Are we there yet?

Where to from here? Dead cat bounce or market bottom? Both the torment and the titillation of financial markets is that no one, not a soul, actually knows. But let's have a stab at it anyway as this, as always, is the big question.It should be said that at some point the market will once again rise above its previous peak, in our case scaled early last November. The vital question is when. It could be some time.
There are broadly five opinions: two optimistic, two pessimistic and one apocalyptic. After years of getting it right with a ''buy the dip'' approach, the optimists have taken a battering of late.

The bulls tend to get it right more often than the bears do as equity markets go up more often than they go down over time.
The first and most optimistic market opinion sees last week's - in fact every week's - bounce as the bottom of the market. It's time to buy, say the bulls, the Fed's salvage operation - hammering the cash rate lower and forking out treasuries to prop up ailing Wall Street banks - has worked. Bear Stearns marked the nadir. Commodity prices will hold. There will be no world recession and a modest recession in the US at worst, which is already factored in to ailing share prices. In any case, China and India will continue to ``decouple'' from the US, they say. Indeed, on a price and a yield basis the equity markets do look cheap.
The second optimistic view, though more realistic than the first, is that we are near enough to the market bottom. Things may take a few months to recover. Volatility will persist as confidence is restored. Still, the worst is over, it's time to buy.
Now to the bears.
The little bears reckon recession in the US and here will reduce consumer activity. Lower demand from consumers means lower company profits. Expectations of future profit determine share prices, hence share prices will continue to slump. The market is 10% to 20% from bottom and we are in for six months to 18 months of bear-market gloom.
Then we have the big bears who, not without reason, see more similarities with 1987, 1974 or 1929 and their aftermath than the blip or bubble of 2001. According to the big bears, there is 20% or more to come and a bear market which will endure for two years to four years or more. Some technical analysts, Elliot Wave adherents for example, are crying that a long-term slump is inevitable. The Armaggedonists are worth a mention too for their doomsday scenarios have been getting more airplay of late, particularly on the internet. For these seers, it's all over for capitalism. Grow your own vegies, buy the home-brew kit and run a few chooks.
Though keen to be proved wrong, this writer has for some time been a swinging bear, moving variously between the little and the big bears' camps. Liquidity has gone from credit markets, the banks are yet to grind through their bad-debt cycle. Inflation is yet to be slain in the US and Europe, or China for that matter. And while the Australian banking system and the consumer are in far better order than their US counterparts, thanks to superior regulation and a more aware and risk-averse culture, consumer debt is at record levels. Any drop in employment, also at record levels will hit company revenues.Company earnings are already being downgraded. The next trend will be asset prices. Company executives and their auditors have been fairly generous in their appraisal of value as the bullmarket soared on for years. Apart from the Allcos, Centros, MFSs, Challengers, Ascianos and Babcock and Macquarie satellites, corporate balance sheets may be in fair shape, but their shape is somewhat skewed by the glowing asset valuations that have helped fuel market prices and helped companies strap on more debt.
The takeover binge has left oceans of goodwill lazing around balance sheets, which at some point will have to be dealt with. One example of a solid financial in this shape is Suncorp, whose $8 billion acquisition of Promina has left $7 billion of goodwill on the balance sheet. The overpaying, the downturn in premium and investment income and the exodus of Promina executives mean the jury is well out on this deal. What of the $7 billion? The rub with the bullish view of the market is that it ignores too much. The US is only just tipping into recession now. It's bad. The rash of loan defaults and foreclosures, and the aftermath is yet to come.
Not only could you buy a house and a car with not a cent upfront, interest-free credit cards were de riguer. There was about $US600 billion in home equity withdrawalls alone last year; that makes a $US200 billion stimulus package look small. Now asset prices are crashing but the banks passed on much of their risk, via CDOs and assorted fancy securitisations to markets.Rather than cop writedowns on this hybrid rubbish, the banks have simply parked it off-balance sheet in SIVs (special investment vehicles) and the like, with the regulators and ratings agencies blithely ignoring it. In its defence, the US government has more critical issues to attend to, such as bailing out Bear Stearns to preclude the drastic knock-on effect of a wave of hedge fund assets freezing up and triggering a 20% drop in the Dow.Still, the financials in the US and elsewhere have a long way to sort out their problems and with credit markets iced over the pain is yet to transpose to the real economy. Globalisation means everything is connected to the US, the engine room of the global economy, including China. Inflation has run into double figures there and to contend that the boom in commodity prices will proceed apace is optimistic in the least. Against this backdrop there are myriad catastrophes that may well befall markets, such as in derivatives - the largely unregulated, unreserved credit insurance market of credit default swaps, for instance. Merrrill Lynch has just sued XL Capital Assurance to force the bond insurer to honor $US3 billion of guarantees on CDOs in a bid to stave off more writedowns of its own. Just one case, just another $US3 billion.What the guarantee of leading bond insurers MBIA and Ambac is worth is anyone's guess. What a rating from S&P or Moody's is worth though doesn't take much guesswork - zilch is the figure. All this is just touching the surface. To call the bottom with any certitude now would be verging on the reckless. It is a fair dinkum disaster out there in finance-land, it's spilling over to the real US economy and the bump-on effect will spread like shockwaves through the world. Should China hold, Australia will be all right but it will hardly bounce back to bullmarket territory for a while. Should China begin to fold, the big bears will be growling ''told you so''.

