From Green to Red - Is Credit Crunch 2.0 Imminent?
Satyajit Das

In Crosstown Traffic, Jimi Hendrix sang:

"can't you see my signals turn from green to red
And with you I can see a traffic jam straight up ahead."

In global financial markets, the signals have changed from green to red. But rather than a simple traffic jam, a full scale credit crash may be ahead.

In financial markets, facts never matter until they do but there are worrying indications.

Fact 1 - The European debt crisis has taken a turn for the worse.

There is a serious risk that even the half-baked bailout plan announced on 21 July 2011 cannot be implemented.

The sticking point is a demand for collateral for the second bailout package. Finland demanded and got Euro 500 million in cash as security against their Euro 1,400 million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France entitling them to special treatment. At least, one German parliamentarian has also asked the logical question, why Germany is not receiving similar collateral.

Of course, Greece, which does not have two Euros to rub together, doesn't have this collateral and would need to borrow it.

Compounding the problem is Greece's fall in Gross Domestic Production ("GDP") was worse than forecast, even before the latest austerity measures become effective. The Greek economy has shrunk by around 15% since the crisis began. 2-year borrowing costs for Greece are now over 40%, pawnbroker levels. The next installment of Greece's first bailout package is due to be released as at end September. Some members of the International Monetary Fund ("IMF") are already expressing deep misgivings about further assistance to Greece, in the light of the seeming inability of the country to meet its end of the bargain.

A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty. Spain and Italy also remain embattled with only European Central Bank ("ECB") purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.

Concerns about US and Japanese government debt are also increasing.

Official forecasts show that America's national debt will increase by $3.5 trillion from its existing $14.5 trillion over the next decade. These forecasts are unlikely to be met unless the political deadlock over the budget is overcome and economic growth recovers. Japan was downgraded to AA- and its longer-term economic prognosis continues to be poor.

Facts 2 - Problems with banks have re-emerged.

Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems. The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2 trillion. French and Germany banks have very large exposures.

If there are defaults, then these banks will need capital, most likely from their sovereigns. As they are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Societe Generale's share price has fallen by nearly 50% in a relatively short period of time.

In the US, concerns about Bank of America ("BA") have emerged, with analysts suggesting that the bank requires significant infusions of capital. The major concerns relate to BA's investment in US mortgage originator Countrywide including continuing litigation losses, exposure to European banks, loans to commercial real estate and the quality of other assets, such as mortgage servicing rights and goodwill resulting from its acquisition of Merrill Lynch.

BA claims that its exposure of $17 billion to European sovereigns was hedged. As the world discovered in 2008, it wasn't whether you were hedged but who you were hedged with and whether they were financially able to perform that was the issue.

BA shares have fallen by roughly 40% price over the past month, compared to a 15% decline in the S&P 500. The cost of credit insurance on BA risk has also increased sharply.

BA decision to issue $5 billion in preference shares to Warren Buffett's Berkshire Hathaway, now confirmed as the market's lender of last resort, at distressed prices was not a statement of strength but weakness. BA needs more capital in any case and Buffett is betting on both BA and if things go wrong that the US taxpayer will bail him out as they did with his investment in Goldman Sachs.

BA's woes confirm that problems in the banking system exist globally, not only in Europe.

Fact 3 - Money markets are seizing up

Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.

Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.

American money market funds, which manage around $1.6 trillion, historically invested around 40-45% ($600-700 billion) with European financial institutions. Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk.

European banks are having to pay higher interest rates, if they can attract funds. The problems are not confined to European financial institutions. Despite limited known direct exposure to European sovereigns and their relatively strong financial positions, Australian banks' credit costs in international money markets have increased by more than 1.00% in less than 3 months.

As a result, non-financial institutions are finding finance less readily available and more expensive. Anecdotal evidence suggest that businesses are having difficulty financing normal commercial transactions, recalling the credit problems of late 2008/ early 2009.

Banks are increasingly following Tennessee Williams' advice for survival: "We have to distrust each other. It is our only defense against betrayal."

Fact 4 - The broader economic environment is deteriorating.

The global economic recovery is stalling. The risk of a recession or minimal growth is significant.

The favourable stock market reaction to the latest report of growth in orders for durable goods in America misses an essential point. At around $200 billion an month, it is still around 20% below its peak in 2007 and only at 2000 levels.

Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.

Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.

The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.

If market seize up again, then "this time it will be different". There might just not be enough money to bail out everyone and every country that may need rescuing.

Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies - namely printing money or quantitative easing - have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.

The global economy may muddle through, but a second credit crash is now distinctly possible. But the trigger and timing is unknown. As John Maynard Keynes remarked: "The expected never happens; it is the unexpected always."

Satyajit Das
August 27, 201

Satyajit Das is author of Traders, Guns and Money: Knowns and unknowns in the dazzling world of derivatives (August 2006) and Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)

www.ritholtz.com


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