Evercore Pan Asset

If this were a normal cycle equity markets would now be on the turn. Markets look ahead a year or two. They have fallen a long way to reflect the poor outlook for company earnings and dividends over the next year or so. Interest rates are falling, commodity prices and inflation are falling. Values of properties and companies are much more realistic. Governments and Central Banks have finally decided to fight recession rather than inflation. As the news of bankruptcies, earnings collapse and dividend cuts intensifies you would expect shares to start rising to discount the recovery which will follow.

Maybe this is not a normal cycle. Usually people who think that are just the pessimists (or the optimists at the top of a bubble) who grasp the prevailing mood late in the day and make the worst decisions. This time, however, we do have to ask when will the banking crisis end? If the banks remain troubled, unable to add to their lending, we could stay in recession for a long time. If more banks go down or have to cut their present stock of lending back, we could see recession turn to slump.

Japan after 1990 is the warning. The greatly over-extended Japanese share market plunged from around 40,000 to under half that, never regained the old peak over 18 years and stands today at one fifth of its old high. Japanese banks never properly recovered from the property and share crash.

The good news is that US and UK markets started this crash at relatively much lower levels than Japan did. The US property market was not as over-extended as Japan’s. The bad news is the large overhang of derivatives, and the massive leverage present in investment banks and hedge funds as well as in the commercial banks.

The Paulson & Brown plans attempted to solve the problem. Paulson Mark I failed the political hurdle. Mark II got through the Senate and Congress with the added spending for interest groups. The idea was to buy up distressed mortgages, to allow banks to improve their balance sheets and to establish a price to value the others. Unfortunately the massive $700 billion allocated was relatively little compared to the scale of the problem.

The Brown plan concentrated on injecting new share capital into banks under pressure. The new capital was designed to pay for losses incurred on over-extended loan books. It will not in itself result in new lending, as the UK regulator at the same time required more capital to support the existing loan book.

Paulson Mark III then switched to copying part of the Brown plan, injecting preference capital into leading US banks.

Meanwhile, banks are still unable or unwilling to make new loans to clients, and are busy trying to reduce loans outstanding to existing customers. They need to make higher profits, to help pay off the large losses they have made on a range of bad lending.

Realising new capital in current circumstances does not translate into new lending, the authorities have also used open market operations to supply liquidity. They have printed more money, made short term loans available to banks, and in the UK offered guarantees for a fee for inter-bank lending. So far none of these things has solved the problem.

The UK package probably requires changes to the terms of the short term lending and guarantees, to bring more of this support into play. The US needs to find more effective ways of committing its $700 billion to loosen banking markets.

In due course you would expect the huge sums being injected in loans and money market assistance to start to work. The markets, however, remain concerned about banking capital. Could the banks have to write off much more on mortgages as unemployment rises and house prices fall? Will there be big losses on the corporate loan books not yet provided for? Will unwinding the massive derivative positions cause more pain? How much might banks lose on the more highly leveraged hedge funds and property companies?

These fears and uncertainties prey on the markets. Evercore Pan-Asset continues to believe that when markets do turn Asian markets should perform better. We remain worried about the UK, where the banks are large in relation to the size of the country and tax revenues, and where there could be more problems ahead in the banks’ loan books.