Credit crisis over? Not likely

By Jon Markman

The major stock indexes blasted to two-month highs last week in defiance of wretched news on the economy, one of those reverso-world moves that the market gods use to keep the public wrong-footed. It seems negative sentiment is so pronounced right now that every time the news is one lumen brighter than total blackness, buyers emerge from their foxholes to nibble.

Yet Satyajit Das, an independent debt derivatives expert who for years has warned of an impending disaster in credit markets, doesn't buy it. I caught him at his Sydney, Australia, office a few days after he emerged from a three-month backcountry trek, and he leapt at the chance to scoff at U.S. bank presidents' vows that the worst of the credit crisis is over.

Paraphrasing Winston Churchill, in a voice dripping with Aussie irony, he quipped, "This is not the end or even the beginning of the end, though it may be the end of the beginning."

Das, who wrote the global credit derivatives business's most widely used textbook, argues that no matter how much equity investors try to ignore the imbalances in debt that continue to weigh on banks' balance sheets, the problem won't go away.

"Given that the bank presidents have been consistently wrong about everything they've said about their losses until now, why on earth would anyone believe them now?" he asked.

Tip of the credit-crisis iceberg

Das' point was driven home last week by Citigroup's (C, news, msgs) announcement of the sale of an additional $4.5 billion worth of shares -- its fifth attempt to raise capital in the past five months, each of which management hinted would be the last.

The troubled bank has now raised $40 billion in the most expensive possible way -- diluting current shareholders -- while contending that everything's fine. Analysts at Goldman Sachs said they were surprised at the paltry amount raised in this round, suggesting it was the best the bank could do for now given its worsening prospects.

Why would anyone want to purchase Citigroup shares on the open or private markets? Buyers believe banks such as Citi have, at their cores, outstanding franchises that the hyenas who have run them recently haven't entirely ruined. Sellers disagree, with Das in particular contending that such wishful thinking ignores the massive "de-leveraging" of the global financial system under way now that threatens to impair banks' ability to lend and grow for years to come.

To believe the worst is over, Das notes, you would have to believe that bank managers have obtained a firm grip on their credit-related losses and have written down at least half of the ultimate total, and that declining home values won't create more losses. He thinks this is impossible because the banks own many of the same losing securities yet have variously written off anywhere from 30% to 80% of their face values.

Das figures that since few banks likely overestimated their losses, the variance in the write-offs means most banks continue to underestimate their losses. Thus he calculates that the $200 billion raised from outside sources so far is just a down payment and that banks have up to $700 billion more to go -- an amount far in excess of their total earnings over the past half-decade.

And it's not just losses on current holdings that are the problem. Das wishes to remind investors of the $1 trillion to $3 trillion that's still in the process of moving onto the banks' balance sheets from related entities where they were hidden. These off-balance-sheet units were created to permit banks to buy vast sums of credit derivatives that they had designed in exchange for big fees. The holdings of the units, called structured investment vehicles, or SIVs, were then used as collateral to do more borrowing from money market funds, again generating more fees.

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Keeping these highly leveraged units off the books meant banks did not have to counterbalance them with any permanent capital, or equity. This was a crucial link in the global liquidity factory that provided funds for this decade's credit bubble.

The cost of a broken lever

Now that money market funds have stopped buying commercial paper issued by SIVs, banking regulations require the banks to bring them onto their books, and that means they must shore up their capital base by selling new shares or shedding other assets. Every dollar that is used for this purpose is a dollar that can't be used to make loans for corporate buybacks, commercial customers or hedge funds. Without such loans, banks' earnings growth will be greatly impaired.

Worse still, the buying power of two key drivers of the last bull market -- hedge funds and corporate Treasurys -- has been crippled because the leverage they've used to reap big profits has suddenly turned against them.

Continued: An example to consider

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