“It borders on the unbelievable”, says CLSA’s Christopher Wood in a special “flash” edition of his Greed & Fear newsletter. After months of telling everybody that the subprime problem would be “contained”, newspaper editorial writers and mainstream economists now say that all problems can be solved with a bit of central bank liquidity, he grumbles.
First in line to cop his rage is the “ultra-conventional” FT (come on, Chris, some of us are, some of us aren’t). Wood quotes an FT editorial comment on Friday, which said: “Based on what we know today, there is no reason to think any big financial institution is in danger”. (To be fair, the rest of the FT’s comment called for “clarity” and “calm”, warning central banks against panicked interest rate cuts and investors against disorderly stampedes for the exits, and said the most serious problem was the uncertainty over the extent of banks’ ABS losses.)
Wood, however, is just getting into his stride: “That the ECB and the Fed have been forced to lend tens of billions of dollars on Thursday and Friday to prevent, or at least delay, a ‘Minsky moment’ (see Short View) is evidence of market failure; most particularly the failure of the asset-backed securities market and its many appendages.”
The cliché trotted out by “conventional thinkers” in recent years, continues Wood, is that securitisation works because losses are spent throughout the system and not contained on banks’ balance sheets. “The truth is more sinister. For the grim analogy that most resembles securitisation-run-amok is a body ravaged by a spreading cancer.”
“Just because it is not possible to see the problem does not mean that the problem does not exist. This is the reality today”, he says.
Next the central banks have the opportunity to cop some of Wood’s ire. That a single announcement from BNP Paribas concerning three investment funds “could trigger such an extension of credit from a usually hawkish ECB is evidence enough of profound problems in the system”, notes Wood. “True, securitisation works from a pure free market perspective. But free market logic only works if market participants believe they will go bust if they make imprudent investment decisions.
“This is why it is very important that central banks re-introduce market discipline back into the system. Lending tens of billions of dollars at the first hint of trouble is clearly not the way to re-introduce such discipline.”
“Conversely, if modern-day authorities are not prepared to see financial institutions fail, then they should stop pretending it is a free market, re-regulate and ban securitisation, as Congress did in 1933″, Wood says.
For now, he notes, the central banks are “obviously trying to effect a compromise between extending liquidity but not raising interest rates”. Wood’s view remains that the financial problems are far from over, because too many structured finance products of dubious value have been sold. It is also the case, he adds, “that the western world’s banking sector is about to see its earnings evaporate as the front-end loaded revenue accounting encouraged by securitisation disintegrates”.
Near term, equity investors in Asia need to keep an eye on the “oil-led commodity complex”, advises Wood. “The anticipated correction in this asset class will exacerbate the growth scare, which will be a negative for Asia. But it will also accelerate Fed easing by giving Bernanke the evidence he needs for such an easing.”
For now, investors should understand that “this is a far bigger problem than the 1998 LTCM affair”, and that “the much-publicised problem in the world of credit will lead in due course to a significant slowdown in the real economy”. This is particularly the case in the US-centric western world where the financial sector has become so much more important relative to the “real” economy, asserts Wood.
The best way of measuring this is the 30 per cent of S&P500 profits generated in the 2007 first-half by the financial services sector, he says. The next biggest generator of profits was the energy sector, “which is why a commodity correction would also exacerbate concerns about diminishing liquidity”, says Wood, noting that clearly, a “not insignificant part of the money pouring into credit hedge funds and assorted black-box investment strategies has come directly, or indirectly, from oil generated wealth”.
