Some Cheers This Christmas!!

(originally published on December 22, 2007)

Technorati Tags: blame game,Christmas,creative central banking,mortgage reforms,Super SIV,Federal Reserve

 

The news flow this week was a contrast of sorts; Bear Stearns suffered its first loss making quarter in its 84 year history with a $6.9 per share loss not even coming close to the $1.79 loss estimated by Thomson Financial. Events at Morgan Stanley were even more bizarre with the bank reporting its first ever quarterly loss due to a massive $9.4Bn write-down, that necessitated a $5Bn infusion from a Chinese sovereign wealth fund. Expectations of a big 4Q write-down at Merrill Lynch forced it to seek a $5Bn liquidity infusion from Singapore's state-owned investment wing Temasek Holdings. On the other hand, Goldman Sachs surprised the street with a stellar set of numbers driven by robust performance from all of its divisions. RIMM also bolstered sentiments with another phenomenal quarter.

The Commerce Department confirmed this week that GDP grew at an astounding 4.9% in 3Q. But as we have argued before, this data looks artificially inflated because of an exceptionally low price deflator. With inflation again rearing its ugly head last week, it is only reasonable to expect both 'reported' and 'actual' GDP growth to suffer significantly in 4Q. Consumer spending rose at an higher-than-forecast 1.1% pace in November as shoppers reportedly took advantage of early holiday discounts. But commentary from Circuit City, Best Buy and other retailers did not evoke the same optimism. Weekly surveys indicate that the November shopping binge may not sustain. ShopperTrak believes that holiday sales posted their third straight weekly decline in the week ended December 15. National Retail Federation estimates that this year's holiday season could be the weakest since 2002. A private report indicated that consumer sentiment slid to its lowest level in over two years in November.

Further, the Conference Board's index of leading economic indicators, a keenly watched measure, fell for the third time in four months and fourth time in six months, stopping just short of signaling a recession. Bill Gross, manager of the world's largest bond fund at PIMCO, commented this week that the economy may have already slipped into a recession this month.

 

 

The front-line indexes staged a minor bounce back this week, retracing some of the losses over the past two weeks. But could this be one of Santa's gifts this Christmas? Could the concerted efforts from the central banks of the world do the improbable? Are we indeed headed for a recession next year? When traders settle down after their holidays, fresh cues are likely to emerge that would help us gauge the prevailing mood of the markets and answer many of the questions dancing in our minds. We prefer to enjoy the holidays for now, knowing fully well that we are likely to have an exciting, albeit challenging, time forecasting financial markets in 2008.

This week we look at how the buck of sub-prime losses is being passed between two equally culpable parties, how the Treasury-supported 'Super SIV' plan met its demise, long overdue but significant mortgage reforms instituted by the Fed and an account of a remarkably creative act of central banking

 

 

 

The blame game begins!

Barclays Plc, the UK banking giant, became the first big plaintiff against the major Wall Street brokerage houses this week after being stung badly by the collapse of two big hedge funds run by Bear Stearns this summer. Barclays is now suing Bear and two of its fund managers, claiming among other things that Bear misled it about the performance of its highly leveraged funds. Barclays lent roughly $400M to the BSAM enhanced fund, which eventually collapsed, taking with it nearly $1.6Bn in losses. The Barclays complaint alleges that the desperate state of the funds were concealed, even as false promises about savvy risk management and open communication were given, treating it as a naive player that was an 'easy liquidity source'. Federal criminal prosecutors are also investigating the collapse of these funds to determine whether fund manager Ralph Cioffi improperly withdrew about $2M of his own money from the riskier of the two hedge funds into another fund with a separate investment strategy even as he made optimistic forecasts about the portfolio's prospects.

Along with highlighting poor risk management practices and very little regulatory oversight, this episode also unearths the plain ignorance about the complexity of structured products even amongst supposedly the most sophisticated of investors. Clearly this is not the end of the story. And whoever wins this battle, this episode will be remembered as the poster of the excesses that eventually led to a near-freeze of the credit markets this summer.

