Credit Contraction Continues

Data released by the RBA today showed that credit conditions continue to tighten in Australia. Private sector credit contracted in December by -0.3%, that is the first month on month contraction in private sector credit since Dec 1992. Year over year private sector credit rose 6.7%, the lowest year over year rise since April 1994.

The RBA attributed most of the contraction to a decline in business credit. That does not bode well for the Australian economy in 2009. My opinion continues to be that the Australian economy probably fell into recession sometime in Q4 of 2008 and we are only just getting warmed up.

Whilst the Rudd government makes forlorn attempts to prop up an over-leveraged household sector and the RBA talks up the prospects of the Australian economy with rose-coloured glasses on, the economy continues to deteriorate.

Serious changes are afoot with respect to the availability of credit and the willingness to lend. Businesses that have traditionally relied on foreign sources of credit will find it tough to roll when it becomes due. The idea that Australia will somehow avoid this fate is wishful thinking yet there seems to be a fair dose of denial still going around.

Expect the RBA to cut the cash rate to historical lows in 2009 as the spectre of deflation and a contracting economy become the focus of attention.

US Home Prices Continue to Fall in November

US Home Prices continued to fall through November 2008 according to the latest Case- Shiller Home Price index report. The 10 city index is now down -26.6% from its peak whilst the 20 city index is down -25.1%.

There are moves afoot to try and put a floor under US housing the whinging about putting a floor under housing prices but since they have only reverted back to early 2004 levelsis it really needed? Don;t they just need to market to adjust itself? From the report:

“The freefall in residential real estate continued through November 2008,” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s. “Since August 2006, the 10-City and 20-City Composites have declined every month – a total of 28 consecutive months. Every region was down in excess of 1% for the November/October period, with eight of the regions recording record monthly declines. Phoenix and Las Vegas were the worst performers for the month at -3.4% and -3.3%,respectively, and also have the lowest returns over the one-year period, returning -32.9% and -31.6% respectively. Overall, more than half of the metro areas had record annual declines.”

Prices will continue to come down and that will persist through most of 2008 despite what the US government does. Some of the worst affected areas could possibly see price declines of -50% or more before the worst is over.

Bye Bye Babcock & Brown Shareholders

With Babcock and Brown's announcement Friday morning, shareholders have effectively been wiped out. Here is the money quote from the announcement:

Consistent with the announcement on 7 January 2009 regarding the Company’s negative net asset position at 31 December 2008, the Board believes that in the current market environment and based on continuing discussions with the banking syndicate there will be no value for equity holders under the revised business plan and balance sheet restructure of Babcock & Brown International Pty Ltd and negligible or no value for holders of the Company’s subordinated notes.

So that's it for BNB shareholders, thanks for coming. BNB was the poster child for the leverage your way to prosperity model that has all but vanished. This was a smoke and mirrors operation that thrived on the near limitless access to cheap credit and the false assumption that asset prices always go up.

Macquarie Bank has actually been doing the same thing for longer, however they have a much stronger capital postion, lower leverage and a better ability to service their debt obligations through a more diversified revenue base. However it is difficult to see how a bank like MQG will prosper unless they radically alter the way they do business. goign forward.

Recoupling Continues

One of the themes I outlined for 2009 was "China will NOT save us", here is what I wrote then:

The myth that Australia is somehow insulated from the global recession because it digs up rocks and sends them to the fast growing Chinese economy will be completely shattered if it hasn't been already. Economists are forecasting the Chinese economy to slow to a growth rate of around 7 - 8% in 2009, I find that far too optimistic giving the growing signs of a sharp slowdown in the Chinese economy.

The myth of decoupling has been replaced by the reality of recoupling. The Chinese manufacturing sector has contracted for five straight months, not a good sign for an economy that relies on manufacturing for more than 40% of its output.

How will a Chinese economy growing at 2 - 4% affect commodity prices and the Australian economy? That is the question that investors should be asking rather than clinging to the hope that China will plow through at an 8% run rate in the face of a global recession.

Indeed forecasts of 7 - 8% growth in the Chinese economy for 2009 seem farfetched given the latest GDP data on the Chinese economy today, From Bloomberg:

China’s Economy Grows 6.8%, Slowest Pace in 7 Years

China’s economy expanded at the slowest pace in seven years as the global recession dragged down exports, increasing pressure for more government spending and lower interest rates to buoy growth.

Gross domestic product grew 6.8 percent in the fourth quarter from a year earlier, after a 9 percent gain in the previous three months, the statistics bureau said in Beijing today. The figure matched the median estimate of 12 economists surveyed by Bloomberg News.

Plummeting Chinese demand for parts and materials for exports is reverberating across Asia and the Pacific, driving Taiwan, South Korea and Australia closer to recessions and worsening Japan’s slump. Premier Wen Jiabao said this week that the government must work urgently this quarter to reverse the slowdown and maintain social stability amid a “very grim” outlook for jobs.

“It’s an astonishingly steep slowdown,” said Paul Cavey, an economist with Macquarie Securities in Hong Kong. “We haven’t yet seen all of the pain.”

Click on the link for the full story. No doubt there is more pain to come. Economists will be ratcheting down their forecasts for Chinese growth and by implication their growth rate targets for the Australian economy.

It is widely acknowledged that Australia went into this economic downturn in better shape that most countries but does that necessarily mean it will whether the storm better given it's leverage to the Chinese economy? These are the questions investors need to ask rather than relying on the hope that things will turn out just fine.

Can You Say Deflation?

