"The worst is yet to come"
September 14, 2008
The title is actually the assessment of banking analyst Meredith Whitney, regarding where we are in the banking crisis. In this report, I run through a scenario of what a banking crisis might look and feel like, and run through the reasons why I consider myself in full agreement with this quote.
Note: This report is for subscribers only.
The title is actually the assessment of banking analyst Meredith Whitney, regarding where we are in the banking crisis. In this report, I run through a scenario of what a banking crisis might look and feel like, and run through the reasons why I consider myself in full agreement with this quote.
Executive summary:
• The damage so far: Bear Stearns, Lehman Bros
• The damage still to come: Washington Mutual, AIG, Merrill Lynch, Citibank, and many others
• The risk of a major systemic banking crisis is very high at this time
• While we wait to see what develops, cash out of the bank is a good idea.
Before I get into the gory details below, I want to begin with the conclusion. What I mean by a “major, systemic banking crisis” is the complete shutdown of the banking system. All banks closed, none operating, no way for you to access your funds. Because of this possibility, you need to get out at least one month’s worth of cash to have on hand (three months is better). Keep it in a safe place.
If the banking system shuts down, your ability to conduct transactions will be severely limited. Cash will be in extremely short supply, as it represents roughly 2% - 3% of total bank account holdings.
When you withdraw actual cash, there are a couple of realities of which you need to be aware. The first is that for any amount over $10,000, a Suspicious Activity Report (SAR) must be filed by the bank with the Treasury Department. No ifs, ands, or buts. Your name will go into the system. Next, even for amounts under $10k, it is at a bank’s discretion as to whether or not they fill one out.
Second, you need to be aware that most bank branches keep very little cash on hand. Large withdrawals of cash represent an operational difficulty for banks, because they are usually on a timed system of deliveries, often just once a week. The way I prefer to handle this is to ask to speak to the bank manager, let them know my intentions, and give them some time to adjust. They always appreciate this courtesy. As a note, in the past I’ve had a couple of people write to me who were very shocked and confused by their reception at the bank when they tried to withdraw more money than was available. Frayed nerves all around.
Okay, here’s a scenario that could play out. I offer it not as the most likely thing that could happen, but only as a means of illustrating the mechanisms and consequences that could transpire if this weekend’s Lehman rescue/dissolution fails. Obviously, I would be utterly surprised if the situation developed exactly like this, as it could unfold in thousands of different ways. I just thought that it might make it “more real” if I could lay out a plausible sequence of events.
Your job is to assign your own weighting to the likeliness of a banking failure and take actions accordingly. If you happen to assign it a zero percent chance? Then do nothing.
++++++++++++++++ Bank Crisis Scenario ++++++++++++++++
Day 1: Four major banks are suddenly revealed to be insolvent, and money begins to be withdrawn from these banks at increasing rates. That night, foreign investors quietly begin to retreat from a stricken US banking system, and the withdrawals spread beyond the four stricken banks. As bank servers begin to log more and more withdrawals, alarm bells go off, and late-night emergency meetings are convened.
Day 2: The next morning, US government and banking officials assure the world that everything is fine and that a new program has been put in place guaranteeing the solvency of the US banking system. Behind the scenes, foreign money continues to leave, as the deep connections of wealthier individuals offer them a better view of the real state of affairs.
Days 3-7: The expatriated money is converted into anything other than dollars, resulting in a dollar slump that confuses all but the most astute of observers. Simultaneously, US interest rates begin to climb, as US bonds are sold off in preference for non-US assets.
Day 14: Fearing a massive run on the dollar and a collapse of the capital markets, the US imposes an emergency order, requiring a 2-week delay in money flows out of the country. This is, of course, nothing more than a capital control, a favored but ultimately inflammatory tactic of countries suffering a currency run. Around this time, a growing proportion of domestic bank account holders realize that, because of the interlocked nature of the banking system, simply moving money from one bank to ‘a better one’ is not a fool-proof strategy.
Days 15-21: Over the next week, cash is demanded with increasing frequency, exacerbating the troubles of an already beleaguered banking system. A cash shortage rapidly develops, leading the Treasury Department to make a high profile show (on television, of course) of armored trucks pulling up to banks with large bags of cash. Assurances are made that everything is fine and that there is enough cash for everyone. Commentators on television make snide comments about the people lining up for cash, suggesting that they are overacting. But the Treasury is caught off guard, and even a 24/7 printing regimen cannot keep pace with cash withdrawals.
Day 25: Currency controls are announced over the weekend, limiting cash withdrawals to no more than $250 over every 48 hour period. A few days later, the government announces that the US banking system, and, by extension, the US stock markets, will be closed for a period of two weeks while the situation is “evaluated” and solutions are identified.
Day 50+: A month later, the markets finally open up again, with the Dow down several thousand points, the dollar worth 50% of its pre-close price, and people everywhere suddenly trying to convert their cash holdings into things. Rampant inflation ensues. The dollar continues to fall.
++++++++++++++++ End Scenario ++++++++++++++++
And here’s why I think something like this could happen.
At the very highest level, we have an insolvent federal government borrowing money from an insolvent financial system as a means of providing capital to bankrupt companies. This strikes me as fundamentally unworkable.
The simple fact is that the entire US banking system is now insolvent. This does not necessarily apply to every company individually – some banks are in fine shape – but when we add up the likely losses and match those against all the known bank capital, we find that the losses are larger. This mean that the entire industry is currently insolvent, and that makes it pretty much a mathematical impossibility that it could ever bail itself out.