 

 

More hype than substance?

As was pointed out by this author earlier, the 'Super SIV' has indeed run into trouble. Citigroup, Bank of America and JP Morgan Chase, who had initially backed the Treasury-backed idea to buy assets from cash-strapped SIVs, announced this week that the fund was 'not needed at this time' . This comes after HSBC, Citigroup, MBIA and others arranged their own bailout plans (only Germany's Dresdner Bank and BMO Financial Group have not yet moved to restructure their SIVs). The statement also indicated that SIVs had reduced their holdings to less than $265Bn in December from $340Bn during the summer. Moody's recently estimated that the average net asset values of SIVs tumbled to 55% in November from 71% a month ago and 102% in June.

The delay in getting the proposal off the ground possibly caused its own demise as events in credit markets went from bad to worse. We had believed that the plan was based on the flawed notion that the fund would pay more for the sub-prime tainted securities than the banks would themselves. The feared fire-sale of assets never happened as most large banks (notably Citigroup and HSBC) decided to take SIV assets and liabilities onto their own balance sheets. However, the proposal probably had the intended effort without ever being implemented; it possibly prevented a panic and boosted market confidence before a more effective remedial action could be thought of.

 

 

The Fed on the button

In the biggest regulatory initiative since Chairman Ben Bernanke took office in February last year, the Federal Reserve proposed new rules for sub-prime mortgages aimed at curbing lending practices that have contributed to a record rise in foreclosures. The new rules put the onus on mortgage companies, regardless of whether they are banks, thrift institutions or independent mortgage companies, to provide 'reasonably reliable evidence' of whether customers can realistically afford their mortgages. Lenders would also be required to disclose hidden sales fees often rolled into interest payments while prohibiting certain types of advertising. If the new rules were violated, borrowers would be able to sue their lenders and seek a limited amount in compensation. The package is broad in scope, covering all high-cost mortgages, defined as loans with rates at least 3 percentage points above a comparable Treasury security for first mortgages.

These proposals mark a sharp change in tack from the Fed's longstanding reluctance to rein in dubious lending practices dating back to Alan Greenspan's tenure at the helm. If you needed an explanation, look no further than Bernanke's accompanying statement,“Unfair and deceptive practices hurt not just borrowers and their families, but entire communities, and, indeed the economy as a whole.” . Unfortunately for the many players affected by one of the biggest financial disasters of the past half-century, the restrictions are about seven years too late!

Creative Act Of Central Banking

(originally published on December 22, 2007)

 

Following limited success of its prior attempts at defusing the crisis by manipulating the more commonly used tools in its arsenal (Open Market Operations, Federal Funds Interest Rate and Discount Window Interest Rate), the Fed unveiled a trump card this week to control the flow of credit in the economy : the Term Auction Facility.

To better understand this, lets get a bit of a background to the current resurgence of the credit crisis. After seemingly letting-up since mid-September, the spread between the one-month LIBOR rate (at which banks make non-collateralized loans to each other) and the Fed funds rate spiked up in late November and continued to rise ever since. Banks have refrained from lending to each other fearing the quality of assets on the balance sheets of potential borrowers. Since banks had enough trouble figuring out the value of the assets they possessed, they figured that other banks must be facing the same problems. The end result was a near-paralysis in inter-bank lending markets.

 

Widening spreads between one-month LIBOR and the effective Fed Funds rate

 

The initial reaction from the central banks was typical. The Fed resorted to temporary injection of funds into the banking system through repurchase agreements by way of open market operations through a set of 20 qualified 'primary' dealers. In addition, the central bank engaged in discount lending, acting as a lender of last resort, under the assumption that during a crisis, solvent but illiquid banks could go to the central bank for a loan that would be made at penalty rates and on good collateral. So when the interbank-markets shut down, theory suggests that the banks should have gone and borrowed at the central bank's discount window.

