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Credit Disaster? Maybe It's Not So Bad After All

Maybe, just maybe, the financial world is not about to implode.

Credit Crunch
Credit Crunch

Such is the level of disaster mongering surrounding the latest phase of the eight-month-old credit crisis that you could be forgiven for thinking we will all soon be hoarding food and reverting to a barter economy.

At the very least, some market pricing and financial commentary has invoked a systemic collapse akin to 1929's stock market crash and the Great Depression that followed.

Let's put that in context. U.S. historians estimate that in the first 10 months of 1930 some 744 U.S. banks failed -- rising to a total of 9,000 by the end of the 1930s. Savers lost the equivalent in today's money of $140 billion in deposits by 1933.

U.S. unemployment rose to 25 percent from 4 percent in 1929 and prices and incomes fell by 20 to 50 percent over the same period.

The debate, as German government spokesman Thomas Steg noted this week, has become "hysterical.''

This crisis is serious, for sure. But there is a pretty good chance it is not 1929 -- even if the U.S. Federal Reserve has adopted depression-era tactics to address it.

"To justify a repeat of last week, you really have to start believing this is going to be 1929 again,'' said Jim O'Neill, chief global economist at Goldman Sachs. "With the Fed moving so quickly, I think that is unlikely.''

But with investors already positioning for a worst case'' scenario, there is a chance of a large pendulum swing.

Last week, a survey by Merrill Lynch showed a majority of 193 fund managers were overweight cash in March, signaling extreme caution.

No coincidence then that three-month U.S. Treasury bill yields are their lowest since the 1950s, at less than 1 percent. Or that safe-haven gold had topped $1,000 an ounce before a violent reversal late last week that may itself signal a turn.

"People are one-way; they've got the cash; they believe equities are cheap,'' said Merrill consultant David Bowers. "They just need a catalyst to know when it is safe to go back into the markets.''

Whatever the catalyst for a turn, it will first need to offer evidence the problem is not getting any worse. The credit crisis, rooted in the U.S. real estate bust, is now essentially one of bank liquidity and solvency. The problem is lack of confidence. Visibility is near zero as markets fail to provide adequate pricing for mortgage assets and securities.

The only burst of clarity tends to happen at the end of each quarter when accounting rules force banks to report asset values on their books. And as they write down assets where market prices are impossible to find, the banks struggle to raise cash to meet capital adequacy rules. This is despite the fact that many of these assets are in suspended animation rather than worthless -- many will still pay out over the life of the loans.

The coincident hoarding and searching for cash in the final weeks of each quarter leaves the weakest exposed and it's no surprise stricken UK lender Northern Rock and U.S. investment house Bear Stearnswere forced to go cap in hand to their central banks in mid-September and mid-March.

What's the Circuit Breaker?

With only volatile derivative prices or bespoke pricing models to go by, conservative accounting has led to huge writedowns, dents to bank capital ratios and a rationing of lending that we now know as the credit crunch.

So what could be the circuit breaker?

First, bankers and investors need to be able to see some for the crisis. Otherwise they will continue to hunker down in safe havens of cash and gold and perpetuate the cycle.

One important development this month -- drowned out by panic surrounding the Bear Stearns rescue -- was that credit rating firm Standard & Poor's said the end was in sight for writedowns of the subprime mortgage assets that sparked the crisis.

Putting total writedowns at some $285 billion, it said the banking sector had already written off the majority of its distressed assets and more than $150 billion was already declared. First quarter writedowns at three Wall Street firms that reported last week -- Goldman Sachs, Lehman Brothers and Morgan Stanley -- were indeed much less than analysts had feared.

S&P also emphasized that some subprime mortgage writedowns are larger than any reasonable estimate of actual losses. This raises the prospect that when the mortgage market normalizes, banks may be able to add "writebacks'' onto quarterly results.

In the meantime, central banks need to stand ready to prevent seizures of the banking system and governments need to do all they can to stabilize the housing and mortgage market.

The Fed has gone some distance by slashing lending rates by three percentage points in six months and recently pumping $400 billion of liquidity into the banks.

The U.S. government's release last week of an additional $200 billion of cash from housing finance agencies to plough into the distressed mortgage market is another major boon.

No magic bullets. But when a turn comes, it may happen fast.

"We have all learnt, many times, that every moment of crisis is always also one of opportunity,'' said Max King at Investec Asset Management.

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