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Outlook 2009: From Market Disorder to Economic Recovery
December 24, 2008

Outlook 2009: Market Disorder to Economic Recovery

"In a networked world, the United States has the potential to be the most connected country; it will also be connected to other power centers that are themselves widely connected. If it pursues the right policies, the United States has the capacity and the cultural capital to reinvent itself."

Anne-Marie Slaughter
Foreign Affairs
January/February 2009

"Engles never flew on an aeroplane; Stalin never wore Dacron."

Deng Xiaoping
The Economist
December 13, 2008

Merry Christmas, Happy Holiday and a Safe and Prosperous New Year!

In the past year or so, we have watched some of the oldest and most widely accepted beliefs in the world of finance tumble. Stability in markets or counterparts or economies is no longer assumed.  Indeed, aggregate economic activity is falling sharply in the US and around the globe.

Some of the largest banks and financial companies are failed or nationalized. Markets have fallen and fearful investors are now willing to pay sovereign borrowers for the privilege of lending these states the very worthless fiat paper currency which they emit as a means of exchange!  A new form of taxation via the Federal Reserve Board just in time for the holidays! 

As the role of the state in the global economy swells and a new hoard of political careerists descends upon Washington, the right of individuals to work, accumulate wealth and hope for better times never seemed more threatened.  The bailout model of political economy followed during the Bush Administration, after all, is about picking winners and losers.  George Orwell wrote in Animal Farm:


But amidst the gloom and doom, we see signs of hope. We see evidence that individuals and institutions are again focused on value instead of transient indicators of price. We see fund managers and individuals alike thinking about the most likely path to ensure the return of capital rather than the prospective and thus speculative expectation for the return on capital.   We expect to see growing numbers of cash investors moving to the banquet table of restructuring even as the economic indicators - and the political response - dominate the headlines in 2009.

While we see the turmoil besetting members of the "bubble in trouble" club, we also see the grassroots movement to fence off the problems of high finance moving along nicely below the radar screen. America adapts and learns quickly. We hear from corporate and non-profit treasurers that they are paying stricter attention to asset preservation. They are voting with deposits and direct placements that the volatility and leverage has been trumped by tangible and sustainable value. Just under the skin, America is as alive as ever. Look for 2009 to find more people asking "Where's the beef?"

Year-end 2008 is an important date for IRA as well. We have rolled-out our explicit letter rating grades for safety and soundness calculated for all US banks and bank holding companies. The A thru F ratings grades are displayed in both the individual IRA Bank Cart Reports as well as in all of the profiles in the IRA Bank Monitor professional analytics tool. The result of several years of work by CEO Dennis Santiago and our development team in LA, the letter ratings in the IRA Bank Monitor now provide individual depositors, corporate treasurers and investment and credit managers, actionable tools for measuring the current safety and soundness of a given depository or group of depositories.

We see 2009 as a watershed year for the portion of the bank ratings community that is focused on safety and soundness instead of discredited equity market indicators. The process of asset placement is about to be a lot more transparent and accountable as good money moves into strong banks.  Users of the IRA Bank Monitor and Bank Cart tools will notice that the banks which made it onto Sheila's List in 2008 were all about one order of magnitude above the industry average stress -- that's a score of 7 or more vs the 1.5 industry average as of Q3 2008. Click here for more information.

In terms of the US banking industry, we expect to see a continued deterioration in the components of the IRA Bank Stress Index  and with it a slide in the overall ratings of the industry.  There is still a considerable feedstock of toxic bubble remnants which needs to work its way through the financial system and there remains the political problem of admitting to and getting on with the reality that there's no such thing as "too big to fail."

Through the third quarter, ROE degradation and loan defaults remain the leading contributors to elevated stress ratings among all US banks. Institutions with lingering bubble toxin issues will continue to feel the effects from distended default experience rates as income streams divert into loss provisions. In 2009, other operating factors such as capital, exposure and efficiency are going to be more and more prominent in terms of their contribution to the overall level of stress in the industry.

