Gillian Tett of the Financial Times perhaps a bit wistfully, looks back on the days when market participants could tell themselves that everything could bubble along at a “just right” level. She now wonder whether despite the troubling prospects, we might somehow stumble through in a way that avoids the worst extremes (the equity markets seem to subscribe to this view).
Schylla and Charybdis seems a more fitting image. And we had termed the Goldilocks fantasy-past-its-sell-by-date as the Tinkerbell market, but to each his own.
Tett sounded early alarms that the debt boom could end badly, and she is similarly not optimistic about finding a clear path though the credit contraction. From the Financial Times:
In recent years, the concept of a “Goldilocks” recovery has permeated the policymaking world. For after decades of painful economic booms and busts, politicians and central bankers have become wedded to the idea of chasing a growth rate that is neither “too hot, nor too cold, but just right” …..
Instead, the hot new topic of debate in financial circles is the “l” word: namely leverage; or, perhaps more accurately, the “d” phrase – “deleveraging”, as the process of cutting debt is called.
In particular, what financiers are urgently trying to work out is whether there is a way to cut debt levels in the banking sector at a pace that is fast enough to reassure investors – but not so fast that sparks a wider market meltdown and credit crunch.
Can Wall Street, in other words, deliver a wave of “Goldilocks deleveraging” that is neither too hot, nor too cold – but somehow “just right” – or, at least not too wrong?
It seems a fiendishly difficult task. The credit crunch has demonstrated with painful clarity in recent months that the financial sector has become dangerously over-levered this decade, to a degree that almost nobody realised before – partly because the normal metrics to measure leverage are pretty useless.
Western policy makers are now eager to see this leverage reduced. And stock market investors agree: the banks that have suffered most badly in the equity markets in recent months are those – such as Lehman Brothers – which are highly levered, relative to peers.
But while deleveraging has got under way in the hedge fund world in recent weeks, one dirty secret of today’s financial sector is that most banks have not yet followed suit; on the contrary, many are still seeing their leverage levels rise because assets are rolling back on to their balance sheets on a large scale.
One obvious way to rectify this would be to raise more capital. Banks such as Lehman Brothers and UBS are now doing precisely that.
But many other banks are finding it hard to follow suit. After all, many private investors remain wary of putting money in banks.
Meanwhile, my recent conversations with US policymakers leave me convinced there is little chance of direct public fund injections either.
That consequently implies that banks will have to slash leverage the hard way: namely by cutting assets. But if the banks cut credit lines to “real economy” borrowers, this will hurt growth; and if they sell securities, this will further depress prices.
Indeed, it seems that one key reason for last month’s turmoil was that large investment banks were trying to cut leverage through the easiest route available – slashing their repo operations with credit funds.
Wall Street executives are now urgently trying to explore other options, such as copying the “ringfencing” idea unveiled by UBS this week, which would essentially spin bad assets into a separate vehicle.
Some also want to create an industry-wide fund to absorb troubled securities, which might be backed by a multilateral group such as the International Monetary Fund.
But I doubt whether these multilateral ideas will fly any time soon – or not unless another downward lurch occurs.
So the essential question remains this: can banks really cut their leverage levels effectively and calmly via furtive asset sales or ringfencing? Or are we heading for more stop-start turmoil?
Personally, I would love to believe in the Goldilocks scenario.
However, history is sadly not on the side of this fairytale. After all, very few episodes of deleveraging have occurred in the banking sector before in a manner that was “just right”.
Stand by, in other words, for plenty more market lurches – accompanied by plenty more growling from the credit bears, as investors are scalded and frozen, all at once.