is translating directly into oil price inflation, for example. But inflation, before it settles into the system, produces real activity: companies respond to rising prices by trying to produce more, and only after some catch-up realise that rising input costs are cutting anticipated incremental profits.
So expect mixed good/bad signals in the real economy for a while. An anonymous poster on rgemonitor reminded us of Keynes' position on the sort of systematic devaluation Bernanke seems engaged in now:
"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."
The real impacts will come through different channels. The American consumer will cut back on spending through wealth effects, and the rest of the world will feel the effect--the US remains a huge source of world demand. http://www.imf.org/external/np/tr/2007/tr070913.htm
Another channel will be through the $-pegged currencies, especially the Yuan. Already China found that internal fuel availability was falling because of fixed, administered internal prices and the fixed dollar exchange rate. Chinese refiners could make money selling their product outside China, at world prices that reflected the increase in dollar-denominated oil prices, but not at internal, administered prices. Fuel had started to go scarce at the pump. How long will the Chinese hold the dollar peg? In order to avoid a generalised version of the fuel story, they will need to increase many internal prices. Why not just re value the Yuan, and, while you're about it, keep more of your reserves in Euro?
I haven't seen anyone seriously calling the end of the dollar as the world's reserve currency. But Bernanke is certainly putting it through the kind of test it has not been through since the end of Bretton Woods. What happens if he follows the logic of cheap money and rapidly returns to nearly zero interest rates again? Indeed, Wolfgang Munchau is bravely asking the European's to do the right thing and raise interest rates against the inflationary risk. But even he knows the central bankers won't do this.
Inflation and devaluation or miraculous boom? I say the first.