Selfishness goes only so far, we also like a fair system

In the minds of many people - including many economists - capitalist economies are powered by selfishness. No, not quite.
The father of economics, Adam Smith, seemed to establish that proposition in 1776 in a famous quote from his book, The Wealth Of Nations: "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
But Smith's views are rather more complicated than that. In the book he wrote 17 years earlier, The Theory Of Moral Sentiments, he observed that "how selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it".
Pioneering research by an inter-disciplinary group of economists, anthropologists, biologists, psychologists and sociologists suggests that, in his earlier theorising, Smith was on to something.
Their experiments imply that people are not simply the selfish, materialistic creatures assumed by economic theory, but rather "conditional co-operators", who behave altruistically as long as others are doing so as well, and "altruistic punishers" who apply sanctions to those who behave unfairly according to the prevailing norms of co-operation.
So people aren't selfless saints, but they're far from being relentlessly selfish competitors. They have a predisposition to co-operate with others, and to punish (at personal cost, if necessary) those who violate the norms of co-operation, even when they're unlikely to recover those costs at a later date.
In the book Moral Sentiments And Material Interests, published by the MIT Press, this condition is called "strong reciprocity". The book is edited by three economists - Herbert Gintis, Samuel Bowles and Ernst Fehr - and an anthropologist, Robert Boyd. Their findings challenge two assumptions of the economists' standard model. First, that people care only about the outcome of economic transactions, not about the process by which the outcome is obtained.
Second, that people care only about what they personally gain or lose, not about what other people gain or lose.
In truth, people care about process as well as outcomes, and care about the deal others are getting - not just their own deal. In other words, they care deeply about what they perceive to be fair.

These conclusions have been drawn from many laboratory experiments, one of which is the "public goods game". The participants play the game over, say, 10 rounds, playing for money. They play in groups of four, but are anonymous to each other.
Each player is given, say, $20. A player divides the money between her private account and a common account. Any money contributed to the common account is increased by, say, 60 per cent, then distributed equally between the four players.
So if one player contributes her whole $20, this is increased to $32, with $8 going to each player. She has lost $12 ($20 - $8), but her three partners are better off by $24 ($8 x 3). She'll be ahead only if her partners also make generous contributions to the common account.
If people were as self-regarding as the economists' model assumes, each would try to "free-ride", contributing nothing themselves but hoping for a share of what the others kicked in.
But, of course, the others being just as self-regarding, none of them would contribute either, so that no one would gain from the benefit-multiplying power of the common account.
The condition of anonymity should make free-riding all the more likely. But repeated experiments of this kind show that groups exhibit a much higher rate of co-operation than the economists' model predicts. Players typically begin by contributing about half their money to the common account. But the proportion declines until, by the last round, most are contributing nothing.
This demonstrates the common finding that people co-operate until they realise others aren't bothering and are, as an Aussie would say, bludging on the system.
Asked after the game why co-operation declined, the players say they became angry with others who contributed less than themselves and retaliated against free-riding low contributors in the only way available to them, by lowering their own contributions.
However, when you give players the option of incurring a cost to themselves in order to punish free-riders, they use that option and it causes the rate of co-operation to stay high.
This happens even though, because the benefits of restored co-operation are shared equally between the players, individual punishers don't gain as much from their action as it costs them. Again, if people really were completely selfish, they wouldn't be prepared to punish others at a net loss to themselves.
In yet another version of the game, where players stayed in the same groups for successive rounds, punishment was more effective in maintaining co-operation than where players kept changing groups.

