The Credit Crunch Will Go On

Link
The Credit Crunch Will Go On
By DAVID ROCHE

The events of Black Sunday (the bankruptcy of Lehman Brothers) and Terrible Tuesday (the forced takeover of AIG) are seen by most observers as either cataclysmic or cathartic; an angry sun setting on decades of "credit" capitalism or the final cleansing of the financial system of its excesses, resulting in swift recovery.

Neither image is accurate. The events of this week are a logical progression in the elimination of credit excesses, marking neither Armageddon nor the beginning of renewal. Unfortunately, this is just another stage in the lengthy adaptation of the market system to a less-than brave new world. But it does allow us to get a glimpse of where we are ultimately heading.

Here are the key events: Two investment banks, categorized as non deposit-taking financial intuitions (NDFIs), were in difficulty. One fire-sold itself to a bank (Merrill). The other went bust (Lehman). In the case of AIG, another NDFI, the government has imposed a controlled bankruptcy through nationalization.

The collapse of these NDFIs ought to have been expected. Why? They have much less capital than banks to support losses and far riskier assets. They borrow and lend money using securities (often pledged by their clients) as collateral. As financial markets fall their gearing ratios (i.e., the value of their debt relative to their assets) rise. To maintain a constant gearing ratio, the NDFI has to liquidate assets and pay down loans. This causes financial asset-prices to fall and the NDFI gearing ratio to rise again.

Then the process begins again.

The points to bear in mind from this are that NDFI balance sheets are notoriously cyclical, far more so than banks, which have much more stable loans. Last November, my firm put the ultimate losses that banks and NDFIs would suffer as a result of the coming credit crisis at about $1.3 trillion (this included losses in the credit insurance industry, specifically singling out AIG). Of those potential losses, approximately half were marked down to NDFIs and the rest to banks. But up to Black Sunday, the NDFIs have admitted losses of only $250 billion, compared to the banks' $510 billion.

Whether this is deceit or denial is immaterial. There are huge losses in the NDFI sector. Recent events are a reckoning with reality -- and not the final one by any means. For example, my firm estimates that about half of the NDFI losses are located in Europe, and there silence, so far, reigns supreme. Moreover, the "real" economy has still not yet registered the full effects of massive credit contraction.

...