Part 1 - Introduction and Opening Oveview

Introduction - A Personal View
October 12, 2008. I originally set out below, to try and predict how the present financial crisis might affect the market for miniature portraits, but I am afraid it has turned into rather a long analysis of the crisis!

A Personal Sense of Deja Vu
It is unclear how long it will take to recover from the current financial crisis, but over the last couple of weeks, CNBC has been compelling viewing. With a few exceptions, most commentators have seemed like deer caught in headlights, without any idea of what is coming next.

As the crisis will be looked back on as a once in a lifetime event, I feel it is worth recording some personal thoughts about it.

Initially, my greatest personal sense was one of deja vu, as in late 1989 I was recruited at short notice as Chief Financial Officer for a major regional bank with over $20b of assets which had got into financial difficulties and needed managerial assistance. (Cartoon sourced from www.berryreview.com/.../)

Previous to that, I had managed an investment company which survived the 1987 crash, largely due to my personal credo that; "profits are interesting, but cash is vital". Thus, it could be said I tend to be conservative by nature.

Anyway, a month after joining the bank in 1989 and assimilating the financial situation, I found I needed to meet with the directors and tell them that a cash injection of $600m to $1000m was required to meet the required capital adequacy ratio.

This was because abnormal losses on lending of $60m to $100m were becoming apparent. If the accumulated capital of the bank was reduced by these losses, the bank would then need to either increase capital or reduce its asset base by ten times the amount of the losses to meet its required capital adequacy ratios.

To put it another way, an abnormal and complete loss by a bank of say $10m, on a loan of $10m, will require the bank to reduce its lending to other customers by ten times that, i.e. $100m so as to meet its legally required capital adequacy ratios, or alternatively to seek $10m of new capital to offset the abnormal loss.

The reaction of the directors to the advice of the capital requirement was effectively denial, which caused me a great deal of stress and worry from their inaction and their desire to paper over the problem.

Eventually matters reached the public domain and over the following months, there was a lot of political infighting which gave me an even greater sense of deja vu, as it had parallels with the current US Presidential election and the politicised actions of Congress.

In the end the bank was saved by a large cash injection of public money and the setting up of a "bad bank" to hold the bad assets, much as with the Paulson plan. Subsequently, the bank was acquired by a much larger bank, but the stock holders had been ill served by bank management and lost most of their investment.

Lessons About Bank Failures
In my view the reason for the near failure, was that several years previously the bank had been publicly listed for the first time and to assist with the issue, $100m of new capital had been injected into the bank.

This extra $100m sounded like a sensible idea, but it gave rise to a major problem. Banks usually have capital adequacy ratios of around $10 capital for each $100 of assets. Thus the capital injection of $100m immediately gave the bank extra lending capacity of $1000m.

This was like Aladdin's Cave, or the Genie in the Bottle, for the lending staff who saw it as an opportunity to grow market share at the expense of their competitors. There was a flood of loan applications as the sales force aggressively sold loans.

With a stable economy and the low nominal value of house and car loans, compared to the new lending pool of $1000m, many of the new loans were for property development and in the lending "feeding frenzy" insufficient account was taken of the risks.

The 1987 share market crash revealed the risks and led to a rapid slow down which, paradoxically, the bank might well have absorbed if its capital had not been increased at the time of listing.

However, the high proportion of risky loans made from the capital increase, meant the bank was brought to its knees.

Thus, for me the parallel with 2008, was the much increased lending ability of the major investment banks when they were freed from regulation and able to increase their lending from ten times their asset base to 30 or 40 times their asset base. As with the example bank mentioned above this immediately meant that the banks concerned could increase their lending from $100 per $10 of capital, to $300 per $10 of capital.

Again it must have seemed like Aladdin's Cave or the Genie in the Bottle for the lending staff and in competing for market share, they went for riskier loans and sought new financial products to use up their vastly increased lending ability.

Like auditors, risk management staff and credit committees in a bank are seen as killjoys, who are trying to prevent lending staff from doing deals and making money. If top executives are also trying to increase market share and their bonuses, the credit committees are in a lonely and invidious position. To use another analogy, the credit committees are like a combination of the boy in the story of "The Emperor's New Clothes" and the goddess Cassandra, shown here.