This suggests that strong reciprocity has a greater effect on co-operation when groups are more coherent and permanent.
You see from all this how concerned people are with their perceptions of what's fair or not fair. The standard economic model abstracts from all considerations of fairness ("equity") and this explains why its attempts to predict human behaviour can be astray.
Note, too, that what we see here is the tendency of people to enforce "pro-social norms" - generally accepted standards of behaviour that serve to advance the interests of the community as a whole.
Why have humans evolved in a way that makes them worry about the welfare of the group rather than just themselves and their close relations? Probably because groups with pro-social norms outcompete groups that are deficient in this respect.
It's not surprising that the great religions - Judaism, Christianity, Buddhism, Islam, Hinduism, and so forth - stress the pro-social norms such as helping your neighbour, giving each his due and turning the other cheek.
These research conclusions have implications for government policy. Economists, convinced of people's simple selfishness, usually propose to deal with antisocial behaviour by raising the material cost of that behaviour. Increase the penalty if you're caught and increase the chance of being caught.
But this research suggests a principal purpose of publicly proclaimed laws and regulations is to stigmatise anti-social behaviour and thereby influence people's values and codes of behaviour.
To put it more positively, the authors say that "effective policies are those that support socially valued outcomes not only by harnessing selfish motives to socially valued ends, but also by evoking, cultivating and empowering public-spirited motives".
Ross Gittins is the Herald's Economics Editor.

the grip of the Big Squeeze

Seasoned market watchers are gobsmacked, but they know there's a whole lot worse to come, write Danny John and Jacob Saulwick.

They have never seen anything like this. Bond traders with decades on the floor; bankers bruised by innumerable sharemarket tumbles; financiers hardened by the graft of years spent rustling up cash. All describe the scale of the present crisis as entirely new to their experience.
Take the head of Deutsche Bank's financial sponsors group, David Backler, who spends his days dipping into the debt market in the service of merger and acquisition deals. Backler is a 20-year veteran of the industry and remembers clearly the fall-out from the recession in the early 1990s and the crisis created by the Long Term Capital Management bail-out in 1998.
Asked if he has ever seen it this bad, Backler's reply is emphatic: "No."
Or Westpac's main numbers man, Group Treasurer Curt Zuber. To a conference on bond issues this week, Zuber could only lament that markets showed no signs of improvement.
"Perhaps the one good thing about this is that we'll all have grand 'war' stories to tell the grandkids about The Liquidity Crisis of 2007, 2008 and maybe beyond."
Then there is Mike Smith, ANZ's chief executive. A career banker who spent 30 years with HSBC before taking on the leadership of Australia's third largest bank last October, Smith recalled the words of Wells Fargo chief executive John Stumpf as he addressed the Australian British Chamber of Commerce yesterday: "It's interesting that the industry has invented new ways to lose money, when the old ways seemed to work just fine."
Ralph Norris, Smith's counterpart at the Commonwealth Bank, believes the cost of credit has risen because the market now has a whole new perception of risk.
"In fact, it's basically been a breakdown in trust," says Norris, whose bank is one of the most exposed to the highly publicised troubles of corporate Australia. "Regardless of how healthy your balance sheet might look, the world has changed. If there is a fundamental dislocation in the global credit markets, your business is likely to be impacted."
WHAT BEGAN with pockets of the American lower-middle classes not being able to pay their mortgages - better known as the subprime crisis - has escalated into a full-blown global liquidity crunch. Every day, the headlines get worse as yet another obscure part of the vast subterranean market for debt starts to implode.
This week it has been "municipal bonds" - bonds issued by state or local governments in the US that attract investors through their tax-exempt status, albeit they have low return. But even "muni" yields have blown out this week, implying that investors are not even willing to park money in government paper.

