The US government's takeover of the bankrupt Fannie Mae (FNM) and Freddie Mac (FRE) on Sunday is reminiscent of the UK government's nationalization of Northern Rock Bank, albeit the scale of Sunday's takeover is several orders of magnitude larger. Still, the result is the same, total loss of capital for the shareholders. I won't repeat the dynamics of what has transpired on Sunday as the volume of similar articles speak for themselves.
Those now contemplating buying 'cheap' banks should be aware that while many of the banks may survive, especially those that are too big to go bust such as the GSEs and Northern Rock in the UK, it does not mean that investors will not experience a near total loss of capital at the once thought of impossibility of big bank busts now increasingly becomes routine as the credit crisis moves into Phase II - The Economic Crunch.
Many banks will be able to hobble along though the aid of bailout money and capital injections by the clearly foolish and inexperienced sovereign wealth funds that know not what to do with all of the newfound petrodollar and Western consumer junk buying wealth. However this does imply that capital will be depleted which basically achieves the same outcome of loss of value of more than 90% for shareholders.
Most of the big banks are insolvent, much of the capital has already been destroyed, the only question that remains is how much of tax payers money will be spent on keeping the banks afloat. Despite all of the hype from the British government and some inexperienced market commentators, the British economy will be hit the hardest from the credit crisis due to the size of the financial sector and the lack of size of the manufacturing sector. Thus we witnessed the Sterling crash by more than 12% against the US Dollar, exceeding the forecast target of £/$1.80 by a good 4 cents. Much commentary has immediately jumped on the bandwagon of how this will boost exporters. But what exporters? The UK's manufacturing base has shrunk to just 14% of the UK economy and of that exporters are barely a pin prick.
The only world-beating industry Britain had was the financial sector, which was inflated by the derivatives market that saw an artificial mark to market pricing boost bank profits, while few wondered how the banks could be making such huge profits, when in actual fact the amount they earned from retail operations was barely 5% of the profits reported.
The answer was that the profits were NOT real, they comprised a tulip mania methodology in the form of CDOs and mortgage backed junk. But that came to a halt suddenly one day in August 2007, when market participants stopped buying the tulip backed securities, and thus the market collapsed. Well, it would have collapsed if there were an open market instead of what resembled an inter bank money market price quote as compiled by the British Banking Association, while reporting a jump in the inter bank rates.
However, this failed to report the true extent of the problem as the Banks, fearing a loss of credibility in a confidence obsessed market place, mis-reported the true extent of distress they were under and hence the crisis to some extent flew under the radar of the regulators,. It was only in March of this year that the true extent of the problem started to dawn on the governments of the world that basically the big Western banks were all virtually bankrupt due to their exposure to the fast deleveraging derivatives market.
Government action was taken, but as I pointed out at the time, the UK government was throwing £50 billion at the financial system, a huge sum for the British taxpayers. This was a mere drop in the the $500 trillion derivatives ocean, and the true amount that the UK taxpayer would end up financing will run in the several hundreds of billions of pounds. Total losses that the tulip-backed banking crisis will generate keeps doubling, up from $100 billion way back in June 2007, to $200 billion, $400, $800, $1600 billion was the latest. Well, losses have now passed $600 billion and we are not passed the worse point yet. Another doubling of estimated losses coming up by year end to $3 trillion?
What does all this mean?
It means that the world's western governments are fighting the twin battles of inflation as a consequence of all of the money being printed for the politicians to save their electoral necks, and deflation from bursting of the credit bubble and global deleveraging.
As I warned way back in March of this year in the article DELEVERAGING- Gold and Commodities Teetering on the Brink of a Bear Market?, inflation will give way to deflation, as the economic crunch transpires. The last component required was to snuff out the commodities bull markets following the final peaks this summer. The impact on inflation will lag somewhat so evidence of deflation may not emerge until early next year in the economic data. However, it will, and this will contribute to deep interest rate cuts.
The UK interest rates could be cut all the way from 5% to as low as 3%. However, as we have witnessed with the deep US interest rate cuts to 2%, the rate cuts will fail to stimulate the economies as it will not be enough to counter asset price deflation as a consequence of banks being forced to sell assets as deleveraging continues.
The trends remain inline with roadmap of March this year as the following graph illustrates:
The light at the end of the tunnel will only come once the banks are able to repair their balance sheets, requiring much more taxpayer bailout money.
What could investors do?
Speaking for myself, I have focused on fixing cash savings inline with government 100% guarantee limits at fixed rates of return above 7% in Sterling for maturity in 2 years time in advance of much lower interest rates, as well as diversifying into other currencies albeit at lower rates of interest. I am avoiding bonds as the consequence of the flood of government bailout debt implies higher bond yields.
The collapse in emerging markets has also perked my interest into accumulating limited holdings for the long-term, primarily in China, and adding to existing investments in India. My original analysis way back in October / November 2007 targeted China's SSEC to fall by 40% to below 4000 as the graph illustrated.
Subsequent analysis in March this year concluded with a revised target of 3,000 to coincide with the strong support zone of between 2,500 to 3,000. The SSEC index has since fallen below that level to under 2,200. The SSEC is clearly homing in on the 2,000 support level and therefore the downside now looks increasingly limited on a long-term basis.
Still these are volatile and uncertain times and the expectation therefore is for all investments to be for a period of well beyond the time frame of the current crisis, so for well beyond 2011, but definitely the "You Must be Mad to buy in this market" conclusion of late last year no longer stands. The market is what I would now consider to be deeply oversold, though despite the strong growth prospects, Chinese stocks could still get cheaper, which for this analyst is an acceptable risk for some long-term exposure, even after taking account of the fact that 2,500 to 3,000 levels will now act as strong overhead resistance.
But where the bulk of portfolios are concerned, cash still has to be king despite the impact of the collective currency devaluation as a result of exploding levels of government debt. That is expected to see UK debt bust through the 40% of GDP golden rule onwards and upwards towards 60% of GDP by late 2009.
And as for the US taking over $5 trillion of Fannie and Freddie debt, whatever bookkeeping tricks are deployed, the fact of the matter is that $5 trillion is now effectively US Government Debt against which illiquid housing stock and derivatives are set. Therefore US debt has now doubled, the consequences of which will be experienced in the loss of the dollar's real value. That does not mean that the US Dollar will fall, as the loss of value is relative to the other collapsing fiat currencies. My analysis of 17th August still stands for the US Dollar to be in a bull market that targets USD 90 by early 2009 (current USD 79).
You're trying hard to protect your capital from asset price deflation and government debt inflation.