Credit Suisse recently issued a report detailing several reasons to remain bullish (see here). Among these reasons was an overreaction to the credit fears in the markets. They claim that this is not a “Lehman-style environment”. Specifically, they said:
“We are not in a Lehman-style environment
The recent rise in the LIBOR spreads (to 53bp, from a low of 13bps in March) has raised concerns in investors' minds that we are in Lehman-type environment. Yet, we think the situation is meaningfully different: for one, banks are now better capitalized than they were in September 2008 (UK banks, for example, now have triple the liquid assets and double the Tier 1 capital they had pre-Lehman). Moreover, when the Lehman default occurred the economy was heading into an ever deeper recession (which had officially started in December 2007), which would turn out to be the worst Western recession in 65 years. This time round, on the other hand, we are only barely three quarters into the economic recovery "“ and on only on two occasions in the last 100 years (1920 and 1981) has a recession started within two years of the end of the previous one. Moreover, central bankers now know what to do to stimulate growth: if there is too much fiscal tightening, then QE would be renewed everywhere!”
There are many excellent points made above and investors must attempt to keep a level head while also being realistic about the potential outcomes that lie ahead. It is very true that the banks are in better condition than they were in September 2008. If there is one thing the bank bailout achieved it is that it helped bolster bank balance sheets. Unfortunately, this was the ultimate form of “trickle down” as Bernanke falsely assumed that banks were reserve constrained and simply needed healthier balance sheets before they would lend. Of course, that myth has been proven entirely wrong as the banks have recovered and Main Street continues to struggle. Lending, unfortunately, is like the tango – it takes two….
So, while the banks are stronger (a relative term) it matters little as the consumer continues to struggle. We’ve basically kicked the can. The continuing weakness across the private sector puts the banks at substantial risk of future weakness. If housing double dips or the consumer tightens substantially the strong bank balance sheets will once again become fragile….Monetary policy will be shown for the farce that it is.
CS also notes that the economy is stronger. This is also true. On the other hand, investor psychology has been shattered. At the end of the day a market is nothing more than the summation of the decisions of its participants. If those participants are risk averse and psychologically fragile you have a potential recipe for disaster (or you get “flash crashes” and wild daily volatility). Richard Koo says psychology is of the utmost importance during a balance sheet recession because any subsequent dips have the potential to be substantially larger than the first. We’re seeing clear signs of mistrust in the market as the “flash crash” is just one more market debacle on top of several others over the last few years.
I attribute much of this psychological deterioration to moral hazard. When participants feel cheated (by bailouts and handouts) the game looks rigged. When the game looks rigged participants are less likely to play. The equity markets look more and more like a system by the banks for the banks. A true capitalist market would not have played out over the last 18 months as it has. But the endless government bailouts and “no one loses” capitalism is having a disastrous and unquantifiable psychological impact on the market. In the end, the system is weakened in my opinion – much like a species that never allows natural selection to take its natural course. So, the “stronger” economy might be here for now, but the fragility of market psychology has only worsened the long-term market outlook.
Finally, CS says we “know what to do”. Ah yes, the old magic bullet. But do we really have the magic bullet? I would argue that monetary policy has failed. Credit Suisse says we just need to reach into the quantitative easing bag of tricks. As Richard Koo has argued, quantitative easing is the “great non-event” (and Koo would know – 6 years of QE had no impact in Japan). After all, when there is little to no risk of inflation (as is the case now) QE is really nothing more than an asset swap. Deposits get transferred in place of some other asset. The bank balance sheet is altered, but nothing has changed in the real economy. The added reserves haven’t made the bank more likely to lend (which is 100% crystal clear in today’s environment where borrowing remains very low).
As I mentioned above, there is clearly no inflation despite endless chirping and fear mongering from various market “experts”, pundits and websites who don’t really understand how the monetary system works. Koo is 100% correct – QE has been a great big “non-event” despite all the fear mongering over “money printing” and hyperinflation (QE isn’t actually money printing, but it sounds scary when you phrase it as such). QE hasn’t cured anything. In fact, it hasn’t done anything for the real economy. All it has done is clear a few bank balance sheets so they can crank up the Enron banking system and continue raping the U.S. consumer at every possible twist and turn. Of course, banks are never reserve constrained so a strategy such as QE is pointless to begin with. Apparently we still haven’t learned this lesson two years after the fact.
Bernanke has been pushing on a string for two years and yet here were are still discussing this horrid credit crisis, the potential of a double dip and rising unemployment. They (those in charge) don’t “know what to do”. That’s why the global economy is still a mess. The politicians are as clueless as the bankers (though at least the bankers have fooled us all into thinking that the show can’t go on without them). Unfortunately, the market is realizing that our leaders are clueless. Investors are realizing that policymakers don’t have a good solution. In fact, the market appears to be realizing that most policymakers are entirely inept. This was most evident in the market calling the EMU’s bluff in less than 48 hours….
