By Satyajit Das | 17 April 2010
|
Bad Risks
In 2009 there was a 'recovery' in financial asset prices. The low or zero interest rate policy ("ZIRP") of major central banks helped increase asset prices. Very low returns on cash or near cash assets forced investors to switch to riskier assets in search of return. The chase for yield drove rallies in debt and equity markets. Low interest rates acted like amphetamine as investors re-risked their investment portfolios.
High credit spreads for investment quality companies, driven by the panic of late 2008 and early 2009, subsided and rates returned to pre-Lehman levels. Credit spreads for investment-grade borrowers fell to just over 100 basis points from their highs of 300 basis points in March 2009. Credit spreads for non-investment grade or junk borrowers market fell to over 500 basis points from the high of 1,300 basis points in the same period, driving returns of over 50% per annum.
Extremely low rated bonds, such as CCC rated bonds (a mere one notch above default), generated even higher returns, falling from rates of 30-40% per annum to around 10%. Re-risking was helped by the return of the "carry trade" as investors used near zero cost funds, especially in dollars, to finance holdings of risky assets. Any asset offering a reasonable return rose sharply in value.
Morgan Stanley analyst Greg Peters outlined the outlook for 2010 in the Financial Times: "We like the junkiest of the junk". As the recovery spread across most asset classes, naysayers were dismissed as perma-bears. As everyone knows: "A bubble is a rising market that one is not invested in; if one is invested, then it is a bull market."
In contrast, the real economy, at best, stabilized during 2009. Most economies, with the exception of Australia and some emerging markets, most notably China and India, contracted during 2009. In Australia, which avoided a recession, GDP per capita actually fell (by around 1.5% per annum). Key real economy indicators, including employment, consumption, investment and trade, remained weak.
Massive government intervention helped arrest the rate of decline of late 2008/early 2009. Without government support, it is highly probable that most economies would have been in severe recession. Elements of the package resembled Soviet 'Gosplans'. Just as China practiced capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.
Despite speculation on the "shape" of the recovery— "V," "U" or "W," key issues are unresolved. Major risks in the financial and real economy remain and may disrupt the hoped for resumption of 'business as usual'.
Bad Banks
Capital injections, central bank purchases of "toxic" assets and explicit government support for deposits and debt issues helped stabilize the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.
In their September 2009 Financial Stability Report, the International Monetary Fund (IMF) forecast total losses from the Global Financial Crisis (GFC) of $3.4 trillion, of which $2.8 trillion would be borne by banks. Approximately $1.5 trillion of those losses, around half of which was attributed to European and U.K. banks, had not been recorded and were expected between Q2 2009 and Q4 2010. In December 2009, the European Central Bank ("ECB"), which is more optimistic than the IMF, forecast that euro-zone bank write-downs between 2007 to 2010 could potentially reach €553 billion ($774 billion), of which some €187 billion ($262 billion) (34%) have not been 'recognised' to date. The ECB feared a second wave of losses reflecting weak economic conditions.
Despite capital injections from governments and/or share issues taking advantage of the recovery in stock prices, bank capital positions remain under pressure from the risk of further losses. For example, the four largest U.S. banks have bad debt reserves of $130 billion (4.3% of loans) and capital of $400 billion against total assets of $7.4 trillion. Difficult to value Level 3 Assets (familiarly known as "mark-to-make-believe" assets) are estimated at around $346 billion, only slightly less than the capital available. The current market fair value of loans for these banks is estimated to be $76 billion below the carrying value.
Thus banks are likely to remain capital constrained in the near future— reducing the availability of credit. The capital shortage is estimated at around $1-2 trillion implying a potential contraction of 20-30% from pre-crisis levels. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage. Constraints on availability of credit and its higher costs are a risk to full/further economic recovery.
Bad Loans
Further losses are likely from consumer loans, including mortgages and credit cards. In the U.S. mortgage market, one-in-10 householders are at least one payment behind (Q3 2009) [[1 in 8 as of 1Q 2010: normxxx]], up from one-in-14 (Q3 2008). If foreclosures (now at 4.47% up from 2.97% one year ago) are included, then one-in-seven mortgagors are in some form of housing distress.
Recent stability in U.S. house prices may be misleading, reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed's mortgage-backed securities (MBS) purchases. The value of 20-30% of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures.
Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve. Rising vacancy rates, falling rentals and declining values of commercial real estate (CRE), primarily office and retail properties, are apparent globally.
In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames— the 12-storey Watermark Place— for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: "I'm unlikely to see [the terms] again in my career."
Global commercial property lending is around $3.4 trillion, 25% of which has been repackaged into commercial mortgage backed securities ("CMBS"). Current values of many properties are substantially below the loan amounts outstanding. Many CRE loans are in breach of covenants. Lenders have waived breaches of loan conditions and extended maturities. CMBS Delinquencies are currently around 3.5%, expected to peak at an estimated 10-12%.
Leveraged or private equity loans also face difficulties. Terra Firma's £4 billion purchase of EMI, financed in part by a £2.6 billion loan from CitiGroup, is an example of the problems. In the recession, EMI's revenues fell by around 20% and losses tripled as cost savings were offset by higher interest charges.
Analyst's estimate that EMI's value is around £1.4 billion, below the level of its debt. In 2009, Terra Firma wrote off half its investment in EMI and offered to inject £1 billion in equity but only if CitiGroup would write off a similar amount of debt. The bank refused. Subsequently, Terra Firma commenced legal proceedings against CitiGroup claiming unspecified punitive damages on top of the £1.5 billion plus write down of its investment.
Many recent private equity loans were cov lite (covenant light); that is, they lacked the usual protective covenants requiring borrowers to meet financial tests, typically minimum amount of shareholders funds, loan to equity ratios and minimum coverage of debt and interest payment by the borrower's earnings or cash flow. Some loans, known as 'toggle' loans, included a pay-in-kind (PIK) feature where borrowers have the option to pay interest by issuing an IOU. This means that the lender cannot declare default in the absence of a failure to make scheduled cash payments— deferring recognition of problems. In the absence of a significant recovery in economic conditions, further losses may be expected to occur.
Borrowers face significant refinancing risks. Over the next 5 years, over $4.2 trillion of debt will need to be refinanced, including $2.7 trillion of CRE loans (peaking in 2011) and $1.5 trillion of leveraged loans (peaking in 2014). Securitization (CMBS and CLO (Collateralised Loan Obligation)) markets that were crucial in funding CRE and private equity transactions remain troubled.
According to one estimate, if the CLO market remains closed and half of the 2012-14 leveraged loan maturities were refinanced in the high-yield bond markets, then issuance volume would need to be double the 2006 peak in high-yield bond issuance to accommodate this requirement. Similarly, the equity injection needed to re-finance commercial real estate debt maturing by 2014 is estimated at between $200-750 billion. Default and re-financing risk remain high. The problems of Dubai World, in substantial part, relate to commercial property refinancing.
Real Bad
The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. As Wells Fargo CEO John Stumpf told The Wall Street Journal on September 19, 2009: "If it's not a government program, it's basically not getting done". Private demand remains somnolent. The problem remains as government incentives encourage current consumption and investment but ultimately "steal" from future demand.
Employment, a key indicator given the importance of consumption in developed economies, continues to decline, albeit at a gentler pace. In the U.S., unemployment reached 10%. Despite attempts to put positive spin on the numbers, the rise in U.S. unemployment was the highest recorded since World War II.
In many countries, enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen. Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long-term and youth unemployment also remains high.
European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment has been the new "export" as guest workers are shipped back to their country of origin or remittances home fell sharply. U.S. economic activity is not generating the 200,000 to 250,000 jobs per month that would allow unemployment levels to fall. In addition, many newly created jobs are part-time, casual, or at lower income levels.
Economic uncertainty has increased saving levels further, crimping consumption. In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure.
In the U.S., dividend cuts have resulted in investors losing approximately $58 billion in income in 2009. It is unlikely that dividends will recover to 2007 or 2008 levels until 2012 to 2013. The ability to borrow against rising asset prices to fund consumption is now rarely available.
In 2009, global trade stabilized after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009, world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. The OECD reported that G7 exports stabilized in Q2 2009, levelling off at a year-on-year decline of 23.3%. There is concern that trade flows in late 2009 were stagnant or had declined as the effects of government stimulus, inventory restocking and Chinese commodity purchases slowed.
