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Here Comes A Whale

September 17, 2007

My friends have at GaveKal have been whale watching for some time. But not for Blue whales or in an ocean. There theory is that Central banks keep throwing dynamite (in terms of liquidity) into the ocean during credit problems, watching little fish die and don't stop until a whale floats to the surface, thereby giving a signal that the credit crisis is close to being over. They think they have spotted that whale.

This week in a very interesting and decidedly different Outside the Box, Charles Gave writes about the current liquidity crisis and the problems surfacing in England. Remember, it was problems in Asia and then Russia that created the problems in 1998. We should all pay attention to what is going on. Are there more whales getting ready to float to the top?

John Mauldin, Editor
Outside the Box

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Here Comes A Whale

GaveKal Ad Hoc Comment, Monday September 17, 2007

For almost a year now, we have been driving our clients crazy with Charles's tired old metaphor about the global liquidity contraction, in which the central banks keep throwing in sticks of dynamite until the ocean finally disgorges a huge dead whale. However much it annoyed our clients, we just couldn't stop using this metaphor for two reasons:

  • Firstly because, on past experience, the long-awaited appearance of the whale - Continental Illinois, Chrysler, Brazil, Drexel Burnham, Kidder Peabody, Mexico, LTCM/Russia, Enron/MCI/Argentina - would announce the beginning of the end of the liquidity crunch.

  • Secondly, because we started thinking in the middle of 2006 that our whale was overdue for an appearance, but it never quite turned up. In February we finally realised what species of a fish we were looking out for - a mortgage lender, with a specialty in high-risk loans - but still the damn creature refused to show. But this weekend, a whale finally surfaced, though somewhere totally unexpected.

Until last week, almost nobody in the markets had heard of Northern Rock PLC. And even on Friday - when Britain's fifth-biggest mortgage lender was officially "rescued" by the Bank of England in its first lender-of-last-resort operation for 34 years - most people in the markets saw this event as "a little local difficulty" compared with the mess in the US sub-prime market or German state banks. Yet over the weekend, it gradually dawned on us that the Northern Rock crisis could be the climactic event of the present liquidity contraction and could even turn into one of the biggest financial events in a generation, comparable to the collapse of the European Exchange-rate Mechanism, which occurred just as suddenly and in eerily similar circumstances exactly 15 years ago (on 16 September, 1992).

Northern Rock may have started life as a small-town "building society" based in grimy, working-class Newcastle, but it is no small-time business. Its balance- sheet is £113 billion, or $230 billion, making it the eighth-biggest bank in Britain, but because of its extremely aggressive growth rate, it became the country's biggest net lender over the past six months. In short, the size of Northern Rock's balance sheet—combined with the enormous and unprecedented support it is could soon require from the British government—easily qualifies Northern Rock as a whale. Sadly for Northern Rock, which has been one of the world's most efficient exponents of new financial technologies and managerial methods, its whale-like £113 billion balance sheet rests on a £3 billion equity base better suited for a sardine. Even worse, its liabilities include only £30 billion of stable (until last week) consumer deposits. Its remaining £80 billion of funding depends on securitisation or on capital market and inter-bank borrowing, which has been hard to come by in the past two months. As a result its free liquidity is almost certainly zero, after a deposit flight of more than £2 billion over the weekend.

Why should any of this matter? After all, the Bank of England offered Northern Rock an unlimited line of credit, so depositors should calm down, the run on the bank should stop and everything should be OK. That is certainly what the British Government, the media and most people in the markets assumed on Friday. But over the weekend, as the queues kept growing outside Northern Rock branches and public attention shifted from the headlines of the "rescue" announcement to the political implications and the financial fine print, the sense of confidence began to evaporate - and rightly so.

First and foremost, the media - and hence Northern Rock's customers - are realising that the Bank's "lifeline" does not amount to a guarantee for creditors or even for small retail depositors. After declaring that the Rock was completely secure and solvent, British government officials, when pressed to be more specific, have merely pointed to the Financial Service Authority's deposit guarantee scheme, which guarantees 100% of deposits up to £2,000, 90% of the next £32,000 and nothing at all beyond that. With that kind of reassurance, it is understandable that retail depositors have been queuing all night to dislodge their money from the Rock. To make matters worse, media commentators and opposition politicians are starting to sense that the Bank of England and the government have seriously mismanaged this crisis and may even have caused it (for example, with the strangely-timed diatribe against bank bailouts from Mervyn King just two days before this bail-out was announced). The sniff of incompetence - and of possible infighting between a hard-line central bank and a panicking government - is undermining the credibility of the official "guarantees" offered to Northern Rock, thereby exacerbating the deposit flight.

Worst of all, the Bank of England and Treasury officials who should have been knocking heads together in the London markets to put an end to this crisis - either by arranging a forced takeover or by reopening interbank credit-lines - seem to have been doing almost nothing. Instead of following the example of the Fed and the ECB and flooding the London market with one-month and threemonth repos, the BoE has offered only overnight assistance and insisted that it is up to the banks to decide for themselves if and when they should start lending again in the normal way. Until last week, London officials were even boasting of a "controlled experiment" in central banking which showed that Britain's distinctive approach to market management was as effective - and more consistent with prudent doctrines of central banking - than the huge moneymarket operations of the ECB and the Fed. British officials even seemed to believe that their idiosyncratic policy of denying the markets longer-term lending had been so successful that spreads between interbank and policy rates were similar in sterling and other currencies, even though the figures showed they were far apart (see below).

