My neighbour and I met at the meeting post across the fence as was our custom.
‘Everybody I meet these days is on the gloomy side,’ he began. ‘It’s beginning to affect my business. I hope it doesn’t continue for too long. As a debt king, what do you think?’
‘An international credit crisis is a comparatively rare event’ I said, ‘and it will take time unravelling it. This is particularly the case now that America is already in the beginnings of recession, and we don’t know at this stage how severe it will turn out to be, and whether it will spread out to Europe, Japan, and even China and India.’
‘So what has been developing in the last few days,’ the neighbour asked?’
‘Let me summarise events for you. Bill Gross, who heads Pimco, the world’s largest bond fund wrote on the company’s website (www.pimco.com) on January 7 that credit default swaps widely used to protect against the risk a company won’t pay its debt may cause losses of US$250 billion this year.
‘He went on to explain that assuming default rates on corporate bonds return to a normal levels of 1.25 per cent, measured as the default rate of all investment grade and junk debt outstanding, $500 billion of credit default swap contracts will be triggered. This he said would cause losses of $250 billion to sellers of the derivatives after accounting for the recovery value of the securities.
‘Gross pointed to Goldman Sachs’s estimate of “mortgage related losses of $200-$400 billion alone, which might lead to a pullback of $2 trillion in aggregate lending. Add that to my $250 billion loss estimate of credit default swaps, as well as prospective losses in commercial real estate and credit cards in 2008, and you have a recipe for a contraction in credit leading to a recession.”
‘If Bill Gross is on the gloomy side, there is more from others. Pierre Cailleteau, of Moody’s Investors’ Service, the largest rating agency in the world (London Times January 7) says “there is a question as to whether banks’s new business models, whereby they originate and redistribute loans, has resulted in unchecked risk taking, liquidity risk and untenably large off-balance sheet liabilities.”
“Moody’s believes that, as the global financial system has become exponentially more complex in recent years, it has spawned problems that defy simple solutions for maintaining financial development and growth and the overall profitability of the financial sector.”
‘The problem outlined by a lot of observers is that financial innovation was supposed to relieve banks of carrying large loan books by a combination of credit derivatives, and securitisation to pass on risks they would previously have held in their entirety.
‘But in reality the risks supposedly transferred to other investors have come back to bite the banks, hurting them in their most vulnerable area, with the risks flooding back on the banks’ balance sheets, often in the form of more complex products, repackaged into even more complex structures.
‘The Alphaville column of the Financial Times (January 4) quoted research from Citibank suggesting the likelihood of an “uncontrollable surge in troubled, illiquid assets on European banks’ balance sheets.” The research estimated an estimated Euro 444 billion in involuntary asset growth in securitisation, asset backed commercial paper and structured investment vehicles.
‘The Citibank summary is that the involuntary asset growth will mark the onset of the “true credit crunch,” while “the scale of the crisis is only just becoming known to the banks themselves.”
‘Is there any good news?’ asked the neighbour, always wanting to hear news of some blue sky ahead.
‘Well there is.’ I said. ‘There is a sliver of hope. As reported on January 11, the Bank of America announced a mutually agreed take over bid for Countrywide Financial, America’s largest mortgage lender with an all share offer of $4 billion, a fraction of the share market value a year ago of $24 billion.’
‘What good news is that,’ said the neighbour. It seems a cheap buy.’
‘Possibly, but as the Wall Street Journal reported, it’s a “big gamble,” given the state of the troubled mortgage market. The fact that the Bank of America is buying Countrywide is quite significant. This is a very shrewd banking group, currently the largest American bank in market capitalisation terms.
‘Formerly known as Nations Bank, with the widest tentacles throughout the United States at the local banking level, and its headquarters in Charlotte, North Carolina, Bank of America must reckon that buying Countrywide will be a safe bet when the credit crisis is finally over. In my book, that is a very good sign.’
‘Thanks for your thoughts today,’ said the neighbour. Let’s meet again in a few days time.’
‘Good idea,’ I said, ‘see you then.’
