Stripped Bear

(not Charlton related, but just as depressing)

It's been an interesting week for Wall Street. Firstly, the financial world's arch nemesis Eliot Sptizer was forced to resign after being embroiled in a prostitution ring.

Then just a few days later, the ongoing rumours about Bear Stearns became reality with terrifying speed, the company ultimately being flogged last night to JP Morgan Chase for a humiliating $2 per share.

Some random thoughts firstly on Eliot Spitzer. He was already independently wealthy thanks to his family's real estate fortune, but exactly how good at sex does a prostitute have to be to warrant $4,300 per hour?

Maybe I'm naive, but that's about the same amount I pay the wife for two months of shopping and child-raising, and I bet the lovely Miss Dupre didn't iron Governor Spitzer's shirts. Then again, with stock markets and house prices falling as quickly as they are, at least he got a decent return on his money.

Let's imagine that she can summon up the energy to do four hourly assignments per day (that's Dupre, not my wife). If I was her agent, I'd sell the work/life balance aspects to her as 'one hour on, two hours off'. If she started at a rather civilised 9am, she'd leave her last satisfied customer at 7pm, allowing plenty of time for dinner and a well-earned gin and tonic.

So she could earn $120,400 per week, or approx £60,000. Do those types of earnings remind you of any other profession by chance? For the first time I'm starting to think footballers might be underpaid, even the ones that play for Charlton.

Talking of people that needed a few grand before they got f*cked, Bear Stearns was the other big story last week in New York. Joe Lewis, the Bahamas-based UK billionaire is rumoured to have personally lost over $1billion buying up Bear Stearns stock during recent months.

Interestingly, Lewis is indirectly the owner of Tottenham Hotspur which really does prove that every cloud has a silver lining. Darren Bent meanwhile was said to be 'over the moon', that he was now only his second worst investment of all time.

As someone who has been cynical, and at times downright contemptuous about the sham that masqueraded as US/UK capitalism over the past five or so years, we are now firmly in the 'I told you so' stage. Unfortunately as I relayed to a journalist friend at the Financial Times today, we are about to head into the 'now I'm also really scared' stage.

A quick recap on how we got here. Global interest rates were cut sharply after the tech bubble burst in 2000, and again after the terrorist attacks in Sep 2001. The (flawed) attraction of low nominal interest rates set in train a wave of leverage which lifted asset prices across the world, particularly property and equities. As asset prices rose further, confidence grew that even more leverage could be applied, thus creating a seemingly virtuous circle that the bulls tried to explain in the language of a 'new paradigm', as opposed to just another bubble.

I think there's an Arabic phrase that, '...money fills the cracks.' Inevitably with the application of leverage seemingly being risk-free, money did indeed fill the cracks, most notoriously in the realm of the US subprime borrower. However this current crisis is not about unemployed 'homebuyers' in Michigan, because the first cracks could have appeared anywhere across the spectrum of dumb lending. Thus any forlorn hope that the crisis would be limited to the large (but ultimately manageable) losses of $250bn or so from subprime, are clearly now in tatters.

Barely a week has passed during the last year, when even those who pay a keen interest in the markets, have not been forced to learn about some new grotesque financial creation. Terms such as SIVs, conduits, Alt-A mortgages, option ARMs, monoline insurers, and CDO squared, have entered the lexicon of even the tabloids, as editors scurry to explain to their readers what it all means to them.

The degree to which the world's banks have expanded their balance sheets in just a few years is truly mind-boggling. By way of an example, Merrill Lynch has so far written off $24.5billion in capital, equivalent to fully 68% of its book value at 1st Jan 2007. That book value represented the accumulated equity and reserves of a 93-year old institution, the sum total of the hard work and innovation of its countless past employees, just simply now vanished at the stroke of an auditor's pen.

The solution to most financial crises, is simply to cut interest rates. Unfortunately this has not, and more worryingly will not solve this crisis. The problem ironically is not a lack of money nor the cost thereof; the sovereign wealth funds of Asia and the Middle East particularly are flush with cash, as ultimately are the central banks whose ability to print money is essentially limitless, inflation concerns aside.

The problem this time is one of solvency, and a complete lack of transparency; the banks need equity right now, not liquidity. Those aforementioned sovereign wealth funds initially provided some, and have already been burned. They won't be so forthcoming this time around.

Millions of loans issued to US homebuyers (and UK ones too I suspect) are fundamentally 'insolvent'; there is no interest rate (including zero) which will allow the borrower to make good on the loan. Meanwhile, thanks to the aforementioned financial creativity of the banks in recent years (especially as it pertains to 'securitisation', ie. the slicing up of debts) no-one can be sure where the losses lie, or more pertinently how much they amount to.

Thus cue a complete unwillingness to lend even to other banks, let alone to apparently creditworthy homeowners, investors or corporations. The virtuous circle has turned vicious, and to its list of victims one can now add Bear Stearns to Northern Rock.

At some level it was reassuring that the Federal Reserve negotiated a successful bailout for Bear Stearns, before the demand for cash from its counterparties and clients turned into a devastating rout. At least for now, they have avoided the humiliation of nationalisation that now haunts the UK. However the share price action today, particularly as it pertained to another venerable Wall Street institution Lehman Brothers, suggests that the 'great unwind' remains firmly in motion.

In all likelihood, the Fed will cut US interest rates by a further 0.75% on Tuesday (possibly by more), in another desperate, but surely flawed attempt to kick start the credit motor again. Eventually the Bank of England will cut UK rates to 3% and beyond, and damned be the pound and inflation.

The main benefit of the rate cuts however will be to further 'steepen' the yield curve (increasing the difference between short-term and long-term interest rates), allowing those banks in the strongest relative positions (think HSBC, JP Morgan Chase, Lloyds TSB etc..) to slowly increase margins, and to begin rebuilding capital. The weaker financial institutions meanwhile will either fail, be nationalised or be snapped up at firesale prices.

The authorities on both sides of the Atlantic are terrified of recession, but it's exactly what both countries need to reassert equilibrium. The UK's current account deficit is now larger (as a % of GDP) than America's, which is the only statistic you need to be highly sceptical of Messrs. Brown or Darling's assertions that the economy is in good shape, or at least immune from the current financial shenanigans. The days of 'spend today, save tomorrow' are over; for the timebeing, cash is king and the piper finally needs to be paid.

When global interest rates were cut after 2000 (see above), it was occurring alongside deflationary pressures emanating from China, India and other emerging markets, aided by the fixed currency pegs that many of them still adopt. Thus the authorities in the West were seemingly able to produce the so-called 'Goldilocks' scenario of solid growth and controlled inflation ('not too hot, not too cold').

By extrapolating this pleasant but unrealistic scenario forward, many of the stupid assumptions that inflated this bubble were built, as if our new friends in Asia wouldn't one day demand the same living standards that we now take for granted.

Unfortunately for us, those same nations have now created a degree of self-sufficient growth, from which their demand for commodities is seemingly insatiable, whilst their supply is inherently constrained (think the 'peak oil thesis' for example). Thus unlike after the tech bubble, the central banks in the developed world now seemingly face a choice between either 'stagflation' (rising inflation and unemployment), or 'deflation', a catastrophic debt-fuelled bust, similar to that experienced by Japan in the 1990s.

Neither prospect is particularly edifying, but for now they seem to have opted for the former as the lesser of two evils. I trust you've buried gold in the garden.