It certainly appears as if the credit crisis is well and truly over or, at the very least, the light which most of us think we can see at the end of the tunnel is no longer that of an oncoming freight train.

No wonder equities are currently enjoying one of their best spells ever. And 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. How is that possible?

“Never in the history of the world has there been a situation so bad that the government can’t make it worse.”

-Unknown

The great bank illusion

The current bull market began in earnest in the second week of March, but what really got everyone going were the surprisingly good Q1 US bank earnings which were reported during the first half of April. Most commentators interpreted the numbers as the clearest piece of evidence yet that we are now firmly on the road to recovery.

Of course US banks made good money in Q1. The environment created for them is the equivalent of the US government reducing the cost of goods to zero for its embattled car manufacturers and then going on to buy – courtesy of the US tax payer – a couple of million cars that nobody really needs. Even Detroit would make money given those conditions!

Liquidity is trapped

The problem for the rest of us is that the banks are not sharing the candy they have been handed. Much of the liquidity created by the central banks remains trapped in the financial sector (see chart 1). Quite simply, the multiplier is not doing its job, as many banks prefer to hoard cash rather than increase lending at this juncture.

This is both good and bad news at the same time. Good because it implies that we probably do not have to worry too much about the inflationary effect of the aggressive monetary easing currently taking place; bad because it means that the economy is not going to kick back to life as quickly as everyone would like – and expect.

Meanwhile investors are growing cautiously optimistic about the GDP outlook for the second half of the year with many now forecasting modest growth – at least in the United States. Only a fool would suggest that GDP would shrink by 5-10% per quarter in perpetuity, as has been the case over the past two quarters. The economic slowdown is now decelerating and, as I pointed out last month, there are good reasons why we may see a temporary lift in economic activity later this year, but it will almost certainly prove transitory.

We are still in a bear market

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 but, as one of my partners pointed out the other day, NYSE saw four 20%+ rallies between 1929 and 1932 (see chart 2). Bear market rallies can be extremely powerful and hence deceiving.

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 $3,600 billion so far in this crisis, will shed another $2,000 billion in 2009¹. If you do not share my pessimism, please take a quick look at chart 3 below. 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 with total household debt now at 96% of GDP vs. 47% in 1982.

Further write-offs to come

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 $1,500 billion to come. So when the US banks reported surprisingly good numbers for Q1 it was certainly not because the economy had suddenly and miraculously revived itself, but because some of the oldest tricks in the book were used to gloss over much bigger problems².

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. As you can see from chart 4, sub-prime is indeed a small fraction of the total loan book for the US banking sector.

Delinquencies are on the rise

And that is precisely what is beginning to happen as illustrated in chart 5. 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 and adjustable rate mortgages have taken off, and prime and jumbo loans are only now starting to suffer.

These are all temporary problems, though, however bad they may appear. 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 year³ which I would like to re-visit (see chart 6).

Banking crises run and run

Reinhart and Rogoff studied every banking crisis of the past generation and made some startling observations. One in particular caught my attention. It has to do with the subsequent rise in government debt which, according to Reinhart and Rogoff, has been “… a defining characteristic of the aftermath of banking crises for over a century”. 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 trillion⁴. And Reinhart and Rogoff’s historical average of 86% of GDP implies an ultimate cost of over $12 trillion!

The IMF is too optimistic

I have a lot of respect for all the good work being produced by the people at the IMF; however, they are sometimes too politically correct for my taste; maybe too afraid of stepping on someone’s toes. So when they go public, as they did recently, with an estimate of how much the current crisis would ultimately cost, their projection will more than likely prove hopelessly inadequate.

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. As you can see from chart 7, using the official IMF estimates, the twelve most industrialised of the world’s G20 countries (in my book known as the Dirty Dozen) will have to issue about $10 trillion worth of new bonds to cover the cost of the current crisis.

The final cost will be enormous

However, if you (like me) believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). 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, because it is so big that it is almost incomprehensible. According to Wikipedia (see chart 9), total private wealth across the world today is about $37 trillion less the losses incurred in 2007-09, so the real number is probably closer to $30 trillion now. 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. No wonder Gordon Brown looks tired!

Where do we find the money?

Obviously, governments may buy a portion of these bonds themselves, but they cannot afford more than a fraction of the total unless they want to challenge Mugabe as the ultimate master of illusion. Neither should investors hold out for sovereign wealth funds to do the dirty work. As is clear from chart 9, the total amount of wealth accumulated in these funds is pocket money when compared to the projected bond issuance over the next few years.

