The stock market might bounce for a while, global currencies might stabilize for a while, but don’t be deceived, large problems remain…very large problems. And the price to fix these problems will run into the tens of trillions of dollars. That’s the kind of price tag that could ruin a national currency or two…even the world’s reserve currency.

While equities continue to go up and up, most of us are left scratching our heads. Is this the real thing or will it go down in history as ‘just’ another bear market rally? Not so long ago, the entire financial system stared Armageddon in the face. Now, only a few months later, equity markets behave as if all the worries of yesterday have been washed away.

The dangerous conclusion to draw from the experience of the past few weeks is that all is now well and dandy and it is time to load up on stocks again. I cannot emphasize it strongly enough: The bull market of March-April 2009 is almost certainly a bear market rally. As one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932. Bear market rallies can be extremely powerful and hence deceiving.

But the problems are not over yet. Not by a long stretch. It will take longer than 18 months to unwind the excesses of the past 25 years. Analysts at Morgan Stanley reckon that the 15 largest banks, which between them have shrunk their balance sheets by about $3.6 trillion so far in this crisis, will shed another $2 trillion in 2009. The US financial sector debt load (as a % of GDP) is now 117%. In the early days of the great bull market in 1982, the same number was 22%. Households are not much better off than the banks, with total household debt now at 96% of GDP vs. 47% in 1982.

The IMF reckons that both European and US banks – but in particular the European ones – are well behind the curve in terms of recognizing their credit crunch related losses. According to the IMF, there is at least another $1.5 trillion to come.

As the recession bites into the lives of ordinary people, banks will face losses not only on sub-prime mortgages but on all loan products. In fact, sub-prime is indeed a small fraction of the total loan book for the US banking sector. Prime and Alt-A mortgages, together with commercial real estate loans total about seven times the size of the subprime market.

Delinquencies are now on the rise on all mortgage products; however, whereas sub-prime started to deteriorate as early as 2007, it is only recently that delinquencies related to Alt-A mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These defaulting mortgages pose a very serious threat to the U.S. economy, but they are only part of the economic crisis worldwide. By far my biggest concern at the moment is the enormity of the debt problem facing most OECD countries. In the March issue of the Absolute Return Letter, I referred to an important study conducted by Carmen Reinhart and Kenneth Rogoff back in December of last year.

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. According to the authors, governments inevitably underestimate the ultimate cost of a banking crisis, because the indirect costs (such as falling tax revenue in subsequent years) end up much higher than predicted.

The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The true cost is important, because it has to be financed through new bond issuance, and it is my thesis that the sheer size of this tsunami will eventually overwhelm the world’s bond markets. Even using the relatively conservative IMF estimates, the twelve largest industrialized countries of the world will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach. Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping $33 trillion. I didn’t even bother to produce a worst case scenario – it all got too depressing!

I need to put the $33 trillion into perspective. Total global savings (loosely adjusted for the big losses in 2008) are probably somewhere in the region of $100 trillion. In other words, financing this crisis could absorb one-third of total global savings.

Hence it comes down to the price at which governments can attract sufficient demand from people like you and me. One of two things may happen. Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk. I am not yet sure which scenario will prevail, but I do know that both are quite bad for equities longer term.

There is a third route, of course. Governments could print money for themselves, which they could then use to purchase their own bonds. We call that process inflation…and it is already underway.

Source: He Who Borrows the Most, Wins

“If a loose monetary policy and rapid asset price inflation were the route to economic prosperity, Argentina would be the richest country in the world by now.”

Albert Edwards
Co-Head, Global Cross Asset Strategy
Societe Generale

August is my month off. Every year I go to Mallorca where my favourite pastime is the occasional glance at the sea whilst reading a good book. This year Peter Bernstein’s ‘Against the Gods’ was top of the pile. Not that I hadn’t read it before. But my last encounter goes back about ten years and I decided that it deserved a re-read. After all, the book is about risk management and few books deal with the subject of risk management better than this one.

I didn’t spend many days on the island before I realised that Mallorca was not in its usual ebullient mood. Clearly the credit crunch had started to bite here as well. My friends on the island, most of whom are in the property business, confirmed my casual observation. The banks are tightening they said. Loans which could easily be obtained only six months ago were no longer available.

A few days later I ran into an article in the Daily Telegraph which illustrates the magnitude of the problem (see chart 1 below). Although this chart is based on U.S. data, the behaviour of banks around the world is broadly similar. It is clear that tightening lending standards are no longer a phenomenon exclusively linked to property loans. Consumer loans in general, and credit card loans in particular, are now subject to much closer scrutiny.

Chart 1: U.S. Lending Standards

Source: The Daily Telegraph

From my vantage point in the Serra de Tramuntana, I started to philosophise about the roots of the current predicament. How could it possibly go so wrong? Is the end in sight yet? What can we learn from this mess? These are obviously big questions, although the answer to the first question is pretty straightforward, the way I look at things. It all went so terribly wrong because of hubris combined with excessive use of leverage. It is funny how we always think that this time it is different. This time we really figured it out, or so we thought. However, the ever present invisible hand had other ideas.

In short, not just the United States but the entire world is dealing with the implications of a near perfect storm which has created havoc on three fronts – falling asset prices, a weakening capital base amongst financial institutions and high inflation. It is the interaction of these dynamics which explains the mess we are currently in, but it is also here we are likely to find the answers to our questions, so let’s jump straight into things:

Observation # 1

It all began with housing and it will end with housing.

When U.S. home prices began to skid, the damage inflicted was swift and devastating. We know now that that the quality of many loans was poor, causing large write-offs across the industry. With house prices in the US and the UK still well above their long-term averages relative to disposable income (see chart 2 below), there is no reason to believe that they will not continue to fall for quite some time yet. The write-offs will spread from sub-prime to prime and to many other countries as well, a process which has, in fact, already begun. Two criteria must be met before property will start to appreciate in value again – house prices must reach (or fall below) their long term equilibrium values and the current overhang (see chart 1) must be dramatically reduced. All this will take time – years rather than months.

Chart 2: Current overvaluation of U.S. and U.K. homes

Source: GMO Quarterly Letter, July 2008