Game Over
Monday, March 31st, 2008
Until about 10 years ago, banks were basically satisfied with their usual business, taking deposits from the public and lending it out to credible users. But in order to dramatically increase their profits and justify hundred-million dollar paydays, they had to enter a new business. Big time gambling under the rule: Heads: I win. Tails: you lose. They leveraged themselves to the hilt, signed derivative contracts in the trillion dollars and dealt in fantasy loans and paper.
Hey, it was good while it lasted. But just like cocaine addicts the greedy idiots in pinstripe costumes needed ever larger doses for their kicks and felt like invincibles.
The failed Wall Street house of Bear Stearns alone had 14 trillion dollars worth of derivatives outstanding. JPMorgan, which rescued Bear with 30 billion USD of public money, is the largest issuer of credit default swaps and has thus guaranteed a lot of bad stuff. It probably had to rescue Bear or pay out to the buyers of its guarantees. It is a rather complicated picture, but it’s clear that many, if not most banks in the world are connected in a spider web of derivatives, swaps and questionable securities. And the whole pile of junk was financed with up to 30 times leverage, meaning for every single dollar available from investors the managers borrowed another 30 dollars, just to spice up the game and increase their take.
But this game is over now.
We think that banks have still a long way to go down, and even if they can eventually sort out the garbage in their balance sheets, they won’t be able to generate big profits from the mad gamble they were engaged in previously. Eventually, bank shares will be a good investment. But they have to hit bottom first and be left for dead for a while.
What does all that mean for the real economy and for stocks other than financials?
Emerging markets, especially in South East Asia, could do relatively well because excess money won’t flow to the US as before, but will look for new destinations. Countries like Thailand, Taiwan or Singapore are thus comparatively attractive. Gold and commodities in general have become more volatile but still offer good opportunities.
A few days ago, there was an interesting report in the Financial Times: the so-called Empty Quarter (a giant desert in Saudi Arabia), which was supposed to hold immense gas reserves, turned out to be, well, empty. This confirms our long-held belief that oil and gas are bound to stay expensive. We therefore hold on to most energy investments despite the wide-held view that a US recession must knock down prices in the sector.
In general we suspect that markets worldwide will trend lower over time. We are reminded of the situation in Japan and Thailand in the nineties when, after huge credit expansions, it took a decade to find a bottom, despite low interest rates. It will go faster this time, because the Americans are not as hesitant as the Japanese to clear the desk. But it could well take us into 2009 till we see a bright horizon again.
Meantime, stay liquid, buy the dips, get out quickly again, that’s what can be done for now.