But as seen in the chart below, total volume of borrowing from the Federal Reserve in the week ended Dec 5 was a mere $342M. Further, Federal Reserve data indicates that in three out of ten days since the crisis started, the maximum trade in the Fed funds market exceeded the discount lending rate, i.e. banks were willing to pay more to borrow from each other than what they would have to pay to borrow from the Fed. Banks' unwillingness to borrow from the Fed's discount window could be attributed to the stigma of being branded uncreditworthy (“you only borrow from the Fed if nobody else is willing to lend to you”).

 

Sudden spike in borrowings from the Fed

 

Thus, while central banks had adequate tools to push funds into the banking system, there was no effective way to distribute it to corners that needed it the most. The Fed can get liquidity to the primary dealers, but with the breakdown of the distribution system, there is no way to ensure that those reserves are then lent to banks that need them. Further reductions in the Fed funds rate will achieve other objectives, but will not fix this problem. Lowering the target Fed funds rate further will only provide additional liquidity reserves to the already flush primary dealers. Additionally, with true globalisation of the financial system (refer the global nature of the sub-prime meltdown driven by essentially US mortgage defaults), dollars have been in short supply outside the US as well, thereby necessitating some cross-border intervention to meet the needs of banks in non-US countries that are short of US dollars.

With this background in place, last week's announcement of a Term Auction Facility (TAF) by the Fed seems like a creative act of central banking. The Fed announced auctions of reserves for terms upto 35 days, allowing all banks (7000+ banks, not just the 20 primary dealers) to participate, with a broader array of collateral accepted than in the standard repo operations. The TAF is also different from the discount window as it is for a fixed term and through an auction (removing the need for banks to come hat in hand, thereby hopefully avoiding the stigma attached to the discount window) with the Fed being the primary determiner of its quantity and timing (not private banks). Also, the Federal Reserve set up swap agreements with the European Central Bank and Swiss National Bank whereby each can obtain dollars from the US in exchange for their own currency and then proceed to offer dollars to banks in their own countries. While the concept is not new, our research indicated that no non-US central bank had ever offered dollars in their open market operations before.

So what do we infer from this? At its most basic level, TAF is simply another mechanism for doing open market operations. However, this certainly goes a bit deeper. Open market operations are conducted by central banks to change the size of its balance sheet or the composition of the assets they hold. The former is the traditional approach to central banking aimed at maintaining the Federal funds rate at its target level. The latter, in contrast, is what the TAF is all about... aimed at shifting assets from US Treasury securities (purchased through permanent and temporary open market repurchase operations) to some of the lower-quality loans such as MBS including sub-prime backed assets, thereby hopefully reducing the risk premiums charged currently in the inter-bank lending markets. The Fed is essentially offering to absorb some of the risk (or the perception of it) that is presumably the root cause of the market's unwillingness to purchase the risky CDOs and MBSs.

In the best case (and most likely in our opinion) scenario, the Fed will suffer no loss and possibly avert to a certain extent a nasty turn in the financial markets ridden with defaults and bankruptcies. In the worst case, the defaults will only be postponed and the Fed will absorb some losses just like everybody else (the only way the Fed can absorb these losses is by more money creation which is one way of dealing with the serious risk of deflation that a major financial turmoil like this could lead to).

This concerted effort from central banks to ease the credit market gridlock seems to be finding some initial success with money market rates declining for four consecutive days this week. The impact was a lot more pronounced in the Eurozone with the cost to borrow in euros plunging a record 50 bps after the ECB injected an unprecedented $500Bn into the banking system on Dec 18 in an attempt to ease the liquidity crunch at year-end. The Fed conducted two of four planned auctions, pushing $40Bn into the banking system. Financial institutions stampeded for this liquidity, submitting $57.7 billion in bids for Friday's auction, a bid-to-cover ratio of 2.88, for an effective rate of 4.67% on Friday, just 8 bps short of the discount window rate. Clearly the discount window rate seems tight and the Fed would do well to reconsider this rate in the next meeting.

