Is the Credit Crisis Over?

Is the credit crisis over?

One clue comes from the market where banks lend money to one another. Our colleague Steve Sjuggerud says the credit crisis is over, at least. How does he know? He says the rate banks charge each other for overnight loans has gone down, and even briefly went under the Fed funds target rate.

If that trend holds, it would be a sign that the crisis in confidence in the banking sector is easing. Banks in Europe and America have taken substantial losses both in their proprietary trading departments and in their loan portfolios. They’ve had to go hat-in-hand to creditors (mostly Sovereign Wealth Funds) in the Middle East and Far East to recapitalize their balance sheets.

As the chart above shows, the Fed’s rate cut action lat week does seem to have loosened the purse strings in the financial sector. At least banks aren’t putting up rates and defending their own capital. So in the short term, Steve is probably right that the credit crisis is over and there is plenty of liquidity in the financial sector. But what exactly does that mean for equity markets and the economy?

If the credit crisis is over, it could mean banks are no longer worried about a “solvency crisis” either. Underlying the rise in inter- bank lending rates was a deep suspicion among financial firms that other firms were sitting on tens of billions in unrealized losses and over-valued assets. Most of those assets, of course, were bundles of sub-prime mortgages that banks and brokerages had either bought or underwritten.

The banks took their medicine on the fourth quarter and realized massive losses on subprime related assets. Merrill Lynch lost US$9.8 billion, Morgan Stanley US$7.8 billion, UBS lost US$14 billion, and Citigroup famously lost US$20 billion and was forced to issue bonds with junk-like yields to attract more capital from the Middle East.

So here’s the question…is the solvency crisis over now that the credit crisis has eased? Having reported billions in losses in subprime mortgages, are the banks in the clear? Is it time to consider buying the financial sector, even as a trade?

Before you go rushing off to buy call options on a financial ETF, here are a few things to consider. First, Wall Street banks (and French, German, and British banks) have shown miserable risk management policies in the last five years. Here we have a French bank claiming a single trader hacked its systems and managed to lose US$7.2 billion.

Where was the adult supervision? Where were the boards charged with protecting shareholder capital? Where were the masters of the universe this whole time? Do they all work for hedge funds? And most importantly, why should we assume that the financial sector’s ability to manage risk has improved with billions in losses? Does shame make us more prudent?

The temptation to buy the banks for an expected earnings bounce is obvious. On a year-over-year basis, 2008’s fourth quarter should look a lot better than 2007’s fourth quarter. The banks should see a big earnings bounce. But you have to wonder who the banks will be lending to this year. Earnings will look comparatively better. But absolutely, will the business of borrowing and lending money be as good as it was anytime soon?

This is the other factor affecting the long-term prospects of the financial sector. Money center banks and investment banks simply never had it so good as they did in the last ten years. We reckon they’ll never have it so good again. The market for financial products is going to undergo a contraction. This means, we think, lower long-term profits for financial institutions.

Besides, if the banks were so bad at judging risk in the subprime market, how can we be sure they did any better in the option-ARM market, the credit default swap market, and the bond insurer market? “Bond insurer woes carry major risks for banks as well,” reports

Last week, American regulators tried to put together a bailout in which banks recapitalize the bond insurers and prevent a downgrade by the ratings agencies, which would in turn force the sale of billions in bonds held by institutions which can only buy AAA rated debt.

“If no new capital is forthcoming for bond insurers,” CNN reports, ‘lenders and other policyholders could end up swallowing heavy losses…Citigroup (NYSE: C), Merrill Lynch (NYSE:MER), Bank of America (NYSE:BAC) and Wachovia (NYSE:WB) are among the most exposed.”

Sound familiar? It’s already been a memorable month, and it’s not over yet. The last few days have been a welcome respite from the credit crisis. But the unwinding of leverage and the deflating of the credit bubble is likely to continue, whether we like it or not. And not everyone likes it, that’s for sure.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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Coffee Addict

Cutting to the chase, the action by the US and other central reserve banks is temporary.

It will probably be effective (with some volatility) until the US election is over. The market has not factored policy sustainability and duration into its thinking because that would require a B- in arithmetic.

The markets have not been allowed to adjust to long term reduction in expected earnings and growth. As the necessary adjustment was prevented, the credit crisis (if over) will only be replaced by a larger, longer term crisis.

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