January 18, 2008 | posted by Michael Baxter in UK economy, US economy, credit crunch |

One piece of good news stood above all the rest yesterday, like a beacon. The big question ruminating around Wall Street is this: will things get worse? Yesterday, after revealing quite appalling write-downs – Merrill Lynch’s boss, John Thain said “I don’t think you should anticipate any further problems of this magnitude.” He added, “There would have to be something incredibly bad out there to have this happen again, and our whole goal is to get 2007 behind us.”

That’s what markets wanted to hear. Sure, 2007 was bad, but let’s move forward now, let’s get all the bad news out of the way, and start 2008 with a clean sleet.

But instead of that, yesterday was another day of blood-letting on Wall Street. The Dow Jones fell 307 points; once upon a time that would have been disastrous, but actually it merely amounted to the worst day in two months. As for the FTSE 100, actually yesterday wasn’t too bad – the index was down 40 points, but then most of the bad news out of America broke after London markets were closed, and this morning, the news from the Far East was pretty grim, with markets tumbling like a contestant on celebrity ice skating.

More to the point, the Dow is now 884 points (6.7 per cent) down this year, and 2004 (14 per cent) lower than the all-time high set on October 9 last year. The FTSE 100 is down 514 points (8 per cent) this year and 818 points (12 per cent) off its six-year high set on 31 October.

So why are markets so far down, when actually the news coming out of corporate America is about what you would have expected?

Okay, let’s be honest, all the write-downs out there are not good. Yesterday, Merrill Lynch pulled off a record no one wanted to hold, by announcing the biggest write-downs from any bank since the subprime crisis first broke. In the 12 months to the end of December, net losses came in at $7.8bn, and total write-down for the year tallied $22.1bn.

By contrast, Citigroup’s $18bn worth of write-downs seem positively frugal.

But really, if there’s anything strange in yesterday’s events, then it’s surprise that markets were surprised. The Fed, the IMF, and that legendary trio of economists, Tom, Dick and Harry have all warned that total subprime-related losses will run to the multiples of 100s of $bn. There is nothing in yesterday’s news which wasn’t as well broadcast in advance as an attack on a goal by an England football team.

Then again, yesterday’s bad news was not restricted to bank losses. More woe relating to the US housing market hit the news desk. Housing starts fell to 1,006,000. That’s the lowest level in 16 years. Then again, there were mitigating factors. The month the data related to, December, was beset by awful weather – and the region where the data was particularly bad was the midwest, where the storms were at their worst. Even so, you can’t just blame the weather for the worst monthly results in 16 years.

Clearly the US housing market is still in crisis – but then, who is surprised to hear that?

Then there’s the investments from the sovereign funds – okay, you don’t need to be full of sagacity to know that there are important long-term implications of the recent investment in banks from sovereign funds from the Middle and Far East, but surely, right now, markets should be celebrating the fact that banks have managed to strengthen their balance sheets. Writing in The Times, Anatole Kaletsky, made this point well when he said, “Instead of heaving a sigh of relief that the two largest and most-troubled institutions at the heart of last year’s credit crunch had replaced their managements and raised enough capital to survive and get back to business, investors and analysts redoubled their panic.“

Why is that?

It seems there was one piece of bad news that also emerged yesterday that wasn’t expected. But maybe to truly answer the question of why the markets have fallen so far this year, we need to rewind the clock back to the irrational exuberance shown in 2007. But maybe there is an even deeper problem, which, right now, markets have failed to grasp.

Amongst all the bad stuff yesterday, Merrill Lynch announced a $3.1 billion write-down related to insurance taken out on some of its mortgage securities. And all of a sudden a new fear has grown. How stable is the business for some forms of financial insurance?

And if the insurance write-down from Merrill wasn’t bad enough, yesterday, Moody’s Investors’ Service raised the spectre of removing the triple-A credit ratings on Ambac Financial and MBIA, the world’s two largest bond insurers. On that news, the FT said this morning, “Shares fell 52 per cent and 31 per cent respectively.”

That’s the trouble with economic crises. One set of bad news often begets another set. It has always been thus.

So that’s a new worry to come on top of all the rest.

But maybe there is a far deeper reason to fret. First we need to ask this: why did markets jump so high last year? At the time, we regularly scratched our head, and said things like markets seem to be interpreting everything as good news, no matter how bad it is. We also drew analogies with a Cheshire cat, saying, “But it sometimes feels as if the smile on Uncle Sam’s face is all there is. It’s like Lewis Carroll’s Cheshire Cat which ‘vanished quite slowly, beginning with the tail, and ending with the grin, which remained some time after the rest of it had gone’.”

Last year, markets were smiling when traders should have been drinking hemlock en masse. Now they are paying the price for that irrational exhilaration.

But maybe there is another deeper problem. Markets remain far too short-termist in their outlook. The banks are the worst culprits of the lot. As Anatole Kaletsky pointed out this morning, much of the money being raised by the US banks is being spent on bonuses and dividends. Shareholders and managers are being rewarded for failure.

Banking crisis must be avoided at all costs. A true banking crisis could send the global economy into depression. So if banks know that governments and central bankers won’t allow full scale failure, they can carry on taking too many risks.

There is no easy solution. But that’s why Mervyn King made the stand he did with Northern Rock, and was slow to pump money into the system last year. That’s why calls for his head, often expressed by banks who have got away with so much recklessness, precisely because there have not been enough central bankers like Mervyn King, are too rich for words