“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”
J. Paul Getty

The banking crisis has truly gone global now with governments all around the world having used desperate measures to prop up their ailing banking sectors. They have used tools never seen before, but banking shares still continue to fall. How is this possible? In this article, I’m going to look at how the banking crisis might play out. I’ll also indicate what you should be looking out for in the coming months to keep ahead of the rest. The 5-stage scenario that I’m going present is very pessimistic, but unfortunately, this is what is being increasingly priced into shares.

Banks That Have Collapsed So Far
Let’s a have a refresher on what’s happened so far. The first bank to find itself in deep trouble was Northern Rock in September 2007. A few months passed before Bear Stearns were finished with a fire sale to JP Morgan on the 17th March 2008. The warnings signs were there but the markets choose to ignore them. The Dow Jones traded comfortably over 11,000 and the FTSE around 5,500. That is until a month ago, when all hell broke lose. Fannie Mae and Freddie Mac were taken under the Fed’s wing on the 7th September. Lehman Bothers were allowed to fail on the 15th, while Merrill Lynch was dumped off to Bank of America. The Fed bailed out AIG on the 16th. The next day, Lloyds TSB announced a quick fire takeover of HBoS. Shortly after, WaMu went belly up and at the moment, Wachovia are being chopped up. Eventually the European banking scene declined into chaos. Bradford & Bingley, Fortis, Hypo Real Estate and Dexia have all required some sort of help in the past two weeks and the top Icelandic banks have now been nationalised.

Stages Of The Current Banking Crisis
Holy-Mother-Of-The-Clouds-Above, that’s a long list of casualties. And I’m just including the big names in there. But I’m not going to play the blame game. Let’s just say that this banking crisis was down to terrible mistakes and myopia from a combination of home owners, lenders, financial markets and regulators.

The outcome is the current banking crisis, which I’m going to broadly split into five stages. (Let’s hope we manage to skip Stage 4!)

Mid-2007 is when all of this kicked off, as US housing prices began their long descent. The value of the bank’s sub-prime mortgages started to collapse. Bank lending started to fall as the credit crunch took hold. Eventually Bank A wouldn’t lend to Bank B because Bank B might be chop suey in the morning. This has been getting worse as more banks have gone under. An unprecedented crisis of confidence has taken hold.

The US has been the most proactive in attempting to stop the crisis here. (Well, they did let the problem start, so they should be trying extra hard to fix it!) The Fed started slashing interest rates in September 2007, even in the face of potential inflationary consequences. This didn’t stimulate lending and borrowing. As the problem got worse, the US started bailing out numerous private companies. They now have a $700bn fund to buy toxic assets in an attempt to put more confidence in the market. Other nations have announced similar bailout plans. The UK has taken a slightly different route with a part-nationalisation, part-bailout scheme. Whether all of this improves confidence remains to be seen.

This is where we probably are now. Yes, I believe that we are only at Stage 2 (a long way to go yet!) For the past few months, banks and others have been increasingly hoarding cash. “Cash is king” now, with everybody pulling their money from those “risky equities.” Cash is needed to shore up balance sheets and fund mounting debt. Companies simply can’t afford to tie it up anywhere else. This problem is only likely to get worse as we near year-end funding rollovers.

This is a trickier problem for regulators to solve. If companies won’t work together, they will die in isolation. For better or worse, we are in a huge global financial system. To be fair, regulators have tried some innovative things to stop the crisis here. First off the mark, the Irish government guaranteed the entire Irish banking system. The Greek, German, Austrian and Danish governments followed with similar deals days later. Banks in the above countries can now leverage off the AAA ratings of their nation when borrowing. The US have gone a step further and are going to start purchasing commercial paper (short-term bonds) directly from companies without any collateral. Will this be enough to get the global system back working?

During Stage 1, most people believed that the banking system was merely going through a crisis of liquidity. This is where banks can’t get their hands on funding without paying a huge price. So central banks around the world started pumping billions of liquidity into the money markets. This was a logical move. Talking about the 1930’s Great Depression, current Fed head Ben Bernanke admitted that they failed to use policies that might have stopped a recession from turning into a depression. Liquidity was withdrawn in what is seen as probably the greatest regulatory mistake ever! Central banks weren’t going to make that boo-boo again.

But it looks like we’re past this being a simple liquidity issue. Despite the billions of liquidity being pumped in, money markets are still completely frozen. This would be completely irrational in a liquidity crisis, but fully rational in a solvency crisis!