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. Take your profits!

Source: The $33,000,000,000,000 Question

But that party is over. And in all probability, bank stocks will remain poor investments over the next five years and beyond.

In the next few years, I see a host of formidable challenges facing the badly bruised financial services industry. This includes new government regulation, losing the traditional investment banking deal-flow and far less lucrative leveraged loan portfolios. All these factors are conspiring to make financial services stocks a dull investment proposition.

The Financial Sector – Flying High Until Last July

The Easy Money is History

Most banks have been operating as casinos for years…that is until last July. Suddenly the sub-prime crisis imploded credit markets.

Sub-prime’s collateral damage will revolutionize the way banks do business going forward. In all likelihood, some of the most profitable revenue streams on Wall Street will disappear, mostly those tied to CDOs or collateralized debt obligations and other illiquid and hard-to-price synthetic securities. Worse, government regulators are bound to reshape the way investment banks mark these illiquid securities. In some cases, I can see banks even forbidding to trade the more exotic and leveraged securities that risk trashing the financial system.

In a nutshell, the investment banking business model is about to change. For shareholders, this implies far less profits as traditional sources of revenues are streamlined or liquidated altogether in 2008 and beyond.

The Fed, Bear Stearns and Systemic Failure

In order to avert a probable run on U.S. and many international prime brokers in March, the Federal Reserve orchestrated a US$39 billion dollar bailout for Bear Stearns. This event marked what many pundits called the “end of the sub-prime crisis” because the Bernanke Fed unofficially guaranteed all major U.S. financial institutions would remain solvent.

The implications of this watershed event are enormous. The Bear Stearns saga shows with brutal clarity that modern financial markets are even more tightly interwoven than before. That leaves regulated institutions even more exposed to each other’s risks. The next U.S. administration will spearhead a global effort to legislate and superimpose a watchdog on the financial services industry as the threat of systemic collapse is addressed through policy initiatives. More rules or restrictions won’t be bullish for bank and investing banking revenues.

The bottom line for the banks and their shareholders is not inspiring.

Greater financial market regulation, especially as it pertains to credit risk, will reduce long-term earnings for most investment banks worldwide. Even with Wall Street’s uncanny ability to create new models to maximize profits, government regulation and a new set of restrictions will likely dilute the innovative financial product development.

Increasingly, the government will scrutinize dealers and market-makers to isolate where systemic risks threaten the global financial system. And I can see the government destructively harsh on Wall Street.

Buffett Correctly Predicts Shareholder Dilution

In an interview with the National Post in Toronto, Canada, earlier this year, Warren Buffett of Berkshire Hathaway urged his audience to avoid most bank stocks in the future. Buffett stated that although some banks might be fair long-term investments, other sectors of the market offer far superior returns.

Buffett correctly predicted a wave of rights offerings. In other words, banks diluted their own banking shares by issuing a rash of new, public shares to finance bulging losses. Five months after his speech in Toronto, Buffett’s prediction came true. Today, many U.S. and European banks have already announced new rights offerings this year to shore-up depleted capital ratios.

For the record, Buffett does own stakes in U.S. Bancorp (NYSE-USB) and Wells Fargo (NYSE-WFC). The former is probably the cleanest of all U.S. large-cap banks with no sub-prime exposure.

U.S. banks have already issued more than US$26 billion worth of preferred stock in 2008 to bolster their balance-sheets. Merrill Lynch this week announced a US$4 billion offering while Citigroup has issued billions in preferred securities since late 2007.

To date, global banks have lost over US$200 billion dollars with Switzerland’s Union Bank of Switzerland (NYSE-UBS) responsible for almost 20% of that total. The International Monetary Fund or IMF has pegged total losses tied to sub-prime and other credit losses to peak at roughly US$1 trillion. That suggests banks still have a stash of cash to write-down over the next several years.

Dead-Cat Bounce or Market Bottom?

From their lows in mid-March following the near-demise of Bear Stearns, U.S. bank stocks have gained 14%. Now investors are starting to bargain hunt amid the credit wreckage.

To be sure, some banks are probably worthy investments at these levels assuming write-downs have peaked and their respective dividends won’t be reduced or cut entirely. But for most of the financial sector, more pain lies ahead as other segments of the credit markets and real estate come undone.