While there is no way to be certain of whether these manouevres would succeed, we have to remark that a spectacularly creative chapter in central banking is being written!

Another Week Of Gains

(originally published on December 8, 2007)

Technorati Tags: foreclosures,S&P 500 earnings,SIV,unemployment

 

Following up on the strong surge the previous week, the front-line indexes stacked up a further near 2% gains this week. The sentiment, in the equity markets at least, was also helped by surprise rate cuts by the Bank of Canada and Bank of England, signaling a significant loosening of monetary policy across the globe. After a steady decline for the better part of November, the front-line indexes have staged a remarkable rebound from near-term oversold levels over the past two weeks.

 

S&P 500 - Daily

 

Nasdaq Composite - Daily

 

Equity investors have a habit of jumping up on shadows and losing out on profits. However, not all shadows are caused by imaginary monsters. While the bounce has caught most by surprise, there are strong headwinds that are likely to stall any further advance.

Markets are still trading a fair distance away from their prior peaks even after a 75 basis points rapid-fire reduction in interest rates. Historically, this has not augured well for the health of the equity markets. A notable change in market character (several large 200-300 points up/down days on the Dow) suggests distribution by risk-averse smarter hands.

With nearly all the companies having reported their 3QCY'07 results, cumulative earnings for the S&P 500 registered a 2.5% decline, for the first time in five years. Operating earnings for the S&P 500, stripping out the various write-downs and charge-offs, declined a sharp 8.5% in 3Q, a far cry from the 9.6% growth seen in 2Q and the 11.6% increase a year ago. The 12.4% sequential decline in earnings in 3Q is the worst performance for almost two decades, rivaling similar earnings declines in 4Q of 1989 and 4Q of 2000, that preceded the previous two recessions. This disastrous showing has led to analysts significantly paring down their estimates for 4Q and beyond.

 

Steady downward revisions in forward earnings estimates for S&P 500

 

With a high likelihood of further write-downs in 4Q, we are possibly staring at the abyss of an 'earnings recession'. It is unclear at this juncture whether this will turn into a full-blown 'production recession'. Nevertheless, an earnings recession is a serious problem as it is profits that drive the entire business cycle. Yet, neither government nor central bankers can actually create earnings power for corporates. Financial markets are still in a disbelief mode, refusing to gauge the extent of the problems and taking heart in minor near-term drivers. There has not been an expanding wave of pessimism that typifies market troughs. The coming week with a key FOMC policy meeting will thus be a litmus test for bulls; it will help us judge better whether this liquidity-led, catalyst-driven bounce off oversold territory is likely to sustain.

This week, we look at how foreclosures are quickly becoming the focal point of US politics in an election year. We then dissect the jobs data to see whether the job market is indeed holding up strongly as indicated. We finally wrap with an account of how SIVs are becoming a real pain in the balance sheets for banks.

A 'SIV'ere problem!

(originally published on December 8, 2007)

Technorati Tags: bailout,Citigroup,SIV,write-down

 

In a definite sign of further deterioration in the financial markets, Rabobank became the third European bank in just two weeks to bail out its troubled structured investment vehicle, Tango Finance, taking assets worth $7.6Bn onto its balance sheet. The SIV, co-managed with Citigroup, has already seen almost half of its assets sold since July due to non-availability of sufficient funding. The business metrics for SIVs have changed dramatically since summer and there is little chance for any SIV, even those holding good assets like Tango supposedly is, to secure any viable funding. Moody's is expected to downgrade $105Bn of debt sold by SIVs after determining the average net asset value of SIVs to have declined to 55% from 71% a month ago (a complete reversal from 102% in June!). Downgrades will only further complicate the problems for SIVs to obtain financing. European banks, largely not in favor of a Super-SIV style bailout package, are increasingly resorting to these confidence-building measures in an attempt to preserve their fledgling reputations.