We see consumer and commercial credit availability will continue to be squeezed particularly in larger institutions as they struggle to bring commitment exposure ratios back into balance. Because of this we see smaller less stressed institutions as the place where the U.S. credit engine will restart first and recommend public policy emphasis on this systemic solution path be vigorously examined. These little birds comprise 2/3'rds of the banking industry; more than enough critical mass to see the first year of a new President's visions blossom into true economic recovery.

That said, there are currently 10 banks among the top 20 US banks by assets that still rate an "A" safety and soundness rating as calculated by the IRA Bank Monitor. We expect to see these ratings deteriorate as the next year progresses and, because of their size, to see their sagas dominate the media even as the real "prime solution" moves along. The trick in 2009, for depositors and investors alike, will be to objectively identify which institutions have the greatest Economic Capital risk and thus are likely to see their nominal current ratings based on the FDIC data move lower as the economic contraction worsens.

During 2009, the concern among regulators and policy makers in Washington is going to move from consumer risk to commercial and business risk. Whereas names such as Citigroup (NYSE:C) were front-and-center of the financial news during 2008 due to the preponderance of consumer and OBS risk on the bank's books, the year ahead will see more focus on commercial risks held by names like JPMorgan Chase (NYSE:JPM) and dozens of other institutions of all sizes with significant C&I exposure.

One of the most important issues facing the markets and the new president, Barack Obama, is accounting for the public funds deployed to date and how to proceed with the economic rescue plan in 2009. We hope that the Congress and President Obama come together on a plan that puts any additional new capital into solvent banks and companies, and requires the orderly liquidation and sale of larger insolvent financial institutions such as C and JPM.  The latter still rates an "A" on the IRA Bank Monitor due to its current performance, but the 4:1 ratio between Economic Capital to current tier one equity suggests a rocky road ahead for JPM.

We expect that public revelations about the bailout will be "Topic A" in the new Congress. As former AIG (NYSE:AIG) CEO Herb Greenberg said on CNBC yesterday morning, the decision by the New York Fed's Tim Geithner, Treasury Secretary Hank Paulson and other government officials to bail-out the credit default counterparties of AIG is a matter of pressing public concern. "Who were these counterparties?," Greenberg rightly asks. "Who would believe that they would be taken out at par?"

As Bloomberg News reported on December 17th, AIG may face another $30 billion in writedowns due to European CDS exposure: "An examination of AIGs credit-default swaps guaranteeing more than $300 billion of corporate loans, mortgages and other assets not covered by a $152.5 billion federal rescue shows the New York-based insurer may value some of its positions at levels that dont reflect distress in the markets, according to an analyst at Gradient Analytics Inc. and a tax consultant who teaches at Columbia University Business School in New York."

In 2009, we predict that the rest of the story will be told regarding AIG and the bailout of Goldman Sachs (NYSE:GS), JPM and the other CDS dealers banks orchestrated by the Fed and Treasury.  During the next year, starting with the confirmation process for Geithner by the Senate Banking Committee, we predict that the Fed is going to be forced to come clean on the hundreds of bailout loans made so far and to explain just why this vast expenditure of public funds was justified. When that explanation is made, then we can really begin the rebuilding process and start thinking about unwinding the government's position.

In fact, now that the remarkable political economists who dominate the Federal Reserve Board have pushed the official interest rate target to zero, the only place to go is up. At some point, we are confident, even the folks at the Fed are going to realize that a zero interest rate policy is doing more harm than good to the global markets, like driving the repo market and many money market funds into extinction. If cash has no time value, then many financial assets are likewise without any worth.  If the Fed wants to liquidate the assets on its balance sheet near par, it should let rates rise. 

We've said it before and we'll say it again, instead of worrying about the indicative "price" of credit, our esteemed colleagues at the US central bank should simply increase money in circulation until Treasury TIPS start to move in yield. There is a reason why the framers of the Federal Reserve Act did not allow the Fed to issue debt.  Let the Fed start creating money and slowly buying all types of paper at market prices, and the steep yield curve will follow in short order. Then a recovery will be well and truly underway. 

Questions? Comments? info@institutionalriskanalytics.com

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