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The Weekly Report

Welcome to the weekly report. This week we look at the Bank for International Settlements (BIS) latest utterances and look at the chart of a hedge Fund showing unusual price action. We start with a look at some "suggestions" made by the BIS in its 78th annual report. This is probably the most important global macro-economic pointer you will see this year that shows the way ahead:

  • "Most of the more specific suggestions for government involvement have been directed to alleviating the likelihood of a full-blown credit crunch in global financial markets. What is sought are ways to mute the potentially powerful interaction between uncertainty about the solvency of borrowers, primarily households, and the solvency of lenders. In fact, steps have already been taken in the United States to use government and quasi-government agencies to support mortgage markets, and thus indirectly house prices, homeowners and lenders as well. In a number of countries, there have been calls for direct government purchases to put a floor under the prices of a variety of financial instruments.

    Of course, this conflicts directly with the need for the market to find its own level if it is eventually to function normally again, and exposes the government to future losses should prices continue to fall regardless. Another approach to the problem focuses not on households' assets but on their liabilities, and suggests that there should be a form of blanket reduction based on certain principles established by governments.

    The downsides of course are evident: the potential direct cost to the government, the moral hazard involved, and the political outrage as "prudent" borrowers and taxpayers are forced to subsidise the "imprudent".

    How might governments help in reducing uncertainties about the solvency of banks and, in turn, the threat of a credit crunch? Evidently, the first step would be to encourage self-help. Both dividends and bonuses should be cut in order to increase capital cushions. The private sector, whether through rights issues or appeals to outside investors, should also be turned to for further capital injections. This process would clearly be facilitated by greater clarity as to the need for capital, in the light of prospective losses and also possible involuntary increases in balance sheets.

    The problem, however, is that the valuation of many structured products is difficult, because there is effectively no market for them, and valuing them using models has many drawbacks. The suggestion that banks might agree on a common "template" for valuations, recognising these shortcomings, nevertheless has significant merit. Of course, such an evaluation might also reveal that the losses are uncomfortably large, a possibility for which the authorities should make preparations in advance.

    One response, if the regulatory authorities were able to determine that the estimated "fair value" losses were much greater than seemed likely to be realised in the end, might be a temporary degree of regulatory forbearance. Conversely, and perhaps more likely, if the regulators felt unable to do this, then the government should not hesitate to intervene directly subject to the principles laid out above.

    Mergers, takeovers, the establishment of a "bad bank" to house bad assets, recapitalisation using public funds and even nationalisation are all procedures that should be contemplated depending on the circumstances.

    When direct public sector intervention seems required, the domestic legal framework and the potential need to involve foreign authorities will be important factors constraining what might in practical terms be done. In such circumstances, it is likely to become evident quite quickly that not enough effort has been put into preparing for the possibility of a financial crisis of some sort. If the authorities must muddle through regardless, the experience will at least provide some indications of what preparations might have been better made in advance."

Regardless of your current financial situation, be you rich or poor, none of the above is for your benefit. The BIS has formalised the discussion about how to save the Western World (and therefore save emerging and developing markets) and has heavily backed the centralised, government driven bail-out approach. Such action would see the end of a capitalist approach to markets, just when free markets are needed the most.

Let's be straight on this, the deleveraging we have seen since the summer of '07 is the natural consequence of prices being affected by a higher than expected level of risk occurring in the markets. It started with the reduction of banks willing to lend short term loans, commercial paper, to each other as the prices of the assets used to secure the loans began to drop markedly. Those assets were being re-priced lower to more realistic levels as the expected income they earned did not match the modelled expectations.

With a lack of short term loan facilities banks who borrowed short to leverage lending long found the business model collapsing. There were only 2 options left, either raise capital to allow leverage to continue or to stop the long term lending and reduce the amount of leverage in use. As we have seen over the past year most banks have attempted to raise capital by begging cash rich Sovereign Wealth Funds, Private Equity or cash rich Institutions to "buy" part of the bank, promising to pay usury rates in return. Or they have issued more equity, diluting share-holder wealth. This is what nearly all the banks have had to do. Some more than once.

The likes of Countrywide, Bear Stearns, a myriad of Mortgage Lenders and a whole bunch of Hedge Funds (Peloton etc) took the second option and stopped the process, or had it stopped for them by a market no longer willing (or able) to allow their business models to continue.

So here we are today, with Bankers wearing brown trousers to work to disguise the fear, the Primary Brokers looking directly into the regulatory future they dread and Hedge Funds hoping they have enough credit available to stay afloat. The actions taken by the Fed, Bank of England et al are now seen as "holding operations" allowing current practises to continue until the dawning of a new way, putting a line under the mess with a new paradigm that will define the next chapter in capitalism.

Whilst the "new way" is awaited, the de-leveraging continues and those invested in the Bank/Broker sector sell out on any rally. It is that chapter, the "new way" that the BIS started to outline. We should plan for the following events (if you think this is far-fetched, remember the reaction when the Fed started its "Facilities"?):

To read the rest of the Weekly Report, click here.

 

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