Disquiet on the western front of the credit world
By John Dizard
Published: March 4 2008 02:00 Last updated: March 4 2008 02:00
The credit world is aligning itself into political factions, divided over the right approach to untangling the present mess. On one side are the trader-fundamentalists, with one hand on the Bloomberg keyboard, the other hand on a dog-eared copy of Atlas Shrugged . They believe in the literal interpretation of scripture, which in this case means that an asset is only worth what the bid side says it is. As far as they are concerned, the only way to deal with the excesses of the credit markets is to take the write-offs and start over, having accepted the revealed truth of what bankruptcy sale buyers are willing to pay.
Opposed to them are the would-be managers of systemic risk. They believe that the aggressive application of the mark-to-market rule would result in another Great Depression, only bigger. Their Qum is Washington DC, where the differences between the Republicans and the Democrats are small relative to their agreement that a deep recession, let alone a depression, must be avoided at all costs. One of those costs could be years of stagnation and low growth. You could call them Keynesians, except that Keynes was strongly opposed to currency debasement. As far as this group is concerned, currency debasement to the point of depravity is a good starting point. (Strangely, they still publicly proclaim adherence to a "strong dollar policy", even at $1.50 to the euro. What would a "weak dollar policy" be?)
However, the anti-fundamentalists are not just a Washington group. They also have strong representation at the top of the major dealers and banks. While the dealers' and banks' trading desks are mostly populated by fundamentalists, management people and board members on the upper floors realise that any thorough "liquidation" would include them.
This political fight is most evident in the US. That's because the US markets and institutions are further along in recognising the extent of the problems, on balance sheets and in business practices, that built up in the past decade. Up to now, European finance has appeared to be a happier place than its counterpart across the Atlantic. However, both the credit trading fundamentalists in New York and the systemic risk managers in Washington have done their own analyses of European balance sheets, and agree that it's a matter of time until the storm moves to the east.
As one credit strategist for a major New York dealer says, "I was over doing client calls in Europe last week, and they told me that they believed the US financial system will recover faster because the loss recognition is swifter." A mark-to-market fundamentalist, he believes that it follows that "Any move to retard loss recognition is, categorically, a mistake." At the end of the day, the liquidations would win the argument on the integrity of their market economics, while the systemic risk managers, aka Keynesians, would have the politics right. Being politicians at heart, however, the systemic risk managers are going to try to split the difference. That is to say the regulators will try to have as much recognition of losses as possible without any contraction of credit availability for the real economy.
That means that while the central bank people and regulators may be willing to have "flexibility" in the mark-to-market accounting of structured credit product on the books of the financial sector, what they want is to accelerate the recapitalisation of the banks and dealers. Banks and dealers with bigger equity bases could afford to take mark-to-market losses while continuing to lend money and maintain liquid securities markets. Simple, right?
As one official told me: "The easiest way to solve for lack of capital is to go get capital. We are in the early stages of capital raising." The first stage was that series of calls on the sovereign wealth funds in recent months. Unfortunately, the limit on that source of equity has probably been reached, both for the banks and the SWFs. Most of the new equity for the banks and dealers will have to come from their home markets.
As that official continued, "We have been encouraging institutions to get going and do road shows. There is no shortage of capital on the sidelines." At some price that is true. Undoubtedly that new equity will have dividends and seniority superior to the old equity. Which is why the bank and dealer management may be hesitant to book those road shows. It's easy for officialdom to say that the equity holders will be diluted, because it's true. However, if you're a C-suite executive or board member, you are supposed to be working to protect the interests of those existing equity holders. We could be talking career death here. So why not put off any decision until we see what the marks will be at the end of the quarter?
Even before the lowest marks-to-market are taken, there are probably some real values to be had in the credit markets. They are not, I believe, to be found in the junk market, which probably does not yet reflect the prospective hits to cash flow from the sinking. But the high-grade credit indexes should see some more tradable rallies.
johndizard@hotmail.com
