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.