As an executive, I can recollect a number of occasions when I have also felt like Cassandra; "destined to be able to forecast the future, but at the same time cursed that no one will believe the forecasts".

The problem is compounded in 2008, in that many banks are affected by abnormal loan losses. Thus there are many banks competing to reduce their asset bases by ten times their losses to maintain their capital adequacy.

In many past banking crises, there was only one bank affected and hence other banks were available and ready to lend to the good customers of any failing bank.

In2008, many banks have abnormal losses and hence the lack of alternative banks willing to loan money to customers of failing banks, coupled with a combined need for many banks to reduce total banking assets, has led to a major credit squeeze.

The 1873 Example

Peter Kedrosky has observed on his website at paul.kedrosky.com/.../10/03/get_your_bankin.html as below that the 1873 crisis is more similar to the current 2008 crisis, than that of 1929 is to 2008.

"A banking crisis in Europe took hold in 1872 after a mortgage lending boom, one in which house prices climbed endlessly, houses became loan collateral, and all sorts of dubious banking and lending behavior went on, much of it pushed by return-seeking banks. Everything came unglued in late 1873 as the European economy unwound and housing prices began falling, thus causing European banks to fail in a cascade, and interbank lending rates to soar as no bank knew which other bank would fail next. The problems spread to the U.S. in 1873, where debt-needy railroads began failing as European banks withdrew funding, this after a long boom had produced an over-levered mess, and then large numbers of U.S. banks followed afterwards.

The whole thing took around four years to unwind in the U.S., and slightly longer in Europe. Admittedly, there was little done at the federal level to ameliorate things in any meaningful way, and there were widespread labor troubles at the same time, both of which helped cause the economy to stay down for the count, adding to the woes."

The Origin of the 2008 Crisis
A major element was the low interest rates offered from 2001. Although 9/11 was a major shock for America and the effect on families who lost loved ones can not be understated or ignored, the event was not as calamitous for the US economy as might be first thought.

It is not intended to be callous, but from an economic point of view the death toll should be compared to the far higher annual US death toll from violence and motor vehicle accidents.

On 9/11 there were about 2750 deaths, compared to annual US deaths reported to be 42,000 for highway deaths in 2001 and 29,000 deaths in 2000 in incidents involving fire arms. A combined total of 71,000 or about 25 times as many as on 9/11.

After the initial shock, the Federal Funds interest rate was reduced to stimulate the economy, but in my view the rate was reduced to a level lower, and for longer, than was necessary.

This is shown in the accompanying graph of the Federal Funds rate.

I think after a short stimulus, if one was needed at all, rates should have been increased to curb demand.

The Federal Reserve Bank should have realised sooner that the required underlying interest rate needed to be closer to 4% or even 5%, not levels of around 1% to 2%, as it was reduced to in 2002/2003.

If this analysis is correct the person most able to have anticipated and prevented the current crisis, but who did not do so was Alan Greenspan who was Governor of the Federal Reserve Bank from August 11, 1987 to January 31, 2006.

The Psychology of Investing at Low Interest Rates
For a highly leveraged investment, low interest rates are seen to be very attractive and so encourage risk taking.

A borrowing rate of 3% compared to one of 6%, gives a much better cash flow and hence seems to reduce risk.

However, for highly geared investments, the major risk is more often with the overall asset value, not the interest rate.

Thus on an investment leveraged at 25:1, a reduction of the interest charge from 6% to 3%, will on the face of it, greatly improve the investment return.

But if at the same time, the overall asset value falls by as little as 4%, the fall in asset value will wipe out the equity completely.

The Effect of Low Interest Rates
The very low interest rates were coupled with Fannie and Freddie being encouraged by politicians to make loans to enable more people to buy homes, some of whom could not afford their repayments when interest rates increased.

The low interest rates also made it attractive for hedge funds and private equity funds to increase their own gearing to make investments and launch large takeover bids for listed companies.

However, I believe the markets could possibly have managed these elements and they would not have led to the current crisis without the removal of capital adequacy ratios for the major US investment banks.

To utilize their lending capacity they aggressively loaned money and developed new financial products right at a time when interest rates were low.

Traditional banks saw this aggressive drive for market share by the investment banks as leading to a reduction in their own market shares. Thus to protect market share the investment arms of traditional banks developed their own new products.

