10/07/08
Insights into the Financial Crisis

A note from Shumeet Banerji to Booz & Company staff

Dear Colleagues,

I have been asked many times over the past few weeks what we think of the economic crisis—and how Booz & Company and our clients might be affected. I thought I would share my response with you, as part of our ongoing conversation about these issues, and because some of you may find this useful input to your thinking in conversations with clients. My observations are backed with a particular form of data—the recent views of business leaders in some of the most important places in the world. For I am writing this on a flight back to London from Beijing, having just attended the World Economic Forum’s Tianjin summer conference—and having spent the previous two weeks visiting Booz & Company clients in Asia, Europe, and the Americas.

So. Is this the end of Capitalism? What caused this? When will it end?

This downturn originated almost entirely in the U.S. financial markets. Essentially, cheap credit from the U.S. Federal Reserve fuelled an extraordinary leveraging of the U.S. economy over the past six years. Its locus is in consumer debt, especially mortgage debt. The original sin was not in (the lack of) regulation, but in the expansion of credit with outrageous terms to un-credit-worthy people—for example, 105% “Loan to Value” loans with no credit checks. The willingness and ability of regional and local lending institutions to then package and re-sell this debt (as "collateralised debt obligations"), first to the big U.S. banks (who in turn used debt to buy it), and then ultimately to parts of the global system, freed up those banks’ balance sheets so they could go at it again. The overall cycle was predicated on the notion that the purchase of the debt would produce a perpetual stream of repayment income against secure collateral—for example, that the real estate market would always rise.

The second victim of cheap debt was the bank balance sheet. Many financial services institutions have imploded because their asset purchases were fuelled by leverage, raising debt/equity rations of some banks to 30: or 40:1. I strongly believe that, once again, the culprit was not the lack of regulation, nor the "complexity" of risk. The job of financial institutions is to collect, price, disaggregate, de-correlate, re-aggregate, and price risk. To blame complexity is to seek a barter economy. The culprits are bad incentive systems and poor risk management at several major banks. Our financial services practice is working on these issues right now.

As many have noted, the larger system fell apart when (inevitably) the U.S. real estate market began to decline. For the primary originators or the resold obligation owners, the assets’ values were below the loan values. More importantly, if a major function of packaging is to create lower risk pools because of aggregation, this only works if they are not collinear. In other words, if all the bets are based on one super-bet—a bet on the U.S. housing market (or not so long ago, the Taiwanese, Korean, or Japanese commercial real estate market), the risks will be related as well.

Currently, the stability of the banking system is at risk because no one knows the bottom. Held to maturity, these assets are likely to be worth a lot more than they are (putatively) worth now. By aggressively marking to market, a large number of banks have, essentially, speculatively destroyed the value of their own assets. The scale of the problem has dragged down all but the best banks, wiping out equity capital. Note that mortgage intensive institutions (WaMu, HBOS), and high leverage players (Lehman, Merrill) have paid the price. Conservative banks have not. And because banks don’t trust each other right now, credit and therefore liquidity has all but dried up.

The $700 billion bailout passed by the U.S. Congress aims to restore liquidity and perhaps partially to recapitalise the banking system. These measures will do this by buying assets from banks in a reverse auction, and thereby undertake a "good bank, bad bank"-style restructuring of the industry. Little detail is known yet on precisely how the U.S. Treasury will spend these funds, but I remain sceptical about some aspects of this plan. I agree that some radical action to ring-fence "bad" assets may be necessary, but the auction design is critical to success, and I am concerned that this intervention carries within it the seeds of the next crisis, exaggerating both institutional and individual moral hazard. (To make sure the government steps in, just make sure you are too big to be allowed to fail.)

The impact of all of this on the "real economy" is fairly clear. Foreclosures and tough credit don’t ease spending, and the U.S. economy is heavily dependent on credit-based consumer spending. (This comprised 72% of the U.S. economy last year). Demand and growth will be slow, with most commentators expecting a recession by the 4th quarter this year. I expect this will be painful, but it won’t lead to another Great Depression. Swift macroeconomic action will soften the blow, and growth will probably return late next year.

The really interesting story is the way the BRIC countries (Brazil, Russia, India, China, and other emerging markets) see all this. In my recent conversations I heard three themes.

First, there was bewilderment at the regulatory and corporate governance failure in the U.S. One Chinese bank CEO joked that Wall Street was the world’s biggest collection of SOEs (state-owned enterprises). Second was a sense of relief that their banking systems are fairly insular, so their exposure to these "sub-prime" assets is comparatively small. And third, there is a general confidence in the fundamentals of their economies to live through this downturn as a correction rather than a recession. In addition, resource-based economies are extraordinarily liquid, and they will see this through rather well.

While some commentators argue that decoupling does not exist, I think we have genuine duality in the world today. Countries with big demographic or resource dividends will follow a very different trajectory through this downturn than the U.S. and Western Europe. And I think they will pull us out. Having heard the Chairman of the China Banking Regulatory Commission (CBRC) and Premier Wen Jiabao speak this week at the World Economic Forum, I must say that the world has something to learn from Chinese leadership in terms of their steady hand on the tiller.

In the end, there will be a tough adjustment in the U.S. and the U.K., a mixed story in Western Europe, and some anxiety in the rest of the world. I expect the U.S. correction will take time. Sovereign wealth funds will own big chunks of Western assets and we will end up with a saner financial system—until the next leap off the cliff.

I believe that these times, though unnerving for some, will create great opportunity for many companies, including many of our clients. Industry structure is fundamentally reshaped by discontinuity. So companies need to have the cleanest balance sheet possible and a very sharp eye on the assets they want to own. To do this well, they need a sharp focus on operational fitness (especially working capital), clarity on what is central and what is superfluous in their portfolios, and a clear sense of which capabilities they are seeking to enhance or build. We have already seen a transition to this new reality come at astonishing speed in the financial sector. There is more to come.

Good luck and regards,

Shumeet