Sean Keane comes from the centre of the maelstrom. For more than 20 years the regional head of short-term interest rate trading for Credit Suisse, he has bought and sold the financial instruments that now have the world's attention.
"The extent to which the market has needed liquidity, and the speed at which credit has disappeared, is something I have never seen in any previous crisis," says Keane.
What has made the present crisis worse than any he has seen before is the scale of the markets for complex financial products that have now become paralysed.
"These markets have become so very large in the last five to 10 years," he says.
Until recently, this had been a great blessing. A vast array of new-fangled credit products allowed banks and other investors to spread the risk of borrowing and lending across a wide range of participants. The lower perceived risk had emboldened lenders, strengthened the hand of borrowers, and driven deal after deal after deal.
During the good times, all of this debt was spread far and wide to banks, hedge funds, superannuation funds - even local councils across NSW. This, says Keane, has been one of the great developments in markets that's allowed them to grow. "But what's happening now is that part of that model is being unwound very quickly," he says. Investors are no longer willing to buy the financial contraptions that have enabled the spread of risk. They want cash. And cash is now very scarce.
The implications of the turmoil in credit markets are simple, if scary. In the scramble for cash, firms are having pay a lot more to borrow money. But banks, facing the same pressures in sourcing funds, are now having to ration who gets what, with price the determining factor.
The stronger and more low risk the company is, the more likely the tap will remain turned on. But for some corporates, and even whole sectors such as property and financial engineering, the well has dried up.
Lucio Febo,the head of distribution for global markets at ABN Amro, says this has already happened. "I would say right now, some banks won't lend to some people, irrespective of the margin they can charge. There has been a tightening in credit standards. Banks are just saying - we're not lending to that sector or that group."
Locally, the new austerity has already claimed an impressive list of victims: the fates of Allco Finance, Centro Property, ABC Learning Centres and property group MFS are all, to some degree, in the hands of banks.

But the problem goes beyond a few overly confident operators.
Mortgage companies, for example, that relied on money markets for funding, have already cut back on lending. The once-mighty Macquarie Group, which has suffered a 50 per cent share-price fall since the credit crisis began last July, announced its goodbyes from that line of work on Wednesday.
And then there are likes of MFS and City Pacific, whose survival prospects in the world of property are looking more doubtful by the day as huge debts threaten to overwhelm them.
More broadly, questions are being asked about the business model of companies that depend on low interest rates and climbing asset values to support a flurry of deal-making - in short, the Macquarie model.
Most assumed that it would not come to this. Even as the subprime meltdown began to undermine the citadels of US banking, the global financial services industry was saying as recently as Christmas that this was an American phenomena and was almost ring-fenced. Normal service would soon resume. "Everyone was hoping that January 1, you'd come in, and things would be different. But here we are in March and things are as bad if not worse," says Febo. Initially, the major Australian banks thought they would largely escape the direct impact of the crisis and the subsequent flow-on effects through specialist debts sectors such as the mortgage securitisation market.
As borrowing costs began to soar and with no alternative sources of finance such as deposits to turn to, cheap mortgage providers such as RAMS lifted rates and then shut up shop, crushed by the weight of global loans that became too expensive to bear.
It was the first sign of a "flight to quality". Facing a sudden and severe drought of low-cost debt, companies began going cap in hand to their bank manager, who lapped up business previously lost to international markets.
At the same time, bank balance sheets got a timely injection from millions of ordinary depositors looking for the proverbial safe haven for their dollars. Nonetheless, Australia's bankers knew they were not immune from the growing ripple effect of the subprime problem.
As much as they are lenders of their customers' money, they too had become big borrowers from more mainstream international funding markets - a reflection of how much the world is a truly global financing hothouse.
The low interest rates that followed the 1997-98 Asian financial crisis and the 2000 "tech wreck" helped drive what became five years of powerful and seemingly unstoppable growth for the banks and their customers.