So, either massive losses have to be recognized, or massive amounts of new capital have to be (either) found or created. The ‘finding’ part is turning out to be tricky, now that the sovereign wealth funds (SWFs) that were tapped last spring have all been badly burned on their initial capital infusions.
This leaves ‘creating’ the capital, which is something the Federal Reserve has been very reluctant to do. And rightly so, since that opens the prospect of a disorderly flight from the dollar, as investors suddenly wonder what a dollar is worth when so many are being created out of thin air.
So we’re currently at something of a stalemate in terms of how banks, the government, and the Federal Reserve would each like to proceed, but the market continues to march on, destroying more and more financial institutions with every passing day. Something has to be done.
The problem is, a slight misstep in one direction will lead to a massive deflationary wipeout of the entire banking system, and in the other direction to hyperinflation of imported products, fueled by the destruction of the dollar.
Against this backdrop, we have this news.
From the New York Times we find this excellent summary of the developing situation with the failure of Lehman Brothers (link to article):
Quote:
The fate of Lehman Brothers, the beleaguered investment bank, hung in the balance on Sunday as Federal Reserve officials and the leaders of major financial institutions continued to gather in emergency meetings trying to complete a plan to rescue the stricken bank.
The talks took on even greater urgency on Sunday as government officials push for a deal to be completed before the markets open. The leading proposal would divide Lehman into two entities, a “good bank” and a “bad bank.” Barclays of Britain would buy the parts of Lehman that have been performing well, while a group of 10 to 15 Wall Street companies would agree to absorb losses from the bank’s troubled assets, according to two people briefed on the proposal. Taxpayer money would not be included in such a deal, they said. Under that plan, the Wall Street banks would agree to provide up to $30 billion of support to absorb the losses of the bad bank.
As mentioned above, the urgency is to get all this worked out prior to the opening of the Asian stock markets. That’s the world we live in now. Government officials in the US are worried about the impact of their decision on the Asian stock markets. Not because they are altruistic or care about the Asians stock market holdings, but because our markets are so interlinked that a failure in one can spread to another and then back home again.
Also, I wonder about the additional $30 billion figure that the banks are being asked to absorb. First, I wonder where they are going to get that capital from, and second, I think the number is entirely too low. It only represents about a 5% decline in the value of the Lehman asset base. While I understand that the “good assets” are going to head off in one direction, leaving the “bad” assets behind, it seems improbable to me that $30 billion is going to be sufficient.
At any rate, if you read between the lines, this next bit (from the same article) captures the mood of the meetings quite well.
Quote:
Both Barclays and Bank of America expressed interest in buying Lehman and were negotiating hard, initially insisting that the government provide financial support. But federal officials were adamant that no public money be used — a big point of contention because many of the top Wall Street executives believe that their banks, which have each written down tens of billions of dollars in assets, do not have the capacity to lead the rescue on their own. The main problem for the banks here is this:
The overarching goal was to prevent a quick liquidation of Lehman, a bank that is so big and so interconnected with others that its abrupt failure would send shock waves through the financial world. Of deep concern is what impact a Lehman failure would have on other securities firms, insurance companies and banks, notably Merrill Lynch and the American International Group, both of which have come under mounting pressure in the markets.
A.I.G., one of the world’s largest insurers, may need to raise $30 billion to $40 billion to avoid a severe downgrade to its credit rating, according to people briefed on the situation.
On the one hand, if banks don’t come up with a workable Lehman solution, the whole mess could come tumbling down. On the other hand, they may be taking on too much, too soon, leaving nothing for downstream problems that might ensue, such as a failure of Merrill Lynch or AIG.
If I were the captain of a large bank that was still in relatively good shape, there is no possible way you could entice me to catch the falling knife that is Lehman Bros. without a big old guarantee. I would want to leave my powder dry for another day.
This brings me back to my original statement. The entire banking system is insolvent. There is no way for an insolvent industry to bail itself out. That’s the hard reality. A “major banking crisis” means that banks cannot do business with each other, because they don’t know who is insolvent and who isn’t. Heck, some of them might not even know if they themselves are insolvent. Just like you would not accept a check for your car if I told you there was a 50% chance it was written by a homeless person, banks cannot do business with firms they suspect of being insolvent.
At this point, all we can do is watch, remain aware, and seek to limit our own exposure to what may come. And no matter what happens on Monday in our markets, whether it is a big up day (engineered for our benefit) or a big down day, I would counsel you to think for yourself and avoid taking too seriously any of the soothing comments that are sure to come from Paulson/Bernanke, et al. This crisis is far from over.
One analyst I trust, and who uses real numbers that I can understand, is Meredith Whitney of Oppenheimer. Here is her most recent assessment (link to article):
Quote:
Meredith Whitney, the Oppenheimer & Co. analyst who called Wall Street's mortgage market meltdown last fall, now says the worst is yet to come for the global financial industry.
"What's ahead is much more severe than what we've seen so far," Whitney told Fortune magazine.
She submits that banks are facing dramatically larger credit losses than they have reported so far and thinks the economy is about to sink into an "early 1980s-style recession," that will "devastate 10 percent of the population," which became financially overextended during the housing boom.
"It feels like I am at the epicenter of the biggest financial crisis in history," she says.
"While my loss estimates are much more severe than those of my peers, my biggest concern is that they are way too low," she said.
I am in full agreement with her assessments.
Your faithful information scout,
Chris Martenson
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