The Fragility of the Financial System

Is the stock market crazy with its recent belly flops? In the past 5 weeks, it's dropped over 15%, with the Dow adding another 519 points today (over 4%). We're getting close to a bona fide bear market. While the trading may look like panic selling, maybe it's not. Over half the market is computerized trading. The firms that do this stuff leave it to the algorithms and machines. Many of the non-computerized sellers are institutional investors--mutual funds, pension funds, hedge funds, and so on. The money managers of these institutions presumably have the professional experience to stay focused even when under stress. Are they right to jump ship so quickly?

The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.

Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.

Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.

Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.

To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.

Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.

Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.

So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.