The drive for new lending and investments acted as an incentive for the major players to sell more and more securitised home mortgage products. Small mortgages were grouped for administrative simplicity and sold as larger packages to major investors.

Hence there was continuing investor appetite, and a selling incentive, for rapidly increasing, and consequently more risky, home lending. Therefore the risk profile of new home owners and their mortgages became worse and worse.

To satisfy their lending procedures and spread their risk, the banks trading and on-selling the securitised home mortgages to investors, mutual funds, hedge funds, and private individuals, took out insurance against with major insurance companies such as AIG against the failure of investment banks who were parties to the products, such as Lehman Bros.

Given the familiarity and mammoth size of the named parties, the risks were assumed to be minimal and hence premiums were also minimal. These insurance products were called Credit Default Swaps (CDS).

The End of the Golden Summer
Inevitably, the increased risk profile of the basic home mortgages, coupled with an increase in interest rates led to rising mortgage defaults and foreclosures.

This situation might possibly have been manageable, if there had been early action to reduce the number of foreclosures.

However, as the number of foreclosures increased in the summer of 2008, investors started to worry about the financial instruments they were holding. The banks started to reassess their risk, with rumour and speculation being exchanged about other financial organisations.

AIG was an early target from its holding and insuring of high values of CDS. It sought and was granted $80b from the US Treasury to remain solvent.

All the five major investment banks were seen to be at risk and were becoming shunned by lenders. Apart from their exposure to CDS, as mainly investment banks, they did not have a large retail deposit base to assist with necessary funding. Now none of the five major investment banks remain trading in their pre September 2008 format.

As mentioned earlier to offset abnormal loan losses, banks need to reduce lending to other customers by ten times as much as the amount of any abnormal losses to maintain their capital adequacy ratio. Thus abnormal losses need immediate attention.

Most bank lending is fixed term lending of various terms, but on the other side of the balance sheet, much borrowing is short term and is from other financial institutions.

The Deepening Crisis
Thus, to guard against a bank breaching its ratios in the event of abnormal losses, it must hoard cash resources by raising capital, deferring new loans, reducing lending limits where possible, ceasing to lend to other banks, and raising cash by selling assets.

We have seen this during in September and October, as interest rates for interbank lending have soared and much interbank lending has dried up. Banks are not willing to make new loans and so the ability to buy and sell commercial property has dried up.

Where this did not happen fast enough the banks affected; such as Bear Stearns, Lehman Bros, Washington Mutual, and Wachovia failed, with portions being acquired by larger and stronger competitors.

Additionally, the reluctance of banks to lend has meant that corporates, mutual funds, and hedge funds have been unable to access funds as readily as in the past. Corporates need funds for normal trading purposes, such as seasonal Christmas inventory.

Hedge and mutual funds need cash for greater planned than redemptions, as has now been happening as their investors get more nervous. The large hedge funds and major share investors now also need extra cash resources to meet any margin calls from lenders.

The effect of the drying up of bank credit has led to there only being two main sources of accessing short term money.

Firstly, by banks, corporates, and hedge funds with any overseas cash or marketable assets, selling them and repatriating their cash assets back to America to operate their core businesses in survival mode. This inwards flight of USD has caused the USD to appreciate rapidly.

Secondly, the only freely operating market mechanism to readily raise cash has been by selling on the share market, both in the United States and overseas.

As the American banks, corporates, many major investors, and hedge funds are all effectively forced sellers, they far outweigh the number of buyers, who themselves are likely to be tight for cash. Hence there are far more sellers than buyers and the share markets round the world have plunged.

Mark-to-Market
Followers of the financial crisis will have seen references to mark-to-market valuations being a problem.

To try and explain this, one should imagine that one owns a small business called Fred's Lights, say selling light fittings. The business has capital of $50,000 and inventory of light fittings which had cost $100,000.

In the same area there is another identical sized competitor, Joe's Lights, also selling identical light fittings, but who goes bankrupt and all his inventory is sold at a liquidation auction. Although it had originally cost $100,000, at auction Joe's inventory only realises $25,000, so there is an actual loss of $75,000.

Under mark-to-market rules assets need to be valued at the lower of cost or current realisable market value.