In the euphoria, Centro Properties, Allco Finance and ABC Learning, to name but a few, came up with ever more fanciful forms of financial engineering. It worked but it required ever more leverage. Debt, though, was easy to come by and even easier to sell to investors eager to join in the profitable binge.
Everyone did well: the banks with their high double-digit earnings, culminating in a combined profit of almost $18 billion for the top five alone last year; companies whose bottom lines knew no bottom; and shareholders, who pocketed ever-rising dividends, and capital gains to boot.
But debt came back with a bang last October after the subprime crisis became a wider liquidity issue. The US investment banks, which rose a boom writing loans to people who could not afford them, had their balance sheets turn to mush. Write-offs and losses have since hit an estimated $US400 billion ($430 billion) and everyone thinks more will come.
WHAT BEGAN as a loan crisis in the US has since closed debt markets, drying up the supply of money throughout the world. Spreads - the difference between official interest rates and those that markets and banks charge to lend among themselves - have blown out to astronomical levels.
Even the spread on the most secure forms of debts - senior bank loans which, if they went bad, would take the bank and possibly the whole financial system with them - has jumped five-fold.
Other forms of corporate leverage have risen to a level where lenders are charging 100 basis points - a full 1 per cent - above official cash rates set by central banks. Meanwhile, troubled companies looking to refinance their existing facilities face crippling rates of 500 to 600 basis points.
Last week, for example, ANZ dipped into one of the markets still open, the Japanese bond market, to raise the equivalent of $1.4 billion. For the privilege, it paid 95 basis points over the local Yen cash rate.
That was a hike of 18 points over what Westpac had coughed up in January but still 15 basis points cheaper than what Goldman Sachs was charged in the same week as ANZ. Traders said it was a sign that Japanese investors viewed Australian banks as more solid than their US counterparts.
But the insidious and all-pervading effects of the liquidity crisis has also started to hurt Australian households.
Having warned home-owners before Christmas that mortgages could rise because of the hit they were taking to their profits, the Australian banks did what their one-shop competitors had been forced to do right at the beginning of the crisis last July.

In a once-in-a-decade move, domestic banks raised mortgage rates unilaterally in January as the Reserve Bank watched from the sidelines.
Some, like the Commonwealth (0.1 of a percentage point) and National Australia Bank (0.12 points), went low; others, like ANZ and St George went higher (0.2 points), as they sought a balance between passing on the "real" costs to consumers and their profit-dependent shareholders.
None of them escaped the political and consumer drubbing that followed, although ANZ copped it worse for seemingly gouging hard-working Aussies already under pressure from 10 successive interest rate rises and higher food and fuel bills.
But any hope that the added mortgage costs might be the last were dashed only last month when the Commonwealth and NAB topped up their rates as global financing prices stayed stubbornly high.
And as the Reserve Bank added a 0.25 percentage point increase to cash rates this week, so the banks went higher in a third round of rises greater than the central bank move.
IF HOME-OWNERS have started to feel squeezed, highly leveraged corporate Australia has already been crunched.
For the banks, the possibility of a bad debt problem had started a slide in their share prices in mid-October. From the top of the bull market when the ASX200 hit 6800 points in November, the index of leading companies has since slid inexorably towards 5258 points, where it finished yesterday.
Five months ago, banking industry leader Commonwealth Bank was trading around $60. By the end of this week, at just $39.52, it had shed nearly $27 billion in market value.
The rest of the sector has suffered just as badly, with market capitalisation losses totalling a further $75 billion for the likes of Westpac, ANZ, NAB and St George.
And while Australia has largely escaped the "bloodbath" seen in the global financial capitals of New York and London and as described by the ANZ's Michael Smith last month, the crisis has certainly started to ooze into the major banks' balance sheets.
What has made matters worse has been the crash and burn of companies such as leasing specialist turned asset manager Allco Finance and shopping mall owner Centro, both sitting on group-wide debts of $7 billion apiece and desperately needing to sell most of their assets to survive.
Their futures now depend totally on the willingness of the Australian banks to refinance their way out of trouble - although, as one senior lender put it this week, they are now in "work-out", which is financial jargon for winding them down.

