Signs are adding up that the long, painful credit crunch is over and banks are bouncing back. But recovery for the real economy is still a ways off
It is time to declare it: the credit crisis is over. The U.S. banking system, epicentre of the chaos, is returning to health; the outlook for the global economy, once seemingly completely black, is brightened by a dawn light.
It is, of course, hardly a consensus yet, but it is the best conclusion to draw from this number: $36bn (£22bn). That is the amount that investors have poured into the weakest of the American banks in the past month, helping to fill the holes which opened up in their balance sheets and crippled their lending activities. Stronger banks such as Goldman Sachs (GS) have raised billions more, giving them greater resources to lend into the U.S. economy and abroad.
None of this is to say that recessions on either side of the Atlantic are about to end, that job insecurity and business caution are about to be replaced by a new bullishness, or that banks will suddenly be turning on the credit taps for sub-prime mortgage applicants or consumers who are already up to their card limits. But the first phase of crisis has given way to something more normal.
The necessary deleveraging of the consumer—their gradual repayment of credit card and burdensome mortgage debt—will continue to be a drag on the economy, but fewer people and businesses that can and should get credit will find their banks turning them away.
And at the root of the problem, credit conditions have improved, too, for the banks and other players in the financial markets. Banks began charging each other sky-high interest rates in 2007 as they feared a coming crisis could sink many of their counterparts, a phenomenon that reached its apogee in the panic of last September, when Lehman Brothers did collapse and the resulting chaos threatened to bring down the entire financial system.
Key to the change has been the "stress tests" conducted last month by the U.S. Treasury on the nation's 19 biggest banks, and which told 10 of them to raise a total of $75bn in new equity capital to weather a deeper than expected recession, according to Matt Warren, an associate director of equity research at Morningstar. "The stress tests forced all banks to raise their level of capital and to even out their abilities to absorb losses. That reduced the serious counter-party concerns and put banks on a steady footing. It was collaborative action that couldn't be done one bank at a time."
The nation's biggest banks, Citigroup (C) and Bank of America (BAC), after absorbing eleven-figure losses on their credit investments, quarter after quarter last year, had seen their shareholders' equity capital reduced to a tiny proportion of the banks' assets. Executives, with their fiduciary duty to shareholders, were forced to defend that last sliver, putting the brakes on lending and dramatically shrinking their activities, with disastrous knock-on consequences for the economy. Thanks to the conversion of government loans into equity, in Citi's case, and a combination of asset sales, private equity conversions and a $13.5bn share sale, in Bank of America's case, that process of shrinkage seems likely to abate in the coming months.
In China this week, Tim Geithner, U.S. Treasury Secretary, expressed doubt that his much-vaunted "public private partnerships" would ever be used in great numbers to buy toxic loans from ailing banks, precisely because so many banks now have enough capital to avoid having to sell them at firesale prices. And next week, the healthiest banks—ones which have proved that they can raise new equity and debt without the benefit of a government guarantee—will be told they can pay back the bailout money which they received last October. It will mark a new beginning.
Meanwhile, the world is adjusting to having a much smaller "shadow banking system", the name given to the network of hedge funds and non-bank institutions which had funded so much of the credit in the economy by buying packages of loans from the banks. Even there, though, there seems optimism, as demand from investors for parcels of car loans has improved, feeding through into more readily available auto loans—and a big improvement in car sales in the U.S. last month.
Ben Bernanke, the chairman of the Federal Reserve and the government's crisis manager-in-chief, was on Capitol Hill yesterday to give testimony that felt noticeably different to his earlier appearances before lawmakers. This time he put the focus on the long term, telling members that they needed to work on ways to cut the government budget deficit, which has been run up to post-Second World War levels to fund economic stimulus packages. It was notable, too, that he expected limited further declines in inflation, in effect taking deflation off the table. And he predicted the start of a slow economic recovery this year, a timeframe he had previously wobbled in his commitment to.
"An important caveat is that our forecast also assumes continuing gradual repair of the financial system and an associated improvement in credit conditions, while a relapse in the financial sector could cause the incipient recovery to stall," Mr Bernanke said—but he sounded more upbeat than ever.
"It is encouraging that the private sector's reliance on the Fed's programmes has declined as market stresses have eased," he said. "Their success in raising private capital suggests that investors are gaining greater confidence in the banking system."
