bizzXceleration: Performance, Value and Profit: A Smidge of Prescience, a Tun of Hurt: Finance Industry Issues Review

Well we'll savor just a small smidgeon of feeling prescient today. Not only are the markets being led down by the Finance sector but one of Bloomberg's lead-off articles (picked up and reinforced as a must-read by BigPicture) was on the re-emergence of the credit squeeze. This morning's other major economic news was Existing Home Sales, which when you take it apart was about as bad as it could be. The headline, as usual for the MSM when dealing with such profound subtleties as recurring seasonal patterns visible for decades, was far off base: Existing Home Sales Top Estimates But Prices Plunge.The real goto is of course CalculatedRisk July Existing Home Sales: Record Inventory . There'll you find that the news was about as bad as it could be with a significant rise in months of sales inventory, a severe price decline, a dominance of foreclosure and short sales and a severe YoY drop in sales. You may recall our post on the crisis coming to head with Fannie and Freddie, perhaps this week which concluded with a promise/threat to take a deep dive review of the structural problems facing the Credit Markets and the Finance Industry and the chart above. What that charts shows in looking at the inflation-adjusted monetary base is that as THE result of the credit crisis liquidity is fast disappearing. While conversely the spread between 10Yr Treasures and Fed Funds, which normally shrinks during a downturn along with a drop in the Monetary Base in a previously predictable pattern, has jumped significantly. A kind of reverse conundrum where instead of long-term rates staying low when they shouldn't as the result of worldwide liquidity excesses they're increasing as those excesses are being drained from the system.

After the break we pull together several prior analysis of the various structural aspects of the crisis so you can see them all in one place and get a better handle on how they all play out together. But we want to start you with a selection of the weekend's headlines, to which you need to pay some careful attention.

Libor Signals Credit Seizing Up as Banks Balk at Lending in Money Markets Most of the bond strategists and salesmen that Resolution Investment Management Ltd.'s Stuart Thomson talked to last August expected the credit crunch to be long over by now. Instead, money markets show there's no end in sight, and it may even worsen. ``It's like an ongoing nightmare and no one is sure when we're going to wake up,'' said Thomson, a money manager in Glasgow at Resolution, which oversees $46 billion in bonds. ``Things are going to get worse before they get better.'' In a replay of the last four months of 2007, interest-rate derivatives imply that banks are becoming more hesitant to lend on speculation credit losses will increase as the global economic slowdown deepens.

Freddie, Fannie Failure Could Be World `Catastrophe,' Yu Says A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China's central bank. ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. ``If it is not the end of the world, it is the end of the current international financial system.''

View of economy somber from Fed mountain retreat

"This turmoil is not going to go away quickly and will require serious efforts to overcome it," John Lipsky IMF
"The financial storm that reached gale force some weeks before our last meeting here in Jackson Hole has not yet subsided, and its effects on the broader economy are becoming apparent," Bernanke
"That's where we are today, in the middle of a financial crisis, with the economy sliding into recession, with monetary policy at maximum easing, and fiscal transfers impotent," Martin Feldstein, Harvard, NBER"More than a year into the most challenging financial crisis of our times we now face a complex and interlocking combination of rising inflation, declining growth, tightening credit conditions, and widespread liquidity tensions," Mario Draghi , ECB, Bank of Italy

A Shallow Recession -- Then a Shallow Recovery Is there a sign of a bottom in financials?The leverage in the financial-service industry is going to be wound down a lot, and I don't think the return on equity for these companies is going to be as great as it has been in the past. So the earnings for these companies in the next up-cycle aren't going to be as good. Maybe the financials have gone down as far as they are going to go down, but I don't think they are going up with any verve. And it sounds as if you see the business model changing for these firms, and becoming less profitable in the post-credit-crunch world.When I came into this business in the mid-1960s, what a doctor made or what I made as a securities analyst or what a lawyer made working at a big firm was all the same. Five years out, our compensation had increased -- pretty much in parallel. But in the period from 1982 to 1999, the compensation in financial services expanded much more rapidly than it did in any other field. I don't know that a securities analyst is a whole lot smarter than a lawyer at a major law firm, and I don't see why securities analysts or investment bankers should be paid so much more. So I think there's going to be a convergence of compensation.