Using this accounting rule Fred's Lights also has to value its inventory effectively on a forced sale basis, at a notional value of $25,000, i.e. $75,000 below cost. This loss of $75,000 notionally wipes out the capital of $50,000, so the business shows a capital deficiency of $25,000 and appears to be insolvent.

When the rule is applied to banks, it means that its assets need to be valued at the same distressed value for similar assets, as were achieved on liquidation of any forced sale of similar assets by a failed bank.

Following on from previous comments above about abnormal losses and the need to reduce bank total assets by ten times the amount of abnormal losses, the market-to-market rule further forces banks to reduce total assets as fast as possible.

Thus, there is a big debate over what asset values should be adopted by surviving banks in these circumstances. The pros and cons are too complicated for this attempt to explain the present financial crisis.

The Japanese Ripple Effect
The impact of all the falling share markets has caused fear amongst Japanese investors who had invested in high yielding currencies, as Yen interest rates were so low.

Thus, there has now been a rapid rise in Yen and a fall in high yielding currencies such as AUD and NZD.

Other Downward Pressures
The drying up of bank credit for corporates and increasing consumer nervousness, has now led to a dramatic fall in consumer demand. For example, US auto sales in September 2008, were 30% lower than in September 2007.

The flow on effect of this tightening of consumer demand has led to reduced earnings outlooks for corporates in 2009 and so put more downwards pressure on the share market.

At present these fears of reduced corporate activity are leading to a view of sharply reduced world demand for commodities. This itself is causing commodity prices to fall, catching hedge fund with large long commodity positions which they are needing to sell at losses.

Some people have wondered why the price of gold has not increased further.

My view of this apparent paradox in a time of fear, is that it is because there are more hedge fund and mutual fund sellers of gold, than there are private buyers of gold. Also remember that two-thirds of world gold production goes into the jewellery trade.

Hence if demand for gold fashion jewellery falls by 10%, say from 67% to 60% of total gold production, then investment buyers will need to buy 20% more gold (i.e. 33% to 40%) to offset the fall in demand and keep the price constant.

Programmed Share Trading - Down and then Up
Yet another downward pressure in the share market has been programmed trading, where selling and buying parameters are incorporated into a computer program and the program trades without human intervention.

It used to be that most trading was by human traders who would have an emotive feel about prices dropping too quickly, but now some 70% of trades are by computers which are unemotional and just trade according to their programmed parameters.

It seems a fair assumption that the recent abnormal share market volatility and index moves have not been adequately built into the trading programs. Hence some irrational buying and selling decisions are being made by computers, with a preponderance on the selling side.

Sooner or later the market will turn upwards. While there may be a sudden large initial rise , I am more inclined to think that the preponderance of programmed trading, will lead to continuing volatility, with further market recovery being of stepped increases over a longer period of time.

This is because programmed trading will trigger selling into any rally.

In addition, it must be expected that individual share trading programs will be adjusted to take account of recent volatility. Thus it will be hard to predict how the various programs will interact over coming weeks.

There were signs of this on October 10, after the initial fall caused by margin covering, when traders decided it was time to buy, but programmed trading wanted to sell more stock on each intra day rally, than the traders were prepared to buy intra day.

Do you still have a sense of humor?
Those without a sense of humour may prefer to skip this section. On eBay there is currently on offer the following item with an opening bid of $1.00 Bankruptcy Sale: United States of America

It is described as;
"Country for sale: Must sell to pay off debt. Great News for potential buyers... own your own country for pennies on the dollar due to credit crisis, high debts and poor management. Low minimum bid and no reserve. This is a bargain! Motivated sellers. (Sale proceeds to be divided equally among all citizens. Sorry, residents who are not citizens will not participate.) Purchase requirements:

1. Must assume all debt to complete purchase and run country with a balanced budget after purchase.
2. Must initiate a "one-man-one-vote" democracy since "representative democracy" is not working and most citizens feel disenfranchised under the current system.
3. Must guarantee the availability of health insurance without pre-existing condition exclusions and allow citizens to join congressional health insurance and retirement program.
4. Must install term limits on all elected positions so there is no longer such thing as a "career politician." Representatives must be required to return to previous work after completing term of service.
5. Must agree to create law stating that any elected official at any level of government including, local, state or federal, found to have acted in his/her own interest over the citizen's will be deported and permanently barred from entrance to the United States of America.

