Global financial crisis:

Whilst Obama was huge, the biggest story of 2008 was undoubtedly the global financial crisis. US equities have halved from $US20 billion to $US10 billion and the Australian market was down 50% at the peak and ended up losing 41% for the calendar year. Wall Street has just had its worst year since the Great Depression. Never before have we seen wealth destruction on a scale like this.

How it started:

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Excessive, reckless and sometimes fraudulent sub-prime lending to millions of Americans was the trigger for the crisis. Sub-prime lending soared during the credit bubble and peaked at more than $US1.3 trillion in March 2007 with about 7.5 million loans outstanding. These were packaged up and sold all over the world, triggering the first truly global financial crisis when the US housing market declined and delinquincies soared.

Whilst the demise of Bear Stearns on March 17 was a portent of things to come, the commodities bubble continued. It wasn’t until July that the oil price peaked at $US147 billion a barrel and then we all sat back and marvelled at the arrival of China during the Beijing Olympics from August 8-24.

The Russian-Georgian war broke out during the Olympics and many observers now believe the slowdown in Chinese production caused by the Olympics was another contributor to the commodity bubble bursting.

After bailing out the likes of Bear Stearns, the sub-prime losses kept coming to the point where Lehman Brothers was allowed to collapse on September 14, the same time that Bank of America bailed out Merrill Lynch. Two days later the US government lent $US85 billion to insurance giant AIG and took an 80% stake as a tsunami exploded around the world because no institution could be trusted any more.

Geared to the eye-balls and gone:

In just one year we’ve seen long established institutions wiped out in the blink of an eye. Gearing was the biggest problem and you shouldn’t forget that Bear Sterns was leveraging its capital 60 times and Lehman Brothers 30 times.

The Lehman CEO Richard Fuld copped a grilling in front of a Congress committee but is still worth hundreds of millions whilst pondering why everyone else except his firm was bailed out. It’s a question which has never been properly answered.

The biggest insurer has gone in AIG, along with $US150 billion of American taxpayer money. Whilst the 9 biggest American banks were forced to take a government injection at the same time, the biggest American bank Citigroup got a subsequent and additional injection of more than $US20 billion, plus Uncle Sam agreed to stand behind $US300 billion in troubled Citi assets. Wow.

Even the biggest American company, General Electric, has been mortally wounded by its finance arm. After paying $500 million for Wizard in Australia it is now exiting with little more than $50 million from Aussie Home Loans and its 33% shareholder, The Commonwealth Bank.

Properly pricing risk:

There were many causes of this financial calamity but the slack lending standards around sub-prime mortgages was only one of them. Loose monetary policy to support the 2003 Iraq invasion triggered an unprecedented credit bubble that saw US junk bonds being priced at a skinny 2% over government bonds. These days it is 15%-plus as the market classically overshoots.

Other causes included the lack of transparency around credit-default swaps, blind faith in rating agencies and confidence in any product touted by Wall Street investment banks. Even Australian councils and charities put up about $2 billion through Grange Securities which was then bought by Lehman Brothers.

There have been several sovereign victims as well. Iceland attracted plenty of attention after it defaulted and nationalised its failed banks, but numerous other countries like Ukraine and Indonesia have also gone cap in hand to the IMF or the World Bank. Others, such as South Korea, have boosted liquidity with the help of a swap facility from the US Federal Reserve, which is printing record amounts of money.

Charlie Aitken’s prediction on NSW nationalisation:

It was interesting to see Charlie Aitken from Southern Cross Equities make the following 20 predictions in the final Eureka Report of the year:

  1. The state of New South Wales will be “nationalised”.
  2. Wayne Swan will be replaced by Lindsay Tanner as federal Treasurer after delivering a “surprise” budget deficit of $10 billion.
  3. Sol Trujillo will leave Telstra and Telstra will be awarded the national broadband network contract.
  4. Australian chief executives will realise Business Class actually isn’t that much worse than First Class.
  5. The Reserve Bank will cut cash rates to 3.75% in February and that will be the end of the cutting cycle.
  6. Gold will peak at $1100 an ounce (from about $845 at Christmas) then fall to $500 in the second half of the year.
  7. There will be an auction of Babcock & Brown memorabilia.
  8. CSL will announce IVIG is a cure for Alzheimer’s Disease.
  9. The new Rio Tinto chief executive will announce a £10 billion rights issue in the first half.
  10. A residential housing construction cycle will commence in Australia.
  11. A lone real estate agent will acknowledge there has actually been a correction at the high end of the Australian residential property market.
  12. That same real estate agent will be mysteriously taken by a shark in the first fatal shark attack on a Sydney beach in 40 years.
  13. Gerry Harvey will stop whining.
  14. The shorting ban on Australian financials will be extended indefinitely.
  15. Those still left at Macquarie Bank will cheer.
  16. Don Argus will anoint former Ford chief Jac Nasser as BHP chairman.
  17. The Australian financial press will write a positive story.
  18. Your children will start asking you, ‘Daddy, what was private equity’?
  19. Followed by, ‘Daddy what was 2 and 20′? And, wait for it…
  20. The benchmark ASX 200 will close the year up 20% at 4300, led by financials!

Whilst Charlie is jesting with much of these, I agree with his prediction about NSW. With the states attempting to borrow more than $20 billion in 2008-09, the Feds will definitely have to explicitly guarantee future state government borrowing or at the very least start buying up their paper.

