The banking crisis: is it all doom and gloom?

published 31 March 2008

Every month we invite the best investors we know for drinks to tell us where they would and would not put their money now

John Stepek: It's looking grim out there, particularly for the banking sector. Do you think the Federal Reserve's actions are helping?

Tim Price (Director of Investment, PFP Group): I'm not sure the Fed has any alternative but to continue to cut rates aggressively. But in light of the rescue of Bear Stearns, there's a limit to what monetary policy on its own can do. I think that soon the US, and maybe other administrations, will need to start using, or to continue to use, taxpayers' money to bail out the financial sector.

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James Ferguson (Economist and stockbroker with Pali International): The banking system is stuffed. It doesn't matter what official interest rates are doing, the problem banks have is that they're all massively undercapitalised, which is code for saying they are bankrupt. But banks don't actually go bankrupt they have to be recapitalised. That means they all need a huge injection of capital, which means that all shareholders of banks pretty much across the board in the West will be diluted virtually to zero.

John: You mean that anyone holding banking stocks will see their value collapse to nothing?

James: I think your default position should be that banks will lose 80% of the value of their equity (from the top). It will get diluted out by the capital injections, which are, I think, inevitable.

John: That's a pretty nasty prospect.

Mike Hollings (Chief investment officer, Ansbacher): The problem is that there is just too much leverage built up in the system. To unwind that leverage will be a long and painful process. In theory, you could allow a cathartic cleansing, but if we start letting banks go bust the whole system will just implode. So what the central bank is trying to do is keep confidence going so that people aren't aware of just how bad it really is. It's giving itself time, hopefully and somehow magically to sort the problem out.

Tim: I think what we're probably all (I assume) agreeing is that one way or another there is going to be a net transfer from taxpayers to shareholders.

James: Well, no, in my scenario, first we pretend that no one is losing money. Then we have to deal with the fact that we know they actually have lost money, and that involves a capital injection. In Japan (and they had ten years to think about it, and so it was quite a good plan in the end) the government said to all the banks: "Right, here you go. You issue preference shares, we buy them. We promise not to exercise our convertible rights for five years, you've got five years to get yourselves back on your feet."

But that did a huge amount of damage to the equity value of the banks because it was acknowledging that they were all effectively diluted to almost zero, and you never knew if they were going to work their way back. The Japanese banking sector fell 92% from peak-to-trough. Even now, Japanese banks are hardly worth much more than at the very bottom. So I don't think equity holders of banks get out of here alive.

Mike: You're right, I think the equity value of the banks will get severely diluted. But the other thing is writing off the debts. Somehow you've got to take the hits and write them off. Sure, you can inflate your way out of it [by cutting interest rates], but there needs to be some pain felt somewhere.

Tim: Do you think that's why some of the authorities are concerned about inflation?

Mike: In the past, if you see rates being cut and you see the Fed has abandoned the dollar and you think inflation is a problem, then you want hard assets whether that's gold, or softs, or oil. I think that's fuelling the second bubble, which will eventually arise in commodities. Every day I'm hearing about a new agricultural fund being set up.

James: I am probably going to disagree with all of you on inflation. I think in 12 months' time we'll have deflation. Last time American producer price inflation (PPI) was over 7% was in November 1990; 12 months later it was negative. In the West, most input costs are labour. Labour costs are diving unit labour costs in real terms are something like negative 3% in the US. So 80% of your costs are going down and only your raw materials cost is going up. So firms can afford not to pass on costs from the commodity space.

Secondly, can you imagine any discretionary product where you could make a price hike stick in America in the next 12 months? You've got people who can't pay their mortgages, can't pay their utility bills people are raiding their savings simply to maintain their quality of life.

Tim: If you're expecting deflation to be the bigger issue, does that mean that you can see any value in, say, gilts yielding less than 4.5%?

James: Yes. I think bonds are going to surprise most people on the upside.

Tim: But this all sounds like the Japanese experience. People were saying that Japanese government bond yields in the 1990s were the biggest short of all time, when they were yielding less than 3%, yet where did they bottom? 0.5%? John: Is that what will happen to the West? Will we still be waiting for stockmarkets to turn around in 20 years' time?

Mike: It's interesting. I find it hugely ironic that the country that has exported this contagion of credit has one of the best-performing major stockmarkets. Last time I looked, the S&P was down about 12% year to date, the Dow was down about 9%. Europe is down 20%, Hong Kong is down 24%, Japan is down 21% everybody else gets it, but the people who started the whole problem apparently don't.

We run funds in GCC countries [Gulf Cooperation Council members, including Saudi Arabia, Kuwait and Qatar], which used to be totally uncorrelated. But in the last two months, they have become much more correlated even the GCC has caught the contagion.

Tim: There is still probably benefit in the support of a petro-economy, rather than a non-petro economy.

Mike: The market in Qatar is probably up 10% in the year-to-date, as opposed to being up 20% it's not a disaster. But the point is that when you get the sharp down-ticks on the S&P, the next day the GCC tends to follow lower.

John: So we are all agreed that everything is terrible.