Trade protectionism threatens recovery in global trade. Despite repeated statements reaffirming a commitment to free trade, most countries have implemented implicit and explicit trade barriers. Traditional techniques (tariffs, embargoes, subsidies) have been supplemented by "buy local" programs, selective industry support schemes and directed lending to domestic borrowers. Emerging markets have been aggressive in introducing protectionist policies. Trade disputes may increase, particularly if economic recovery stalls and unemployment remains high.
Stock prices assume a rapid recovery in corporate earnings. Beating much reduced expectations and a return to previous earnings levels are easily confused. The "E" in the P/E ratio remains difficult to forecast. Equity pricing assumes a return to 2006 levels when U.S. corporate earnings represented a record share of profits in GDP.
In 2009, full year earning per share for the S&P 500 were around $60, down from $65 in 2008 and 30% below peak earnings of $85 recorded in 2006. In 2009, company results reflected the effects of aggressive cost cutting and the benefits of government support. To return to pre-crisis levels and rates of growth, improvements in revenue and underlying demand are necessary.
Stocks are also not cheap. Jeremy Grantham, founder of Boston-based fund manager GMO, recently noted ruefully that after 20 years of more or less permanent overpricing of the S&P 500, the market saw just five months of underpricing after the March 2009 trough. Growth in emerging markets reflects the effect of aggressive government policies to stimulate the economy both at home and in developed countries.
Emerging markets, led by China, India and Brazil, implemented anti-cyclical spending programs that in percentage terms were larger than those in developed markets. Emerging markets preserved or introduced social spending programs to protect more vulnerable parts of the population. They also benefited from the government spending in developed economies, which flowed into emerging market exports.
The spending has fueled speculative booms in emerging markets and also in commodity suppliers who now function as proxies for direct exposure to China and India. The boom was exacerbated by the rapid flow of funds into emerging markets. In 2009, inflows into emerging market equity funds increased to $80.3 billion, well above the $29.5 billion previous record in 2007 and the highest since 1997 when data was first recorded.
The inflow compared to outflows of $86 billion from developed world equity funds in 2009 as investors sought exposure to faster growth and better prospects in emerging markets, especially the BRIC (Brazil, Russia, India and China) economies. The small size of emerging markets accentuated the effect of these inflows. Emerging markets traded at about 20 times their trailing 12-month earnings at the end of 2009, compared to about 8 times in March 2009. Potential disappointments in the rate of improvement in developed economies or a reassessment of the prospects of emerging markets remain potential risks during 2010.
Bad Fiscals
From late 2008 onwards, government intervention, on an unprecedented scale, has been a dominant factor in economic matters. Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment. Central banks have maintained low interest rates, pumped liquidity into the financial system and "warehoused" 'toxic' assets to support the financial system.
In the U.S., Fed holdings of MBS reached around $1 trillion. The purchases provided much needed liquidity to banks and reduced potential write-down on these securities. They also helped keep interest rates low and maintained the supply of housing finance.
The takeover of and government support for Government Sponsored Enterprises (GSE), such as the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), was an integral part of the process. The U.S. government has now agreed to provide unlimited support to Fannie and Freddie. Governments and central banks around the world followed the U.S. lead, implementing similar measures.
Even emerging markets introduced aggressive cash transfer and make-work schemes allowing their fiscal positions to deteriorate. Brazil expanded its popular "Bolsa Familia" assistance scheme for poor families. India also expanded a program guaranteeing 100 days public work employment scheme in rural areas.
Financing these initiatives presents significant challenges. In the five quarters ending September 30, 2009, U.S. Treasury borrowing and outstanding GSE-guaranteed MBS increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).
In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances. Credit default spreads on sovereign debt for most issuers decreased in line with the general fall in credit margins.
Central bank purchases under quantitative easing (read: printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed asset purchase, quantitative-easing programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2 trillion.
Large deficits are likely for some years. Continued spending and reduced tax income will ensure significant ongoing financing requirements. In the absence of a sharp and significant return of growth, the budgetary position will remain difficult. In many countries, the deficits are structural and not entirely related to the GFC.
Foreign purchases of U.S. debt (the largest single borrower) have increased in dollar terms but decreased as a percentage of the total, as new issuance outpaces growth in demand. If the global economy slows and the inevitable adjustment in global imbalances takes place, the U.S. will purchase fewer foreign goods, reducing foreign current account surpluses and the U.S. dollars available for purchasing future Treasury securities. Chinese demand, which has underpinned recent foreign purchases, is uncertain in the future.