As repeated ad nauseum here, I believe as 2008 finished with a hint of deflation so that theme will continue in 2009. The latest TD Securities Melbourne Institute Monthly Inflation guage for December showed inflation fell -0.2% in December after falling -0.6% in November. Inflation is now up 2.2% from 1 year ago.

That is more than 1 year in advance of when the RBA had forecast inflation to come down to such levels. No doubt the RBA will be entertaining more rate cuts at their meeting in February. Presently futures are forecasting a 90% chance of a 100 bps rate cut at the February 4th meeting. That may be a bit too much, but you can expect at least another50 bps cut.

An Unprecented Age of Financial Idiocy

Seriously, could you possibly get a more incompetent gaggle of fools running major US financial corporations? The denial, obfuscation and outright lies that have continually been offered up in defense of continuing losses and write-offs have reached comical proportions.

Anyone with a clue, knew that Bank of America clearly paid too much for Countrywide and Merril Lynch. Countrywide was a disaster teetering on the brink of bankruptcy when B of A bought it. However Merril is an even more monumental blunder, given the terms of the government rescue announced today. We now know that Merril was not worth even a tenth of the $29 per share price tag B of A paid.

Much has been said about Ken Lewis, the CEO of B of A as being one of the best CEO's on Wall Street, that doesn't say much for the rest of them. Lewis' blunders in the last 12 months demonstrate that he is at best completely and utterly incompetent.

Whilst Vikram Pandit is not responsible the postion that Citigroup now finds itself. The fact that he has continually defended Citi's financial supermarket model only to turn around and start splitting up the company because it is insolvent proves that he had no idea what he was doing.

So now today the stockmarket is celebrating because the US government has made the biggest US bank a ward of the state alongside Citigroup. It makes you wonder who is stupider, the CEO's on Wall Street or stock market traders. This article siums up the sorry state of the situation, from marketwatch.com:

Government giving $20 billion to Bank of America
Guaranteeing losses on over $400 billion worth of Citi, Bank of America assets

The U.S. government on Friday announced it was injecting $20 billion into Bank of America and guaranteeing losses on over $400 billion of assets both from Citigroup and the Charlotte, N.C. lender.

In a statement released Friday, the Treasury Department and the Federal Deposit Insurance Corporation said they will invest $20 billion in Bank of America (BAC) from the Troubled Assets Relief Program in exchange for preferred stock paying an 8% dividend.

The government also will provide Bank of America protection against the possibility of unusually large losses on an asset pool of approximately $118 billion of loans, securities backed by residential and commercial real estate loans and other such assets, which have been marked to current value.

Bank of America will absorb the first $10 billion of losses while the government will share losses from there, up to $10 billion. If that pool of assets sees losses of over $20 billion, then the government will absorb hits on 90% of them.

A similar guarantee was provided to Citigroup: Uncle Sam is on the hook for $301 billion of assets, with Citi (C) taking the first $39.5 billion of hits, and then the government absorbing 90% of the rest.

The Federal Reserve also is ready to backstop "residual risk in the asset pool" if necessary.

The government relief comes as Bank of America stock skidded to a 17-year low, following Thursday's report in The Wall Street Journal that such a relief program was near. Investors were unnerved by the additional losses at Merrill Lynch.

Both Bank of America and Citigroup (C) detailed billions of dollars during the fourth quarter, and that doesn't even include the estimated $15 billion of losses from Merrill Lynch.

Indigestion problems for Bank of America

I expended a lot of time criticizing B of A for their acquisition of Countrywide almost 16 months ago. In fact I have been critical of every one of these major takeovers such as JP Morgan's purchase of Bear Stearns and Washington Mutual.

The problem with these acquisitions is not that there are not some valuable assets up for grabs, it is that they simply paid too much for them. Every quarter, we learn that the value of assets on the major banks balance sheets are not what they were worth just one quarter ago.

Thus whatever the acquiring banks thought was fair value to pay for these assets turned out not to be. So is it any wonder that B of A is now balking at the Merril acquisition? From Bloomberg:

Bank of America May Receive U.S. Aid for Merrill Lynch Purchase
Bank of America Corp., the biggest U.S. bank by assets, may get more aid from the government to help absorb losses tied to this month’s acquisition of Merrill Lynch & Co., three people familiar with the matter said.

Details are likely to be disclosed on Jan. 20, the people said. That’s when Bank of America may post its first quarterly loss in 17 years as it digests the purchases of Merrill Lynch and Countrywide Financial Corp. The combined company has already received $25 billion from the U.S.

Bank of America, based in Charlotte, North Carolina, told regulators in December the takeover might be abandoned because of Merrill’s worse-than-expected results, said the people, who declined to be identified because the talks are private. The government insisted the transaction go forward because its collapse would create new turmoil in the financial system, they said.

“Bank of America has all kinds of problems with its acquisitions,” said Gary Townsend, president of Hill-Townsend Capital LLC in Chevy Chase, Maryland. “They’ve been so acquisitive, they find themselves with very little in tangible equity.”

The part in bold is the point here, the major banks are woefully under capitalized and as I have been saying for some time, the equity injections are not enough, they are just absorbing the losses, they are not being restored to financial health.

Again lets be clear, the major US financial institutions are insolvent, the only thing preventing their equity from going to zero is that the US government is standing behind them.

However according to Chris Whalen, who has been spot on with respect to the problems at the major US banks, the US government's presence may not be enough to stop the equity of firms like Citibank, B of A and JP Morgan from going to zero. Click on the image below to hear Whalen's latest thoughts.


JPMorgan Chase Earnings