Banks: The End of the Beginning...

And what we've seen thus far is just the beginning of a multi-year unwinding of excessive leverage levels, not just within the banking sector, but within Western economies at large. So far nearly $200bn had been raised to recapitalise banks, primarily in the US, and at least another $75-100bn looks likely in the next few weeks in the UK and Europe (Irish, Portuguese and Italian banks look like prime candidates and apart from HSBC and Standard, all UK banks look under capitalised). There is a consensus among bank directors (whose credibility has been shredded by the sudden volte face) that it's now or never in the rush to improve capital ratios while markets remain relatively receptive. So we have a short $300bn of cash coming in, against write offs so far announced of about the same size; however many estimates of ultimate industry write-offs now reach $750-1000bn, and thus these fund raisings are potentially inadequate to even underpin current Tier 1 capital ratios across the sector, just as regulators are demanding a greater capital cushion (US and UK regulators now setting a 6% minimum). SWF's seem reluctant to commit further funds at present, leaving existing shareholders facing highly dilutive rights issues and hybrid convertibles. Although this new funding should tighten credit spreads near term, this is before the next leg of the credit crunch kicks in; we can expect surging default rates across a range of consumer and corporate lending.

The real economy has been remarkably resilient so far to the implosion in credit markets, but this will inevitably change as we head into 2009 (current US recession fears may prove premature, this looks more like a prolonged grind of sub-par growth, punctuated by negative GDP quarters, possibly extending through 2010) and global growth ratchets down sharply. Like a financial Tsunami, we have had the credit earthquake but the tidal wave of default is still cresting and about to hit home. US banks wrote off just 63bp (0.63%) of loan value in 2006, but a level approaching 180-200bp is likely this year and next. In the UK a rise to 120bp is widely forecast, and even higher levels in the property slump exposed Spanish and Irish banks. As for corporate lending, Moodys is forecasting a 4.2% global default rate for junk bonds in 2008 rising to nearly 5% in 2009 (from sub 1% two years ago) with an average recovery of 43c on the dollar. Note that in 2002, post the dotcom crash, this default rate hit over 10%. When investment banks like Goldman Sachs talk of the 'end' of the credit crunch, they are talking about the first stage of soaring CDS spreads and subprime write downs focused on the financial markets, and I would agree that this is now largely discounted. However the second stage, focused on the credit crunch effects rebounding back on banks from the real economy, will prove far more intractable and will probably lead to severe dividend cuts on a 12 mth view across the sector to conserve cash. There is decent value in domestic banks in emerging markets like Russia and India, which are in the very early stages of a consumer boom and have a fast growing local credit market set for secular growth, but where valuations have been hit by the slump in global sector sentiment. However, in the US and Europe the remarkably generous response by shareholders so far to cash calls is unlikely to stand the test of further stress in the credit markets; bottom fishing in financials can be classified as an extreme sport.

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