When All The Feedback Goes One Way, Market Movement Becomes Irresistible

The Age

Wednesday July 16, 2008

Malcolm Maiden

The lead from the US makes it plain - the runs affect markets, not just banks.

THE US economist who called the 2000 tech wreck and the US housing market slump, Robert Shiller, says the market is fed by positive and negative feedback loops.

Feedback comes from many sources, including company announcements, broker research, market analysis, government statements and the media. When they point the same way, the current of sentiment runs strong, and is not easily deflected.

That is the position the markets are in right now. In the first two days of this week, people attending the Reserve Bank's 2008 conference have heard a series of speeches about the financial crisis, and one of them, by Brunel University economics and finance professor and former Bank of England staffer, E. Philip Davis, explained how confidence can turn into a run, as the feedback loops that Shiller identified strengthen.

Once one bank has experienced a run, contagion is possible, Davis says. Lenders may react to "balance sheet similarities" between the bank that has been hit by a run and other banks, or to concerns about counter-party exposure to the original victim.

And while retail customers are traditionally thought to be the ones who spark a run, at Northern Rock in Britain last September, for example, and at California's IndyMac Bancorp this month, Davis says large wholesale depositors and customers are becoming increasingly important.

They are better informed, less likely to have lender of last resort protection, and they are supplying a progressively larger portion of bank funding.

The confidence of wholesale players in the banking system is crucial: it almost evaporated in March, when Bear Stearns veered towards collapse, only to be put back together again by US Federal Reserve boss Ben Bernanke.

But since then, the US housing market downturn has intensified, the technical insolvency of the two groups that fund half the $US12 trillion mortgage market, Fannie Mae and Freddie Mac, has become apparent, and hopes that the crisis is easing have faded.

It is a time of elevated risk, even from the perspective of the crisis. As Davis observed in his paper, when confidence fails and a run occurs, banks that are officially adequately capitalised can still be brought to their knees - because, in a run, it is not the capital base that matters first, but liquidity: the ability to meet demands for payment, and in a run, unusually high demand.

This sharemarket fell heavily again yesterday, in sympathy with the new US dynamic, which sees America's regional banking industry scrutinised in its entirety for its ability to maintain liquidity and solvency as America's housing market downturn ships losses straight on to bank balance sheets by way of the mark-to-market accounting rule, and shares in banks considered the most vulnerable, including Washington Mutual, sold heavily.

But the fall here also reflects gnawing concern that this much collateral damage cannot be taken and then simply repaired; that the economic slowdown that is under way could be severe enough to undermine the commodity price boom that has been keeping Australia's economy relatively strong.

"Funding risk now interacts with market liquidity risk, to create difficult challenges ..." Davis says. "Runs must be envisaged in markets and not just banks, which, given mark-to-market accounting, leads on to threats to the liquidity and solvency of banks via market price changes."

That's it in a nutshell, really, for regulators, and for investors. The Australian market is still protected from the worst balance-sheet losses from the credit crisis because the local banks were only paddling in the securitised debt pool. There is no need for customer queues here.

And this economy is still buttressed by commodity prices, albeit less solidly than it was six months ago. But when the big-money centres are in a spin and Shiller's negative feedback loops are in full force, that counts for little. Local investors await Wall Street's next temperature reading, and when they get it, they will react accordingly - up or down.

AMID the gloom yesterday, there were two small steps forward for the local market that were larger ones for the companies involved.

In Melbourne, Centro announced that it had sold 29 of 31 US shopping centres in its Centro America Fund (CAF) for $US714 million, $US290million of which will go to debt reduction after secured lenders to the properties and minority investors in CAF get their share. And in Sydney, Allco announced that its banks had finally agreed to a debt refinancing, and a debt reduction timetable.

Centro's shopping centres were sold at a 10% discount to book value, but that is reasonable in the stressed circumstances, and Centro gets to continue managing the properties for at least a year.

Centro has a way to go. It owes its banks and US noteholders about $3.6 billion. But final bids are also in for four shopping centres in Centro Australia Wholesale Fund (CAWF) - Centro Bankstown in Sydney, Centro Galleria and Centro Halls Head in Western Australia, and Centro Colonnades in Adelaide. The gross could be $1 billion, and net proceeds about half that.

Allco has agreed to pull its debt load down from $830million to $400 million by next June (it is already effectively at $691 million after asset sales) and will pay 3.5% over the bill rate on outstanding debt of $600 million-plus, 3% between $400 million and $600million, and 2.75% below $400 million. That's steep. Babcock & Brown paid 2% over bank bills to refinance its $2.8billion facility at the end of June. But it is a lifeline, and in that sense, priceless.

mmaiden@theage.com.au

© 2008 The Age

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