Credit bubble pop looms

By Michael Coote

Friday 8th November 2002

Australasian banks have been reporting superlative profits. The view might be taken that banking stocks look like a good investment.

But an opposite, bearish view is more appropriate. Banks will probably lead the charge in the next downleg of the collapse in sharemarkets. The world is moving from the bursting of an asset bubble to the popping of a credit bubble.

Banks operating locally have benefited from a residential property boom and funds flowing into safe harbour investments like term deposits, cash funds and mortgage funds.

In New Zealand, however, the leaky homes scandal implies mortgaged households sitting on negative equity at a time when households generally are overextended on credit and personal bankruptcies are rising.

Australia has a property boom about to bust. It is the credit crunch to come that will affect bank share prices.

Banks are looking like startled possums transfixed by the beam of oncoming headlights.

Since the bear market set in early in 2000, waves of large capitalisation sectors have been sideswiped. Sequentially, the sectors of technology, telecommunications, airlines and insurance have crashed, with oddball contributions from the likes of Enron as fudged accounting has been flushed out.

Now it looks as though banks are next on the hit list. Like companies in the aforementioned sectors, banks tend to weigh heavily on stock indices. When they pack up the general trend of the sharemarket will follow.

There are serious concerns about the state of banks in leading economies. In the US, the UK, Germany, and Japan, things are not going right for banks.

The Japanese banking crisis is well known. Belated attempts by the Japanese government to force banks to come clean on dud loans are not likely to have the full effect required. Vested interests will probably defeat newly appointed financial affairs minister Heizo Takenaka.

Banks in Japan have argued that hardline reforms promoted by Mr Takenaka will collapse their capital adequacy ratios, an irony considering unrecoverable loans are scarcely capital backing to begin with. So Japanese bank stocks can be written off, especially considering a government bailout would blow out the strained fiscal deficit even further and deteriorate Japanese credit ratings.

In the UK, a property bubble is about to implode, creating another negative household equity recession in its wake. Thus British banks can be skipped.

In Germany, private sector banks are paying the price of venturing into marginal activities because they cannot compete with public sector banks that, like our government-owned version, offer cheap mortgages and high deposit rates. Give listed German banks a miss.

In the US, banks are faced with another property bubble, over-indebted households, falling consumer confidence (the lowest since the recession of 1993), and fear of lending to businesses.

These businesses in turn cannot raise capital by issuing new equity in a bear market to replace the drought of bank credit or repay their existing debts. Goodbye US banks from the Christmas shopping list.

It is most likely that a crash in banking stocks will pull sharemarkets down as we go into 2003.

Accordingly it grows wearisome to listen to the daylight saving Pollyannas who tell us it is coldest and darkest nearest dawn and that market recovery is poised to return with the tincture of Aurora's punctual arousal from her virgin couch.

Fiddling with the hands of the clock is not going to bring forward the meanest blush of sunshine in the midst of an Arctic winter.

What does it mean for equities that the banks of the four biggest economies are for various reasons facing a credit crunch? Surely at least the flow-on effects will be systemic.

Other stocks will be hammered where they need debt or capital that they cannot raise or repay. Economic globalisation will ensure all economies, including New Zealand's, are dragged into the same black hole in synchronised fashion.

Talk of further interest rate cuts by the US Federal Reserve to avert such a crisis ignores the fact that US banks are not passing on cheaper rates to business customers because of fear of risk and that these same banks don't want to lend if they can help it anyway.

Lower interest rates will be feckless as an instrument of turnaround. The cupboard is bare from that point of view. The Fed has lost control. It can cut interest rates but it can't force banks to lend or pass on any savings to borrowers.

The world may well be already engulfed in worldwide deflationary depression we just haven't noticed lately and where bank stocks are concerned, it is probably a short-seller's market.

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