On the other hand, US banks have steadfastly refused to consolidate their SIV assets into their balance sheets, preferring instead to go with a Super-SIV bailout package spearheaded by Citigroup. Citigroup, with as much as $66Bn worth of assets stuck in its SIVs, is right in the eye of the storm. Citi has already committed emergency funds to the tune of $10Bn to save its troubled SIVs. Eminent gurus like Greenspan and Buffett have gone on record suggesting that if SIV assets are never marked to market, banks may only be delaying their day of reckoning. With Citi likely to account for a big chunk of the SIV bailout, the entire exercise is essentially akin to lending money to itself.

Interestingly, Citadel's recent purchase of the banking assets of E*Trade Financial set a price on similar assets at around 26 cents to the dollar. With this transaction being one of the few observable trades of such assets in recent times, a quick back-of-the-hand calculation suggests a worst-case scenario of Citi suffering a further $26Bn in after tax write-offs, if its assets were valued similarly. Citi will be unable to survive this kind of an assault on its balance sheet, at least not with the company intact and in its current form. Citi cannot afford any more large write-downs because of the existing banking regulations and on account of being a public company.

Will the government then step in to bail out Citigroup as well? There is certainly a precedent in recent history of bailing out large US corporations ('too big to fail' hypothesis). Or will it be private buyers? Citi's battered portfolio will have an attractive lure to a private buyer if the credit markets do indeed normalize (its assets are surely worth more than 26 cents on a dollar in a better market). Any buyer will, however, surely extract his pound of flesh. Expect issuance of preferred convertible stock to the buyer carrying an irresistible coupon (a la Abu Dhabi's recent purchase of a 7% stake).

Jim Morrison (of The Doors fame) crooned way back in the 1960s : “When the music's over, turn out the lights”. While the SIV music has stopped playing, it is not yet time to turn out the lights!!

Will The Real Jobs Data Please Stand Up??

(originally published on December 8, 2007)

Technorati Tags: birth-death adjustment,unemployment,phantom job creation

 

Several key market-moving employment indicators were released this week. Ben Bernanke went on record earlier suggesting that this data will help him make up his mind about future policy action. First up, payroll firm Automatic Data Processing using its database of 23 million workers indicated that private non-farm payroll employment gained a phenomenal 189,000 for the month of November. Remarkably, ADP report suggested that construction jobs fell by only 6000 in November, the smallest decline since January, while financial sector jobs actually grew by 10,000 after months of decline. Later in the week, the Bureau of Labor Statistics reported that non-farm payrolls rose by 94,000 in the month of November after a strong 170,000 increase in October. The jobless rate remained constant at 4.7% for the third month in a row. Encouragingly, temporary hiring, one of the leading indicators of job creation, increased for the second consecutive month. Going purely by the official figures, jobs have proved to one of the few bright spots in a year when home prices saw their sharpest plunge in over four decades, energy costs soared to a record high and spiraling sub-prime losses threatened to bring global financial markets on their knees.

This begs the question : Is the jobs market really the pillar that is holding the economy back from a collapse or is there more to read into the headline numbers? The Birth/Death adjustment, a major component of the BLS' Current Employment Statistics (CES) program since 2003, hypothesizes how many jobs were created/shelved by companies, either too new and/or too small to figure in any sample of the CES. The major drawback in this and other model-based approaches is that it assumes a predictable continuation of historical patterns and is therefore susceptible to produce unreliable estimates at economic inflection points or during periods when there are sudden changes in trend. At the top of a cycle (like now, when business deaths are likely to be more common than usual), this adjustment will potentially hypothesize sizable phantom job creation. In BLS' own estimate, the B/D adjustment remains the most problematic part of the estimate process.