The upshot is that the British authorities have somehow persuaded themselves that "markets" will deliver a solution, even in the sort of banking crisis where markets on their own have repeatedly been shown to fail. As a result, there seems to be no great urgency to do anything more about Northern Rock. One weekend newspaper reported that the BoE refused a credit line to several potential bidders for Northern Rock, on the grounds that this would constitute a government subsidy, potentially in conflict with EU rules. Another paper reported that the Bank was confident of new bidders emerging for Northern Rock, once its final results were published at the end of the year!

The bottom line is that the Bank of England, the media and the markets have no idea of the force which could be about to hit them - a situation uncannily reminiscent of the days before Black Wednesday, exactly 15 years ago. To see this, let us follow to its logical conclusion the British authorities' insistence on a "market-based solution" to this bank-run (which would be, if it happened, a first in the monetary history of the world). In saying this we recognise that markets rarely follow any course to its logical conclusion. Unpredictable events usually intervene to turn any crisis or economic miracle into some kind of fudge or muddling through. Every few years, however, some market somewhere in the world, gets the bit between its teeth and goes all the way - Wall Street in 1987, the ERM in 1992, Russia in 1998, internet stocks in 2000. When this happens, the implacable logic of Darwinian survival takes over and events usually move much faster than anybody expects.

So what would happen if all participants in the British money markets today followed their individual economic interests to their logical conclusion? The logical course for anyone with money in Northern Rock is quite clear. After reading the details of the government's half-baked guarantees and reading about possible rows between the Bank of England, the FSA and the Treasury, anyone with a deposit above the £2,000 guarantee limit would take all their money out of Northern Rock - and do it quickly.

What if this happened? Northern Rock, when it last reported, had £30 billion of customer accounts and £4 billion of interbank deposits. As these deposits evaporated, it is hard to believe that the £17 billion of capital market liabilities on its balance sheet would stay put, even if its £47 billion of securitised notes remained stable, since these are backed by securitised mortgages of roughly the same value. With essentially all its liquidity already exhausted, the Rock would have to turn to the BoE for a loan of at least £30-£40 billion. This would probably be the biggest single loan ever advanced by a government to any private company anywhere in the world. What would be the political reaction to such a loan, especially after Mervyn King's long lecture last week against bank bailouts? And how much more criticism would there be when the press and the opposition noticed that Northern Rock has only £31 billion of normal unsecuritised residential mortgages on its balance sheet, so that the collateral offered to the Bank of England would have to include £6 billion of risky buy-tolet mortgages and £8 billion of totally unsecured loans?

Would Gordon Brown authorise such a loan and face the political backlash? He probably would , but "probably" is not an answer that will satisfy the Rock's depositors and creditors once the media starts to ask this question in the next few days, as they probably will. And if the Government tried to leave itself any wiggle-room with the answer, the flood of money out of Northern Rock would turn into a tidal wave. The BoE would then have to stand by its promise to support Northern Rock. But what would happen to other British banks which relied on interbank lending and securitisation in the same way as Northern Rock, though with less extended balance sheets (Bradford & Bingley, Alliance & Leicester, maybe even the Halifax/HBOS, Europe's biggest mortgage bank).

Would their depositors be reassured or would they start to worry that the Bank of England was reaching the limits of the taxpayers' tolerance and central banking prudence? It seems probable that some would demand similar reassurance - and if they failed to get it, they would join the Rock's savers in the handful of banks that are clearly "too big to fail". If a bank run spread from Northern Rock to any other institution - even a very small one - the game would suddenly be up, just as it was on Black Wednesday.

Gordon Brown would have to offer blanket guarantees to all British banks, exposing the Treasury to potential losses even bigger than it suffered in the ERM debacle. The Bank would have to slash interest rates and flood markets with money, as it did in 1992, in a desperate attempt to restore the normal levels of inter-bank lending whose failure triggered the Northern Rock crisis. Just as John Major had to eat the words of his defiant speech to the Scottish CBI just days before the ERM collapse, Mervyn King would have to tear up last Wednesday's carefully-crafted statement. What then would be left of Gordon Brown's reputation for financial competence or of the Bank's hard-won credibility and independence? In short, the Northern Rock "rescue" could easily turn into a financial - and political - crisis on the scale of Black Wednesday.

We are not saying that such a disaster is likely - only that it is possible. One sure way to stop it would be for the Bank of England to lend aggressively this week to reopen the London interbank market. Another would be to arrange an immediate forced sale of Northern Rock, with government guarantees to back it. If either of these events happened they could mark the "big whale" moment for which we have been waiting for so long. Combined with a Fed rate cut on Tuesday, they could mark the climax of the present liquidity contraction.

But as of this weekend, there has been no evidence of the authorities in Britain even thinking about radical and urgent solutions. They simply don't seem to be aware of the scale of the threat they face. Gordon Brown and the Bank of England seem to be waiting calmly for the markets to resolve their problems, while the roar of a tidal wave seems faintly audible from afar. The mood in London at the moment feels more like the weekend before Black Wednesday than the weekend after LTCM.

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Your thinking there may be a few more whales to surface this time analyst,

John Mauldin

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