Shipping not available. Take possession in Washington, D.C. before November elections. Special interests welcome to bid since you already control the country anyway as long as you agree to the above non-negotiable terms."

Where to from here? - Short Term
On a more serious note, on Friday 10 October there were signs on the market that the bottom might be near. One sign was that a major settlement of Lehman CDS was settled without apparent problems. The parties who insured the product are now required to pay the insured parties around 90 cents in the dollar.

The US Treasury now appears to be considering investing in major American banks. The best way for the Treasury to do this is to act as underwriters at each bank for a cash issue of say, five year convertible preferred stock, to existing stockholders.

This would enable existing stockholders to subscribe to avoid being diluted and avoid criticism of the effects of such dilution. Being five years convertible preferred stock would help protect the Treasury investment and the conversion would provide an exit strategy for the Treasury.

Insofar as the various world economies are concerned, for most countries I doubt there will be a large recession. The most likely scenario is really for the average citizen in America or Western Europe to need to imagine that their financial position is likely to revert to what it was several years ago. That is, not as wealthy as the Dow peak in 2007, but about the same as in 2003.

For example, and as a crude measure, on October 10, 2008 the Dow index was 8451 and well below its peak of a year earlier on October 9, 2007, when the Dow Jones Industrial Average closed at the record level of 14165.

But even so, at the October 10, 2008 close of 8451 was equivalent to where the Dow was in 1998 before the drop in interest rates. Thus before any recovery, the Dow October 10 level is similar to 1998 level.

The 14165 peak must include an element of Housing Bubble, so must be discounted as a target in the medium term. It seems therefore be that recovery is likely to settle somewhere between the 1998 index and the 2007 index.

Many investors will measure their investment recovery against progress towards the 14165 peak, but they are likely to have to wait a long time to reach 14165 again.

Using a 2008 low point of say 8450 and the 2007 peak of 14165, a simple average is about 11300.

The 11,300 mark represented the level of the Dow in late 1999 and was touched again in 2000, 2001, and also between 2006 and 2008. The equilibrium level between 1999 and 2008, however looks closer to 10000 and so between 10,000 and 11000 seems a more likely target range over the next year or two.

With 12000 being a more likely maximum recovery by 2010 than the previous peak of 14165.

Thus, as a result of the financial crisis, there may be a small decline in average living standards in America and Europe, perhaps equivalent to the loss of two or three years of growth, say of the years 2006 to 2008.

This would be an inconvenience for most people in America and Europe, but not a catastrophe. It is therefore to be hoped that consumers in Western economies can recover their confidence before any further damage is done to Western economies.

Where to from here? - Longer Term
The two major growing consumer economies at present are China and India. Much of their investment capital comes from within their own countries, plus Japan, Taiwan, Singapore, and the Middle East.

The population of China and India is close to 2.5 billion, with over another 1 billion in Indonesia, Pakistan, Bangladesh, Philippines, Vietnam, Thailand, and smaller developing countries in Asia.

The Asian total population of around 4 billion for developing Asian countries (and excluding Japan and South Korea at 180m) is nearly five times that of America and the European Union combined, which is about 800m.

There continues to be a rapid growth in living standards in China and India, although off a very low base. There is also likely to be continuing consumer growth within Russia, population 140m, even if some of the Russian oligarchs have lost large amounts of money on their equity investments.

Thus a 10% drop in consumer confidence in the USA and Europe, affects 80m people.

But if 10% of people in China and India alone feel more consumer confidence, that affects 250m people even if their average consumption is much lower than in Western economies.

Thus, although Chinese and Indian exports to America and Europe will suffer in the short term, I think the growth of Chinese and Indian internal consumer demand over time, will more than compensate for their lost exports.

Rapid growth will continue in China, India, and some other Asian countries. Thus exporters of commodities to those areas should be able to grow strongly in parallel with the Asian growth.

Part of the reason for the current rapid increase in the value of the USD is due to investment funds flowing into America from investors in Asia and the Middle East to take advantage of the cheaper American equity market.

Overall, I therefore see an increasing change in the balance of the world economy as America and Europe overcome their financial indigestion, while Asian consumers spend more in their own economies.

This will mean faster growth in Asia over the next five years than in Europe or America.