So the question remains – is this another Lehman Brothers? No one can be certain, but I would venture to argue that the potential is there for a crisis far worse than Lehman. The global economy, arguably, has never confronted such massive hurdles. The Euro appears fundamentally broken. As I’ve repeatedly stated the problems in the Euro are inherent within the currency. The solvency crisis is simply a byproduct of an inherently flawed currency system. In addition, investor sentiment is incredibly fragile. And finally, those in charge don’t appear to have a grasp on the actual problems at hand and have failed to provide a viable solution despite two years of constant meddling. It’s impossible to know whether these issues will turn into something larger than Lehman or whether they will simply go away quietly only to meet us at a later date. But the one thing that appears certain is that the risks in this market remain extraordinarily high and the very fact that there is the potential for another Lehman (or something worse) should have us all concerned – not to mention furious.
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Sounds like you’re turning more bearish, or at least allowing for the fat tail to become even fatter.
I keep hearing that “this is not another Lehman”. That may be true, and that’s all fine and good, but we don’t need another Lehman to lose 30%+ in the market. It just may take one year instead of one month. In my mind, the absence of a Lehman does not imply things are all rosy.
And by the way, I think the EU could be the next Lehman.
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TPC Reply:May 27th, 2010 at 12:21 PM
I think Greece was a warning shot. There is the potential for something much larger to develop over the coming months/years….
I am bearish, but have maintained that shorting is a poor risk/reward trade since the flash crash….I wouldn’t be shocked if we rallied for a bit. This looks an awful lot like Bear Stearns to me.
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I am not sure whether the European banks are stronger.Their heavy exposure to the PIIGS and Eastern European debt makes them suspectible to a downturn in those markets.The problems in Spanish Cajas and German Landesbank fester underneath the surface and may explose anytime like it did with CajaSur
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In Banking Reply:May 27th, 2010 at 9:13 AM
Hence the surge in LIBOR – everyone’s still at Texas Hold ‘em poker game, the river is horrible, and no one has any clue what the other players are holding
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TPC Reply:May 27th, 2010 at 12:23 PM
Credit markets not trusting the move in equities. That means this is mostly short covering and recovery from yesterday’s overreaction.
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In Banking Reply:May 27th, 2010 at 1:05 PM
Yup. If China’s little trumpet call is such good news, why has the Euro barely moved??
More importantly, with China tanking – why is it a good thing they’re holding potentially worthless paper???
Great call on the BSC feel to it – I totally agree with that assessment!
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So does this good condition the banks are now in mean that the Toxic assets that are still hiding under that musty old blanket in the basement are no longer toxic?
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In Banking Reply:May 27th, 2010 at 9:17 AM
Awe, come on – its a shiny weather proof TARP remember? Pay no attention to that eye-sore – when the garbage men come to collect it, they promise to pay us a premium because they have other garbage men who promised them the same….
I still can’t believe that acronym. What the hell was Hanky Panky Paulson thinking besides, “you fools, I sold my Goldman stock at the top for a cool 700 million and didn’t pay a dime to Uncle Sam….THAT’S how you make money!”
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TPC – I am so thankful I found this site. Yesterday and today, you addressed the very issues I have been struggling with.
The moral hazard issues have spooked rational folks. “When the game looks rigged participants are less likely to play.” And because natural selection was not allowed its day, we are left with Phoney and Fraudy, market to fantasy, and bloated balance sheets at the banks.
“And finally, those in charge don’t appear to have a grasp on the actual problems at hand and have failed to provide a viable solution despite two years of constant meddling.”
Actually, it is amazing that anyone is left in the markets at all after all of the meddling. And why would and business try to expand when there is constant meddling. You have no idea what will hit you next so businesses and individuals are hoarding what they have. The psychology is fragile and the numbers (foreclosures and unemployment) continue to get worse. To the average person, it feels like TPTB put the person, who played by the previous set of rules, to the wayside.
Given that the leaders are clueless and that there is no demand for loans, where do we go from here? I expect many politicians will lose their jobs come November but that in itself will not solve our problem. Ben Bernanke will still be around and with the financial bill gutted of meaningful reform, the banks will still have the upper hand.
It will still be some time before folks have their personal balance sheets in order. Meanwhile, you are made to look like a fool to desire a paid off home and money in the bank. The economy is still not healing. We are right back to the problems of moral hazard and a weakened consumer psychology.
If you could do something today, what would it be? If Ben said, “I give up, tell me what to do,” what would your answer be?
I wish we could turn back the clock and deal with the banks when they were weak – before we created even bigger monsters….But we are here – today – in this horrific situation – Now what?
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TPC Reply:May 27th, 2010 at 12:25 PM
Well, that was my solution back in 2008 (I mailed them to the Fed and actually got a response though my ideas were obviously ignored). Kill many of the banks, cut taxes, focus on jobs growth. In other words, focus on MAIN STREET (where the real problem is) and let Wall Street kills itself. My ideas were completely ignored and now look like that would have been much more effective than what we’ve done….
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