James: I don't think everything is. When this happened in Japan, it happened to an equity market that was incredibly expensive. In the West equities are now very cheap. The trouble is that we're in the first phase here. Markets are discovering nasty stuff everywhere they turn, and selling what's liquid ahead of what they should be selling. In the end we will get a proper shake out, and the stuff that is really toxic will keep going down and down and down, and a lot of stuff will have big rebounds.

Tim: But presumably you wouldn't be buying any banks!

Ana Cukic-Munro (Co-head, Multi-Asset Group, Insight Investment): The US is clearly in recession. And that has to affect the UK. But I think it's still possible to profit in this recessionary environment.

Mike: I agree of course there is money to be made. I mean we have been almost praying for this. Keeping interest rates too low for too long equals mispriced risk across the board. Now, finally, you are getting value coming back in the market.

Ana: In equities, if you move away from cyclical exposure you can still find value in companies that benefit from water infrastructure, environment, and agriculture, plays on a long-term theme.

Mike: One of the infrastructure plays that we like a lot is General Electric (US:GE) because it's a major beneficiary from a weaker dollar. It's got the whole suite: desalination, railroads, infrastructure

James: I think this is still going to be a year mainly for bonds I've said for a long time short-dated government bonds, because I'm not knowledgeable enough on bonds to know where to find the best deals. But there is already some tantalising value to be found in equities. Most equities were not overbought before they started, they're now looking 20% cheaper and in most cases are discounting depression-type earnings.

John: Any suggestions?

James: The names I really like are Legal & General (LGEN) on the insurance side, because I think it's not going to be compelled to realise its losses in the same way its rivals are, and you've got a nice, boring sort of stock there. I also think the media sector looks interesting.

Johnston Press (JPR) is trading at 3.5 times earnings it's priced as if the firm won't be here in 12 months' time, as if it'll be wiped out by the internet. But if you look at the shares, they have come off 75% from the high. There's an element of catching a falling knife, but there's got to be value there. I also like the oil firms, although I'm not a huge oil bull. I think the commodity story may well be getting close to the peak. Industrial metals may have already peaked.

Mike: So you want to avoid the miners?

James: Yes. I think the miners are toast!

John: I know we've got a divergence of opinions around the table here. Tim, how do you feel about that?

Tim: I can absolutely agree that, at least in the near to medium term, the whole commodity sector is topped out. Where I struggle with the doom-mongers is that I can't personally find a sector that has a more attractive, very-long-term story. Tim Bond from Barclays recently said that, according to the International Energy Agency, the global energy sector alone needs a real $22trn over the next two decades to meet the anticipated rise in primary energy demand. If that figure is even remotely close to the "genuine" figure, then that is the most extraordinary investment theme for the next five to ten years. So I wouldn't have any problem buying into stocks that are basically energy sector suppliers or service businesses.

There are two I'd mention. One is Bucyrus (US:BUCY), which is a supplier to the mining sector. It makes large excavation machinery for surface mining. The other is a small cap in the UK, Lamprell (LAM), which provides construction services for oil and gas rigs.

Ana: I think in general, commodity markets have been overbought. But there are still opportunities. Everyone has been talking about corn prices increasing. But nobody looks at livestock. High corn prices translate into higher meat prices a rise in corn prices is followed by rising livestock prices with a three-to-six month lag.

Also, platinum is interesting: 80% is produced in South Africa, which is suffering from power supply problems that they can't resolve until 2013. Platinum is used as an auto-catalyst for cars over one million new orders are expected to come from Chinese consumers, where General Motors is investing over $5bn. Youcan buy into livestock via the Livestock Exchange-Traded Commodity (AIGL), and platinum is also tracked by an ETC (PHPT).

James: If we are making recommendations to MoneyWeek readers, then the first thing for them to do is to shore up their balance sheets. The thing that's most likely to happen to most people is their mortgage rates going through the roof. Let's face it, HBOS borrowed money at 9.5% last week, so what are they going to lend at if they borrow at 9.5?

John: So your top investment at the moment is your mortgage?

James: To be honest, the top investment ever is your mortgage. It just seems so boring.

John: What about gold, now it's gone over $1,000 an ounce?

Tim: I think gold will probably pull back I don't know to what extent but I still wouldn't want to be short of gold.

James: I wouldn't buy gold now. You've got to think about what drives gold. I mean, sure, it's a dollar hedge, but then so is every other currency. The thing about gold that's always struck me is that it doesn't produce a yield. So gold is basically a buy when yield is hard to come by. I think the credit crunch is going to make big yields very easy to come by. You are starting to look at 10% yields being available, when last year 5% was amazing. Goldbugs will suddenly be saying, "why am I buying this quite expensive thing that yields nothing when I could be making my money work?"

Mike: Unless you can't trust the little bit of paper.

Tim: This is what it comes down to. It's portfolio insurance. I'm perfectly happy having, say, 10% exposure within a portfolio on the basis that if the gold price falls, that should be consistent with a rise in the price of financial assets and vice versa. That is the attraction of gold.