Their problems, though, have also raised significant questions about what the immediate future holds for the banks, their stock market valuations and, inevitably, their profits. Investment bank UBS has calculated the majors could be sitting on at least $5.5 billion in problem debts and the figure might be a lot higher.
At ABN Amro, senior banking analyst Jarrod Martin describes the ASX-listed banks as a "sector under siege".
Martin and his team mapped out for their clients this week three scenarios which could determine the fate of the banks for the rest of this financial year and the following two years to come.
The first is that the liquidity crisis will be short-lived and a "blip" on the earnings front, which means the recent 25 per cent fall in bank share prices would make them a relative bargain; the second, that this is a return to a traditional cycle of bad debts and a slowing economy that will restrain profit growth to low single digits. And the third? The danger of a full-blown recession in the wider economy, leading to huge write-offs, losses and capital injections.
Martin believes the banks are caught between the first two, where their exposures to the likes of Centro and Allco, could lead to a "cyclical deterioration" of bad debts. "We believe there is a real risk that the liquidity crunch will continue longer than the market is expecting," he said in a Wednesday briefing note. "Given the funding and capital positions of the banks this could lead to lending being constrained, with a subsequent slowdown in corporate activity and therefore economic growth."
For the near future, Martin is erring on the side of pessimism, believing there is more bad news to come.
And while price falls have made the banks particularly cheap stocks to buy - they are trading around 10 times earnings as against more than 15 times just a few months ago - he rated only NAB and Westpac as worth snapping up "in a sector under siege".
Martin also asked the question that is on everyone's lips: Is this a blip or just the beginning?
PUT THAT same question to seasoned observers and the answer is the same. They just don't know.
Deutsche's David Backler believes part of the answer lies with the banks, particularly those globally that have had massive write-downs, with the prospect of a lot more to come.
"The market is still dealing with the new liquidity conditions in real time and it will be a while before things settle and people start acting less reactively." And that probably means, he argues, more re-adjustments and possible asset write-downs.

His colleague, Marla Heller, who heads Deutsche Australian and New Zealand leverage finance division concurs. "This credit dislocation has affected the banking sector much more than was originally expected." It "has significantly altered the fundamentals of the sector resulting in a recalibration of pricing and terms".
For Curt Zuber at Westpac, the landscape of doing business has changed. "Liquidity has been redefined," he states baldly. "Duration that was there yesterday is hard to come by. Volume that was there yesterday is evaporating," which presented challenges both for borrowers and investors.
Many in the market "found that securities previously very liquid can't be sold in stressed conditions. Credits that normally could be bought and sold with a quick phone call at a fraction from mid-market, are no longer trading, at any price. And perhaps just as importantly, market intermediaries are no longer holding large inventories. This has greatly reduced secondary market trading and pressured primary market performance."
The lead -and more bad news - will almost certainly come from the US, where losses are the order of the day.
The Commonwealth's Ralph Norris reckons the global industry is staring at a sea of red in the order of another $200 billion. "So where the rest is, is still the unknown answer," he says.
"The question is but an unknown answer and, certainly, that is one of the reasons why we are continuing to see the volatility in markets and why there will be a continuing pressure on risk premiums in regard to debt."
Norris believes the world is facing a rocky ride for at least another 12 months. And he and ANZ's Michael Smith know Australia will not escape.
With the US staring into the abyss of recession, what we have seen already could indeed just be the start. Smith said yesterday the global economy was weakening on the back of an international financial system in turmoil.
"The bottom line is higher credit costs, a tightening of credit availability in Australia and an erosion of business confidence," he said.
"If we can't properly reprice lending, there is a real risk banks will ultimately be limited in the amount we are able to lend customers to buy houses or to expand their businesses."
His words are starting to hit home.