Still Waiting

“This suspense is terrible. I hope it will last.”

- The Hon. Gwendolen Fairfax in ‘The Importance of Being Earnest’ by Oscar Wilde.

The failure of Lehman Brothers in September 2008 will forever be regarded by capital markets professionals as a JFK assassination-style moment, an occasion now set in amber that marked the moment when everything changed – or at least should have done. With the benefit of hindsight, it’s somewhat remarkable that the bankruptcy of a second tier investment bank better known for credit trading than for any facility with stock underwriting, for example, could trigger a global credit crunch. But it did. Andrew Ross Sorkin’s ‘Too Big To Fail’ – still probably the best example of financial crisis porn – masterfully explains why:

It was just past 7:00 a.m. on the morning of Saturday, September 13, 2008. Jamie Dimon, CEO of JP Morgan, went into his home library and dialled into a conference call with two dozen members of his management team.

 

“You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case,” Dimon told his staff.

 

“..Here’s the drill,” he continued. “We need to prepare right now for Lehman Brothers filing [for bankruptcy]. Then he paused. “And for Merrill Lynch filing.” He paused again.

 

“And for AIG filing.” Another pause. “And for Morgan Stanley filing.” And after a final, even longer pause, he added: “And potentially for Goldman Sachs filing.”

There was a collective gasp on the phone.

As we now know, Lehman Brothers remained the only lamb to be sacrificed at the altar of the financial markets. The US administration quickly capitulated in the face of those markets. The other institutions were therefore rapidly forced into shotgun marriages, emergency capital- raisings, or bailed out by taxpayers, or mysteriously allowed to convert into commercial banks (a privilege never granted to Lehman Brothers, but somehow deemed appropriate for fellow brokerage firm Goldman Sachs). But in a parallel universe, with less supine taxpayers and altogether less biddable regulators, there would have been a domino-style failure by, and concomitant run on, the financial system.

A revisionist British political perspective now blames everything on pesky North American speculators. The chart below, for example, courtesy of Grant Williams, shows the extent to which a culture philosophically committed to living beyond its means has infected its host:

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This conveniently ignores the run on Northern Rock from the previous year, or the bail-outs of the likes of Lloyds and RBS. That Barclays Bank, which only avoided taking the taxpayer’s shilling by resorting to capital-raising from the Middle East that is now subject to a criminal probe by the Serious Fraud Office, has been wrestling with a £12.8 billion capital “hole” and seemingly been less than transparent in its own capital reporting, would suggest that the UK banking system is not exactly as healthily restructured as it really should be, five years after the Lehman bankruptcy. James Ferguson of the MacroStrategy Partnership asks,

How many other banks, concerned that their leverage looks borderline, are similarly fudging their capital numbers? With so many banks only just on the right side of the regulatory minimum hurdle and incentivised to stay there, this is of paramount importance. Banks that are hiding the fact that they are below the regulatory minimum capital requirement are not merely technically insolvent but are unlikely, indeed unable, to address other balance sheet issues like forbearance on NPLs [non-performing loans] and hidden losses.

And it is not just Britain’s banks that are “wrestling” to right-size their capital and leverage ratios five years after the Lehman bankruptcy. The chart below, via Grant Williams and Zero Hedge, shows the problem of bank lending is just as serious in the beleaguered euro zone:

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Deutsche Bank, for example, has just said that it intends to shrink its balance sheet by another €250 billion over the next two years to comply with stricter leverage rules. So here’s the bottom line. As far as we’re concerned, whether or not the western banking system is insolvent, it makes sense to behave, as an investor, as if it is – especially after the Bank of Cyprus confirmed that depositors with savings over the €100,000 “guaranteed” threshold will lose 47.5% of their money.

This commentary will deliberately not include any charts relating to market performance – because they would be meaningless, given the extent to which the financial markets have become mesmerised by promises, hopes or fears of further monetary largesse from their respective central banks.

Instead, we restrict chart use to economic statistics (for better or worse). As the chart below shows, we can to all intents and purposes ignore what the FTSE 100 is saying about UK economic prospects (and we acknowledge that the FTSE is a poor barometer for purely domestic UK economic health given its international composition). Rather, we can simply acknowledge that this “recession” would appear to be more severe than the 1920s or 1930s Depressions, on the basis of duration to date and the lack of any obvious recovery (as opposed to QE-driven stock market string-pulling). If it is a recovery, it is one that economist Liam Halligan calls “the most feeble in our history”.

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In summary, we do not inhabit a remotely “normal” economy. We inhabit a recessionary slump that our monetary authorities seem determined to perpetuate by any means possible. Now that they have driven monetary policy rates to zero, conventional policy no longer works, so we are faced with the prospect of further quantitative easing until the system collapses on itself.Given the inherent unattractiveness of bank deposits and pretty much any form of fiat currency in a world beset by competitive currency devaluation, we would much rather hold gold. Yes, its “value” in inconstant and ever-depreciating dollars is volatile, but as fund manager Tony Deden points out,

In ten years’ time, our gold bars will still be gold bars. In fifty years too. And in one hundred. In fact, our gold bars will still be gold bars in a thousand years from now, and will have roughly the same purchasing power. Therefore, gold has a property which is unique in comparison with everything else we know: the risk of a permanent loss of purchasing power is close to zero. This is worth reflecting on. It is a most powerful property and implies that the loss of purchasing power such as that [which gold holders have experienced] in the last quarter can only be temporary.

Once again, we do not inhabit a “normal” economy. We live in a financialised world in which our banks cannot be trusted, our politicians cannot be trusted, our money cannot be trusted, and – not least thanks to ongoing spasms of QE and expectations of much more of the same – our markets cannot be trusted. But we have to play the hand we’re dealt. So in addition to holding the monetary metals as a long term insurance against the loss of purchasing power consistent with holding paper money in a money-printing orgy, we also hold the highest quality bonds we can identify, and market neutral trend-following funds, alongside ultra-defensive equities with genuine secular growth potential (not least the Halley Asian Prosperity Fund, a classic Graham-and-Dodd deep value fund which focuses on Asian domestic consumption without the taint of exposure to western economies that have gone conclusively ex-growth).

At some point (though the timing is impossible to predict), asset markets that cannot be pumped artificially higher will start moving, under the forces of inevitable gravitation, lower. The possibility of a secular dual bear market in equities and bonds does not seem unrealistic. In such an environment, conventionally positioned portfolios (that are long stocks in line with an index, and long bonds in line with an index) will incur massive losses. Yes, the suspense is terrible, and as fiduciaries we are obligated to survive through it as best we can, by diversifying our clients’ capital as prudently as present conditions allow. But unlike for Wilde’s Gwendolen, for us the reckoning cannot come soon enough.

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