3 January 2008

Insight: Post credit bubble wealth transfer will beggar belief

By John Plender, chairman of Quintain

When financial market bubbles burst, a transfer of assets from the weak and undercapitalised to the strong and liquid invariably follows. The unprecedented scale of the credit bubble that burst last August suggests that the extent of the resulting wealth transfer will beggar belief.

The process is already well under way. So far, sovereign wealth funds have mopped up some $25bn worth of equity and debt in Citigroup, UBS, Merrill Lynch and Morgan Stanley. One of the safest predictions for 2008 is that this will lead to political friction of the beggar-thy-neighbour kind, with Western politicians complaining that their financial crown jewels are being sold for a song. Yet it is far from clear that the jewels are outright bargains.

In the long run it is admittedly hard not to believe that investing in an 11 per cent IOU in Citigroup with conversion rights attached represents good value. That said, it is possible that this and other comparable investments might be available on better terms at a later date. For while the immediate liquidity problems of the banks have been dealt with over the December 31 year end, more intractable difficulties remain.

A consequence of banks having set up off-balance sheet vehicles such as conduits and structured investment vehicles is that they are now having to put illiquid assets back on to the balance sheet under back-up agreements.

Those assets are piling up uncomfortably fast in relation to the banks’ ability to attract stable funding. They also put strain on bank capital just when dud assets are having to be marked-to-market under the eagle eye of auditors. After the experience of Enron, the Big Four firms are hell bent on providing a pro-cyclical twist to a dangerous financial downturn to protect their backs.

Meantime, a deterioration in credit quality is spreading from subprime mortgages across the financial system. The combined capital and liquidity constraint on the banks is in turn having a malign impact on the real economy where the banks will themselves induce a second round of asset transfers from weak to strong as they tighten lending conditions or put in insolvency experts, especially lower down the business scale.

A final problem is that until all the complex mortgage related structured products can be valued in a way that carries conviction, valuing banks will be a hazardous process. Much hitherto lucrative securitisation business may have gone for ever. The one certainty is that much more capital will have to be raised.

Then there is a currency question. To the extent that their investments in the west are unhedged, sovereign wealth funds take a big risk. There must be a fair chance that the dollar could weaken even further as financial unbalances in the US continue to unwind. There are few safe bets in currency markets, but in Europe the nearest thing to one is that sterling, attached to a debt-sodden UK economy afflicted with larger financial imbalances than the US, will sink. Those high growth economies of eastern Europe that have large current account deficits look similarly vulnerable on the currency front. So while there will be opportunities to buy these countries’ assets cheaply, the timing will be tricky.

For western politicians to complain about the loss of crown jewels is special pleading of a particularly invidious kind. For there is a marked similarity in what is happening today to what happened in the 1997-98 crisis in Asia. Then hot money from western banks exacerbated financial bubbles and inflation across the region. When the hot money pulled out, more stable western funds snapped up Asian assets on the cheap. Now official money from Asia and from the petro-economies has contributed to the western credit bubble. And the sovereign wealth funds are mopping up after the burst.

The significant difference is that the debacle in Asia was followed by truly appalling losses in output and employment whereas the US is merely at risk of recession rather than slump. Not only is hypocrisy an issue here. There is folly when people in current-account glasshouses throw protectionist stones.

1 comment:

Mike said...

Excellent post. I realize this isn't written by you but I frequent your blog and appreciate your perspective.