And with the NSW economy already in the worst shape of any state, the time will surely come for some serious efficiency drives in the bloated public sector because revenue measures are difficult when you already run the highest taxing state in the country.

The global recession:

Most of the world’s major economies are now in recession and even China’s growth has slowed to about 7%. Who says China can’t go negative like the rest of the world? We’ve already seen demand for Australian commodities crash through the floor since the Olympics.

All asset classes falling simultaneously has led to extraordinary pump-priming with Keynesian economics back in favour. However, even the $US700 billion TARP plus talk of another $US700 billion stimulus package from President-elect Barack Obama and interest rates at 0.25% hasn’t done the trick yet.

We’re still going through the world’s biggest margin call and the world’s biggest debt for equity swap, but as long as the crisis doesn’t trigger too much geo-political conflict, the productivity gains from technological innovation should see the world economy pick up steam over time once confidence in the financial system is rebuilt.

How Australia is weathering the storm:

Australia is suffering just like everyone else, especially because we are highly dependent on foreign capital and have been hit extremely hard by the bursting of the resources bubble.

Who would have thought oil would crash from $US147.27 on July 11 to just $US33, although the latest war in Gaza temporarily pushed it back above $US40 a barrel.

Indeed, some of key commodity exports have been hammered as follows:

  • Nickel: $US33,400 a tonne in March to just $US9625, a drop of 71%
  • Copper: $US8730 a tonne in April to just $US2845, a drop of 67.4%
  • Who can forget BHP announcing price increases of up to 240% for its Queensland coking coal just last April.
  • And how about this June 23 announcement from Rio Tinto revealing Baosteel had agreed to a near doubling of prices for Pilbara lump iron-ore.

These will surely be largely reversed by the time the next contracts kick in come April and May 2009.

Currencies are the ultimate measure of national strength and ours has crashed from more than US98c on July 16 to a low of almost US60c on October 28.

However, unemployment is still officially only 4.4% and official interest rates have been slashed from 7.25% to 4.25% since March, saving households about $30 billion on the $1 trillion of mortgage debt they carry. With the Aussie dollar back up near to US70c, the Reserve Bank does have the capacity to further cut official interest rates if things get really bad in 2009.

But the biggest risk of all remains a significant increase in unemployment leading to huge bad debt write-offs in the banking sector, which traditionally is the last to cut dividends during the economic cycle.

I reckon industrial and resource stocks have largely bottomed but there’s a chance banks could shed 20-30% from here courtesy of annual bad debt write-offs leaping from $3 billion in 2005-06 to more than $20 billion in the year to September 30, 2009.

Coming changes to global financial regulation:

The days of cowboy capitalism are long gone and we’re already seeing the largely un-regulated hedge fund industry get smashed. If the shadow banking system disappeared with Bear Stearns and Lehman Brothers, don’t expect the completely un-regulated credit default swap market to survive in any form other than as a licensed, transparent, capital-backed and over-the-counter exchange-traded system.

With governments around the world bailing out or guaranteeing their banking systems, the banking masters of the universe will no longer enjoy a free lunch courtesy of the rest of us. Financial services companies peaked at about 43% of the Australian equities market and about 30% globally. With more than $US1 trillion already written off, expect it to settle back at about 15% as banking returns to being a utility that services the rest of the economy.

Never again will someone like Hank Paulson, who made $US500 million as CEO of Goldman Sachs, finish up running the US Treasury and advocating no rules capitalism and the mantra of enlightened self-interest.

The final nail in that particular coffin has come from none other than former NASDAQ chairman Bernie Madoff, whose extraordinary $75 billion Ponzi scheme has caused financial devastation, especially in New York.

What the GFC means for global politics:

Remember Georgia. Russia, with $US500 billion-plus in foreign reserves, was going to make the Georgians pay for their Olympic incursion into South Ossetia. Now, with oil crashing 70% from the peak, Russia has been one of the biggest victims of the GFC.

Still the Georgian war was quite dramatic as The Irish Times explains:

Georgia foolishly started it by bombarding the South Ossetian “capital” Tskhinvali with BM-21 multiple rocket launchers during the night of August 7th-8th, and sending Georgian ground troops into the breakaway enclave they had lost in the early 1990s. Backed by the Russians, the South Ossetians had provoked the attack by shelling Georgian villages, but Saakashvili fell into their trap.

Within three days, the Georgian army was routed by far superior Russian forces. Under the watchful eye of Russian officers, the South Ossetian, Cossack and Chechen militiamen of the “North Caucasus Volunteers” continued to “ethnically cleanse” Georgian villages in South Ossetia through the second week of August.

However, whilst the US and European military support for Georgia looked weak, foreign capital fled Russia and then Vladimir Putin’s failure to devalue the rouble saw more than $US200 billion of reserves spent propping up the currency.

All this talk of Russian expansionism looks dead as nations increasingly rely on foreign capital to prosper and punchy Putin is not attractive to anyone. Rupert Murdoch summed it up best on the conference call for his June quarter earnings when he said this two days before the Georgian war errupted:

“The more I read about investments in Russia, the less I like the feel of it. The more successful we’d be, the more vulnerable we’d be to have it stolen from us.”

If Rupert won’t deal, you must be really bad and the Russians have taken quite hit this year.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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