 

 

 

To better understand the nature and impact of this adjustment, refer to the above charts from Econobrowser. The actual number of new jobs created that can be measured has dropped drastically over the past several quarters. The measured portion of the CES was as high as 70% in early 2006. However, this has steadily dropped to as low as 20% now. In other words, the current data that BLS doles out and which the Fed looks at closely, is 80% imagined and 20% measured. If this analysis is indeed correct, the ongoing economic expansion is much weaker than reported or made to believe. Our findings are largely consistent with observations from various sentiment surveys, commentary from several recruitment firms and job losses at various financial and housing related firms.

The Fed possibly knows this better than most; but in the absence of a better alternative, it persists with this flawed model. The headline jobs data this week was weak enough to allow the Fed to cut rates going forward, but not dire enough to warrant an aggressive 50 bps reduction. Fed fund futures suggest that traders have pared back their bets on a 50 bps cut next week to 26% from over 51% a week ago, while factoring in a near-certain 25 bps rate cut.

Calls are now getting louder for a more aggressive rate-cutting intervention by the Fed. Citigroup's chief economist expects the Fed to reduce benchmark rates by 100 basis points by June '08. Bill Gross, manager of the world's largest bond fund, argues emphatically for a 'real' Fed funds rate of 1% (assuming a 2% rate of inflation, that works out to a 3% nominal Fed funds rate). The Fed is faced with looming dark clouds that threaten to wash out a six-year expansion. The very least that the markets will accept will be a 25 basis point rate cut next week.

Foreclosures closing in on the polity!

(originally published on December 8, 2007)

Technorati Tags: foreclosures,US politics

 

The Mortgage Bankers Association estimated this week that a record 0.79% of mortgages entered foreclosure proceedings in the three months ended September 30, up from a previous record of 0.65% in 2Q'07 and more than double the 0.32% rate a year earlier. 5.59% of all borrowers were at least 30 days late in making their mortgage payments, just shy of the 5.68% record set in 1986. Further, a record 1.26% of borrowers were 90-plus days late, putting them at significant risk of slipping into foreclosure. Sub-prime adjustable rate mortgages had particularly ugly delinquency and foreclosure rates with the survey estimating a record high 15.6% borrowers, or nearly one in six, being seriously delinquent.

Foreclosures now have become the focal point of US politics. We had remarked in our prior WMRs that the rising foreclosure rates were likely to crystallize a major change in policy making. The reason is simple. Foreclosures – those on the brink or past the line – are a subset of a much larger cohort of trouble. A foreclosure in a street affects not only the household concerned, but depresses property values all across the street, affecting the entire neighborhood. Moreover, half the foreclosures are in the states of Florida, Texas and California. It is nearly impossible to become the President of the United States without winning at least two of these three states. With the ARM resets set to peak in May 2008, it should not come as a surprise that this topic has become the rallying point in the Presidential race.

In this context, the bail-out package announced by the Bush administration was also not completely unexpected. Under the deal, loans that originated between Jan 1 '05 and July 31 '07 (and those that reset between Jan 1 '08 and July 31 '10) qualify for the bailout, potentially bringing a much-needed respite to as many as 1.2 million sub-prime homeowners. In some cases, loan-servicing companies will agree to freeze mortgages at their low introductory 'teaser' rate for a fixed period, while in other cases, credit counselors will walk mortgage holders through refinancing processes. The deal, however, will not provide any relief to those homeowners who are behind by more than 30 days in their payment, those that have already refinanced or have been more than 60 days delinquent on more than one payment during the past year.

At its most basic level, the proposal aims to stop and reverse the domino effect of falling home prices and rising foreclosures. While the intention is laudable for sure, cherry-picking winners and losers from the rubble of the sub-prime mortgage meltdown is probably not the best way to go about it. It still remains to be seen if these attempts can indeed prevent a full-blown housing recession - an event that many believe is already underway.