15 Jan 2009

Death Spiral in the Banking System out of Control?

After having watched the Banking System all our adult life (and some more) we are the first to admit that managements have committed serious errors of judgement. This just reinforces our view that hiring the right people is the most important job for all those working in positions of responsibility in any bank of other financial service business.
But this particular banking crisis is characterised by certain features that have a tendency to push institutions further down the path to ultimate destruction. For instance, hardly anyone seems to focus on what proportion of the loan books are actually delinquent. Instead, there is constant talk of 'toxic assets' most of which turn out to be mortgages that just happen to be under water to different degrees. Nothing new to that. That has happened before and will happen again.
Instead, the markets, commentators and the authorities are completely enthralled by what can only be described as a 'death spiral' of weakening economic data and falling asset prices which drive 'market prices' down. The main culprit is the 'mark-to-market' rule that has been designed to keep accountants, auditors and theoreticians in academia happy. Never mind that these 'prices' are created in thin markets and pushed around by speculation. They are accepted as gospel truth even though it is a well-established fact that all markets overshoot - on the way up and on the way down.
As a result prices for so-called 'toxic' assets are divorced from reality where assets may be somewhat impaired but are still in the major part serviced by debtors. The difference between these two levels of valuation is the difference between a banking system that is in trouble but able to work its way out of a hole and a banking system destined to hit the buffers sooner or later.
In addition, respected analysts such as Meredith Whitney (CNBC, 14 Jan 2009) paint a horror picture where banks are supposed to look at economic data such as employment or home price trends and mark down their books according to some spurious economic forecast. That assumes that economic forecasting is an accurate science - a heroic assumption if there ever was one!
The latest fashion among commentators is the reference to the 'Swedish Model' of bank rescue. As no one seems to realise what is driving the death spiral they jump to the conclusion that all bad assets should be written off against shareholder equity. Given the logic of 'mark-to-market' that would mean that ever-declining 'market prices' would set the benchmark for these write-offs. Naturally, the authorities - who must share a major part of the blame (banking was always heavily regulated and the authorities were if anything supposed to prevent bank runs) have to step in and nationalise the institutions.
Ironically this outcome would not even mean that lending can resume as usual. In our impatient age politicians, the media, academics and the world of business seem to have forgotten that credit cycles are a major - maybe the major - force behind economic cycles. After an extended period of excess credit creation it is inevitable that a period of credit contraction will follow. Banks have to rebuild balance sheets and the same applies to business and consumers.

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