They start with the aforementioned Bloomberg story about the resurgence of tough credit market conditions. Followed by what should be the scariest of them all - a quasi-official warning from a Chinese economist that the Chinese government is counting on being made whole in any FNM/FRE rescue. In other words the credit worthiness of the US government is on tender here - the alternative being a credit implosion that would make the BSC collapse a Su. walk in the park. Then of course the sages and gurus have issued their findings from the mountaintop and see nothing but continued trouble ahead. And finally an excerpt from a Barron's interview with Byron Wien in which he tells us the adjustment process of drying out the liquidity excesses will go on for years and that the Finance Industry as we knew it will disappear for ever.

After the break we walk thru the spreading credit contagion (the Rocks in the Pond or RiP Model), the linkages between credit and economic conditions, the bad feedback between the credit contagion and the economy and the implosion of Finance Industry business models. Needless to say we're making three key points.

1. This isn't over by a long shot.

2. There is a developing vicious feedback loop between credit problems and the economy which is likely to get worse before it gets better.

3. The Finance Industry as we've known it for almost 25 years is about to go thru an enormous re-structuring.

Rocks in the Pond

Let's start with our infamous "Rocks in the Pond" conceptual model which shows how failure in one market and asset class ripples up a chain of synthetic debt instruments to destroy value. At least in one dimension. And ripples across other credit markets as the whole mechanism is brought into question, even when the markets being impacted are not apparently directly related. Oddly enough this appears to be exactly what's happening and, as sadly anticipated, one asset group after another is rocking then toppling until we reach our current state of continuous chaos. (Cramer's Anniversary: Continuing Credit Metastasis and Economic Outlook)

Vicious Cycles: Credit Breakdown and Economic Feedbacks

When you put this back in the context of Finance Industry business operations and models you get a situation where all the players are exposed to further writedowns and loan losses. In fact "ALL" we've seen so far is the consequences of, say, the first few rows of the RiP model where a small subset of real estate related loans and instruments have gone bad and taken the associated synthetic debt with them. In other words as the economy worsens what you're going to see is increased losses in real estate, business and commercial loans and consumer loans. Which lead back to further credit tightening which engenders further economic weakness and so on and so on. The systems theorists call that a feedback loop, or after they've been drinking a vicious cycle.

Vicious Cycle II: Multiple Feedbacks and the Death Spiral Effect

The thing that everybody is missing - well one of the things actually - is that ALL we've seen so far is the breakdown internal to the credit and finance markets and the Finance Industry as the liquidities are dried up. That loop has yet to run it's course. But there are two that are just beginning. The first is the credit market - economy feedback which'll work thru the mechanisms outlined above. The next is the feedback connections normal to a business cycle where weakening consumer demand leads to a drop in business spending. (News Alert: Vicious Credit, Economy, Market Cycle Spotted) And in this case where globally spreading recession takes away the prop of exports from the US. The Credit Loop is in the danger zone while the other two loops are in the Warning (Yellow) Zone but are more than likely headed for the Red Zone as well. Hence our earlier warnings that the economy is beginning to cross the "Tipping Points" of a "normal" cyclic downturn. (Tipping Points, Blindsides, Ouches: Tough Times Getting Tougher,LT Business Cycle De-construction: Time to Pay the Piper)

Finance Industry Performance: Broken Business Models

Since 1980 the Finance Industry has taken an increasing share of US corporate profits and, as Wien points out, has done so on no clear fundamental or sustainable long-term basis. What drove that performance - which jumped post the bursting of the Tech Bubble - was leverage. When you look at the major lines of business of the industry as a whole what you see is that a primary difference between traditional banking or finance was the amount of leverage. In basic banking where deposits are re-loaned the leverage was 10:1, 10X. In Investment Banking the other major revenue source was basically advice and technical expertise. After the dust settles and the blood is sponged up we'll see a return to basics. But that's a long way away. The business models where leverage was driven to 30:1 or, using synthetic instruments, 70:1, are not only going away to never return. But the process is far from even started nor is the damage begun to be offset. In the near-term we can expect Lehman to disappear as an independent entity and Fannie & Freddie to be first Federally funded and then re-built (we sincerely hope). But that'll just be the beginnings of consolidations and buyouts, business models changes and a general de-leveraging and risk re-pricing. The Industry archives have extensive surveys, collections and analysis of all this and it's worth your while to at least just skim them over. But we'll particularly draw your attention to a couple of key postings. (Riding the Storm - NOT: Breakdowns, Culture & Malfeasance in Finance,Markets and Financials:4 Year Crunch, Broken BizzMods, Red Sky Mornings, Investor Take Warning: More Finance Industry, Bad Times, Bad Companies: More Finance Industry)