March 26, 2008
This week, as financial markets recover their balance somewhat, millions of investors are trying to make sense of the past few weeks. Why did bank shares collapse so much? Can any rebound be sustained and what might be around the next corner?
Before we try to answer these questions, it is important to appreciate that we are probably not out of the woods yet. The volatility in markets implies that one piece of bad news can send shares tumbling. On the other hand, a ray of hope is seized upon as a sign that good times are ahead.
Traders are caught in the constant crossfire, reeling from fear to elation. If we block our ears to this din, it is not hard to see that we are now in a new phase and this might last much longer than many expect.
This phase could be described as the great unwinding. All over the world, leveraged bets that were placed in the past five or six years are being unwound and credit is getting not only tighter but in many cases has disappeared altogether.
Many people have been terrified by the suddenness and the magnitude of the downturn and are seeking a plausible explanation of the crisis that doesn’t involve things we’ve never heard of like CDOs, ABSs, monoline insurers and structured products.
One interesting way of looking at the behaviour of financial markets is through the medium of geology. The Earth’s rigid outer shell, the lithosphere, is broken up into an extraordinary mosaic of oceanic and continental plates.
The financial equivalents of the geological mosaics are the many markets which reflect global economic trends such as the stock markets, the commodity markets, housing markets and foreign exchange markets.
In geology, just underneath the lithosphere, there is another layer — a more fluid, plasticky surface, called the asthenosphere. This is the uppermost layer of the Earth’s boiling core, which bubbles away below. Trends in financial markets and global economics, such as bank lending, house prices and immigration, can be compared to this pressure bubbling away under the surface.
Ultimately, when the pressure in the bowels of the Earth gets too intense, the core bubbles and occasionally, where the lithosphere is thin or cracked, it explodes into violent volcanoes. In financial markets, these violent volcanoes can be seen in banking crises, house price booms and busts, large falls in exchange rates and gyrating stock prices.
Normal day-to-day market fluctuations are like the daily grinding of the Earth’s continental plates. So for example, along the 1,200km San Andreas Fault, the Pacific Plate has been grinding horizontally past the North American Plate for 10 million years at an average rate of about 5cm per year (about the same speed as your fingernails grow).
There are about 10 other main fault lines across the globe, so earthquakes both on land and under the sea are relatively easy to locate, but predicting precisely when they will happen is almost impossible.
The crucial thing is that although we can assess the pressure points, we don’t know for sure exactly when and with what intensity the financial markets will erupt.
In times like this, we are living on a financial San Andreas Fault and everyone is worried that the next tremor will be “the big one”.
This is why, despite the Fed’s extraordinary action last week, things remain uncertain. Every rally is followed by a trough and the financial markets lack direction.
Once we accept this, we can begin to try to answer some fundamental questions. Given the centrality of our banking system to our economy, have our banks been permanently weakened by the past few weeks’ convulsions?
Optimists, citing yesterday’s rally, are claiming that there is a great buying opportunity out there and that Irish banks will recover strongly, touching and surpassing the previous heights.
This view is hard to substantiate because the Irish banks are not really banks per se but, for the purpose of this discussion, they are simply large leveraged bets on the inflated property market.
Last September, I was criticised for describing in ‘The Generation Game’ certain Irish banks as nothing but “leveraged hedge funds, betting on property”.
I stick to this contention and believe that the Irish property market — far from being close to the bottom — has never looked weaker.
The reason for this outlook is simple. As the banks pull up the credit drawbridge to try to (a) convince shareholders that they are being prudent, (b) repair their balance sheets, they begin to see that lending to a falling property market is the quickest way of losing money.
House prices in Ireland will continue to fall this year and next and possibly longer. Remember, banks are not heroes.
They are not in the business of bargain hunting. They don’t sniff around the bottom of a market, hoping to catch a turning point. They are now in the preservation, rather than expansion mode.
The negative impact on the housing market of this credit contraction would be bad enough, but it is made worse by the fact that there are so many unsold houses in Ireland. This enormous oversupply of property will take years to unwind.
However, this is good long-term news for all of us. Ireland needs to wean itself off the housing obsession.
Unfortunately for us, the credit crisis hasn’t so much served to wean us off as suddenly rip the teat away, leaving the soft, pampered, milk-fed economy in shock. This shock will be difficult to take in the short-term but will only strengthen us medium-term.
In the past few years, the housing lobby has hijacked the debate in Ireland, forcing people to think that the economy and the housing market were one and the same thing. They are not.
For the rest of the economy to recover, the over-bearing presence of the housing market has to recede.
This will liberate capital for more productive investments. In a world of trade, no country ever got rich through speculation on a fixed asset like land.
I know it doesn’t seem like that now, but the collapse in Irish bank shares — in some cases by as much as 70pc in a year — is a blessing in disguise.