The banks bounce back
The world's governments have delivered vast support to the financial system. At least £400bn of taxpayers' funds have been used to recapitalise banks (£37bn in the UK), and more than £500bn on buying up their "toxic" assets, through the U.S. "Troubled Asset Relief Programme" and other schemes. State guarantees to get the wholesale markets moving again come to more than £3 trillion, and a further £1trn has gone on other loans and nationalisations.
It has done some good. The consensus is that the financial system has indeed been stabilised, if not saved. This has been achieved via recapitalisation, pioneered in the UK last autumn, the fiscal and monetary packages that have so far averted an outright slump, and much more confidence in the authorities' ability, including that of the IMF, to cope with bank and sovereign crises and limit their systemic impact.
The banks are also more stable simply because so many of them are state-owned and most have comprehensive government-backed guarantees for depositors. Few expect another globally significant institution to fall on the disastrous scale of the Lehmans collapse last September.
In the UK, confidence in Barclays (BARC.L) has recovered to such an extent that some of the strategic investors it brought in with new funds have now been able to sell their stakes at a profit, with buyers found.
Appetite for risk is growing
Globally, investors seem to have regained at least some of their appetite for risk since the "panic of 2008"—and on a remarkably synchronised international basis. The recent decline of the dollar and falls in UK and U.S. bond markets suggest that investors are ready to move out of such safe havens towards traditionally risky asset classes such as equities.
Higher gilt yields have been a reflection of this trend and a signal of more normal, mildly inflationary, times ahead. The very sectors that drove share markets down so comprehensively last year are now pushing them back up again—the banks, mining, and retail and emerging markets. And just as the decline in the banks' market capitalisation was part of a vicious cycle of falling asset values more widely, so now the apparent discovery of most of those uncertain losses on mortgage-backed securities is helping to push bank valuations back up again.
The recovery in commodity prices since their nadir last December—oil is up around 50 per cent since then—has helped mining and resources shares, and surprisingly resilient retail sales have underpinned the stores. Markets such as China and India have staged exceptionally strong recoveries; the latter helped by the results of recent elections.
Equity markets seem to be convinced that the fiscal and monetary boosts administered to the world economy by the G20 have at least prevented the onset of a 1930s-style depression.
Credit markets are easing
Almost all of the standard measures of the premiums that markets demand for holding comparatively risky assets, most obviously private sector and bank debt, have eased. Banks are more willing to lend to each other and at lower rates than at the peak of the credit crunch.
The Libor/OIS spread, for example, is a barometer of how risky interbank lending is perceived to be against an effectively insured overnight index swap. At the peak of the crisis, the dollar reading peaked at about 360 basis points, or 3.6 percentage points. It has now subsided to about 65 basis points—though in normal times the spread is closer to 10 basis points.
Other credit market stress indices—such as "Teds" (which compare safe U.S. Treasury bills and interbank lending), and the iTraxx (which monitors the credit default swap market, basically the cost of insuring debts)—reveal similar trends. The credit crunch cannot be declared finally over, but this is perhaps the beginning of the end of it. The dynamics of the situation—rising consumer and business confidence feeding equity, bond and property market sentiment—are at last going in the right direction.
Glass half empty? Risks to watch for
The banks are definitely not comprehensively "fixed"—in terms of returning to normal patterns of lending. Even if they have sufficient capital on a regulatory basis, and can raise sufficient funds to pay back state shareholders, that does not mean they will now put lending ahead of preserving their capital, which is what shareholders and markets require.
Nor is the toxic assets saga entirely over: The IMF says as much as two thirds of the $4 trillion in bank write-downs are yet to be revealed. U.S. property prices are a long way off a strong recovery, which will go on undermining mortgage-backed securities.
Nor can new bank failures—with the possibility of further panic—be ruled out. Some of the emerging economies of eastern Europe are in a precarious state, many reliant on aid from the IMF. That fragility, in turn, is a continuing threat to those European banks that have large exposures to them.
More generally, in many western economies higher public debt and heavier taxation will constrain growth. Longer term, the threat is of an inflationary "double whammy"; after a lag of a year or two, the current surge in commodity prices and unprecedented monetary easing may feed through and converge to create a sharp inflationary spike, even as unemployment is rising and output barely recovered. Stagflation may yet be the abiding legacy of the credit crunch.