Insolvency is when a company has greater total debts than total assets, a situation of negative capital. Some banks may be in that situation now. Let’s look at Anglo Irish Bank for example. They are now back trading where they were before the government guarantee. How is this possible considering that all of their deposits are safe and they can now leverage off a AAA rating? Well the potential for insolvency is one big reason. Anglo Irish gave billions in loans to developers during the good times. Now it’s looking likely that a growing number of them will default on their repayments. As this happens, more and more assets (future loan repayments) are wiped off the balance sheet. Potentially, Irish banks still aren’t safe. Their fortunes are intertwined with the general construction industry.

To play out the scenario, let’s say an Irish bank became insolvent and went under. The Irish government would have to liquidate the assets, surely at a price that would be below market value. But they would have to pay full price on all the debt. Shortfall – a few billion! If one bank goes under, the domino effect may drag a few more down. Then a huge bill is staring the Irish State right in the face!

I don’t think that the situation will get anywhere near that bad, but the slim possibility must be accounted for. I just hope that the Irish government has done enough analysis and conclusively decided that this was a gamble worth taking. Other countries with the same guarantees face similar issues.

“Ah no way, it couldn’t possibly get any worse could it?” Unfortunately, it could. But we’re not at this stage yet and it’s not certain that it will happen. For prudence sake though, I must include it.

The “real” economy is made up of companies that actually make stuff, the backbone of every economy, e.g. CRH, Next, Apple, Coca-Cola. We are in a recession, which is natural and manageable. But a depression (there’s no strict definition, but GDP 15% lower than its peak is a decent cut-off point) requires a collapse in the real economy. The situation would then become very nasty!

The real economy was heading into a slowdown even without the banking crisis. The hope was that the banks could have sorted out their balance sheets before “real” companies and families started to feel the pinch. This hasn’t happened and both problems are now side-by-side. The financial panic has shattered confidence in other industries. This is eerily similar to how the Great Depression started. A vicious cycle occurred between the banking sector and the real economy and the downward spiral accelerated.

Altria, a huge US recession-proof tobacco company, has had to delay its buyout of US Smokeless Tobacco. The world’s sixth largest company, General Electric, is struggling to fund its short term needs too. No matter how solid your company is, you can’t get your hands on any credit – the frozen money markets have extended to the real economy.

The market is worried. The $700bn US bailout was passed and the market collapsed. Why? Worries about the overall world economy are a big reason. Economic indicators are getting worse and worse at a faster pace. There have been no signs so far of any turnaround. In the US, the crucial non-farm payrolls have been negative for all nine months in 2008. September was the worst month so far with 159,000 jobs lost. Non-farms, along with the ISM Index (survey of purchasing managers) is what the US Fed thinks affects the economy. Needless to say, the ISM is negative, standing at 43.5 (50 is neutral), it’s lowest level in this current downturn. These pessimistic indicators are reinforced by shocking housing stats, falling retail sales and lower industrial production. It’s not just the US; these indicators are equally as dismal in Ireland, the UK and the Eurozone.

It is the real economy that governments and central banks must now target. For once, they need to be proactive and stop any self-perpetuating slide before it starts. The US has been the first off the mark. Their decision to purchase commercial paper (short-term bonds) directly from companies without any collateral extends to all sectors.

But we still need a more proactive global scheme. They need to come up with something that will stimulate growth in the world economy (which is falling fast.) Yesterday’s co-ordinated rate cut was a start. But as the market showed by its response, rate cuts aren’t the best solution to this problem. Back to the drawing board. Luckily, there is a G7 meeting in Washington tomorrow. Usually this meeting is only good for caterers and sellers of fine wine. But this time, they have a chance to get a global plan off the ground.

This stage will inevitably come. The questions are when and how much pain must we go through before we get there?

Conclusion
I know that I have been pretty pessimistic in this piece. I apologise for that as I normally like to focus on the positive. However, I felt that I must write something to ward off traders from attempting to “call the bottom” of markets. “It couldn’t fall any further” is a phrase I always hear. “If it’s not bankrupt, it can fall further” is how I always respond. Since September 2007, hundreds of well-respected analysts have attempted to call the bottom and they have all lost their shirts.

When trading banks always stay vigilant. Keep an open mind and stay informed about both sides of the argument. Also keep a close eye on the various economic indicators. They are going to become ever more crucial in the coming months, as they will tell us when Stage 5 is near.