A Global Credit Market Update

Since stock market lows in March, the S&P 500 has rallied 12%. Which leads to the question, are we through the worst of the credit market crisis? To answer that question we should look at current data on the extent of the credit crisis and how much money banks may need to raise to shore up their balance sheets.

A recent report, published by Bank of America, listed the total capital raised by 11 of the worlds largest banks at $260 billion and the estimated write-downs at $338 billion, a $78 billion dollar shortfall. The IMF estimated in their April Global Stability Report the total credit related write-downs worldwide could reach a trillion dollars. More recently, the bond rating company Fitch, estimates global credit market losses totaling somewhere between $400 & $550 billion. The variation in estimates can be attributed to the credit market addressed, when the research was conducted, the complexity of the credit market, and other factors.  It does appear additional funds will need to be raised by banks and both Fed Governor Bernanke and Treasury Secretary Paulsen echoed as much in the last week.

So far banks have been fairly successful in raising capital but they may find it more challenging in the future since they have already tapped several liquidity sources, such as sovereign wealth funds and private equity. Some of the initial deals were completed before banks disclosed the full extent of their losses. To protect the new investors, some banks agreed to compensate them if the bank sold more stock at lower prices in future deals. The end result for those banks needing to raise more capital under this condition could mean further dilution to existing shareholders. Another challenge for banks is determining the current value of certain assets. Due to the illiquid nature of the complex securities in question, which are backed by troubled loans, determining the value of some of these assets is difficult and may have caused banks to focus on shorter-term capital needs. In addition, federal regulators and rating agencies are expected to increase the capital requirements for holding certain security types and increasing disclosure on assets held.

The future is still unclear, but some themes have developed:

• Some banks are very likely to need to raise more capital
• Additional shareholder dilution might be required to raise capital
• The extent of capital needs by banks may not be fully known
• Regulators and insurers may require banks to maintain more capital if they hold certain security types
• One of the root causes of the credit crisis, falling U.S. home prices, continues

After the credit crisis climax with the Bear Stearns bailout, U.S. stocks started an upward trend and showed some resilience recently. Just last week the NASDAQ 100 led U.S. markets, up 3.6%; firmly above its 200 day moving average. The S&P 500 rose 2.7% and the Dow turned in a weekly gain of 1.9%. Market leading stocks delivered terrific performances, with the IBD 100 up 4.2%. Volume characteristics improved but still lack the conviction often found at the start of a prolonged bull-market rally. Current market action would be a lot more credible if an improved lending environment (the Ted Spread is still negative) between banks returned and the U.S. housing market stabilized. Those investors putting new money to work in the current rally appear to be focused on 1) a belief the credit market issues have been controlled 2) an overall less dismal economic environment in the U.S. 3) continued economic expansion in emerging markets 4) covering short positions.

While monetary authorities have stepped in to prevent a financial market meltdown and some credit market conditions have improved, there are still potential problems on the horizon.  For a look ahead, the price of gold may be a good indicator of more bad news. It has been known as a flight to safety asset.  In mid-March, at the height of the Bear Stearns crisis, gold traded around $1,000 an ounce but then fell to around $850 by the end of April.  So far in May it has rallied back to just over $900 an ounce.  It is important to remember that gold is influence by other factors, like inflation.

GLD = GOLD