Zhu Min, Deputy Governor of the People's Bank of China, recently observed that "the world does not have so much money to buy more U.S. Treasuries." He added that "the United States cannot force foreign governments to increase their holdings of Treasuries " While increasing domestic savings and mandatory purchases by banks may provide some demand, it is not clear where successive large deficits are to be funded. Most deficit nations face similar challenges.
Recently, large investors including Pimco, one of the world's biggest bond fund managers, have reduced exposure to U.S. and U.K. government bonds, warning that the record levels of issuance is becoming increasingly problematic. Current initiatives mean that public debt in most countries, even many emerging markets, will increase sharply straining fiscal flexibility. For example, Japanese public debt is approaching 200% of GDP and government borrowing now exceeds tax revenues. In emerging markets, many new spending programs may prove difficult to discontinue politically.
The problems of government finances are not confined to national governments. In the U.S., the fiscal problems of major states, some larger than many foreign countries, is well documented. Ultimately, governments will have to balance the books.
With projected public debt as of 2014 at or around 80-100% of GDP (with the dishonourable exception of Japan), the IMF estimates that just to maintain public debt levels, major developed economies will have to run budget surpluses of around 3-4% of GDP [[for a number of years— something that few, if any, OECD countries have done even in the recent boom years.: normxxx]] Ireland, Greece and Spain provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country's history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut.
More recently, Greece and Spain proposed austerity programs focused on major spending cuts and tax increases. The impact of such fiscal programs on growth and social harmony is likely to be severe. Credit rating agencies may downgrade sovereign borrowers. Many major government bond investors, such as central banks, sovereign wealth funds, pension funds and asset managers, have investment mandates that limit them to AAA and AA securities.
Central banks typically restrict the use of lower rated government bonds as collateral in repos (repurchase agreements) in secured borrowings. Downgrades below AA may increase the difficulty for some countries to raise debt, particularly in international markets. Lower ratings will also increase the cost of borrowing and that, in turn, will affect the ability to continue to finance government spending. In particular, the large outstanding stock of government debt means a large portion of the budget will need to be directed to servicing interest— further restricting government spending on other initiatives.
The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: "I want to come back as the bond market. That's where the real power is. You can intimidate everybody". Politicians everywhere will learn the reality that in Thatcher's terms: "You can't buck the markets."
Focus in the short run will be on the PIGS (Portugal, Ireland, Greece, Spain). Net external debt of the PIGS is: Portugal €177 billion (108% of GDP), Ireland €123 billion (68% of GDP), Greece €208 billion (87% of GDP), and Spain €950 billion (91% of GDP). If the risky debt of Eastern European countries is added, the total amount of debt in question approaches €2 trillion.
In the longer term attention will shift, inevitably, to major economies with high levels of government debt— the FIBS (France, Italy, Britain, States). At least, Japan has its very large pool of domestic savings [[but which is fast fading.: normxxx]] In February 2010, after the U.S. Governments announced budget estimates forecasting large deficits for the foreseeable future, ratings agency Standard and Poors issued the following warning:
|
Bad Policy
Governments and central banks have dealt with symptoms but not addressed the underlying causes of the GFC. The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt.
Despite some regulatory initiatives, many of the excesses of the financial system remain. The reliance of debt fuelled consumption and the related issue of global imbalance remains in the "too difficult basket". Few, if any, lessons have been learned, especially by bankers. Large bonuses are merely emblematic of a return to old practices. Leverage and pre-crisis lax lending conditions are returning to sections of the market.
Policies assume that the problems relate to temporary liquidity constraints resulted from 'non-functioning' markets for some financial assets. They fail to acknowledge the severity of the problems and the extent to which the previous high prices of some assets reflected excessive liquidity that overstated their true value. Policy makers assume that liberal application of liquidity— financial 'botox'— represents a permanent cure. In Albert Einstein's words: "You can never solve a problem with the thinking that created it."
At best, governments are hoping that 'loose' money will create inflation, allowing reflation of asset prices, and thereby alleviating the worst of the problems. The morality of punishing savers and rewarding excessive borrowing has not been debated. The reflation hypothesis itself may be flawed. Inflation probably needs convergence of several conditions— excessively loose money supply, active lending by banks to increase the velocity of the money and an imbalance between supply and demand.
Loose money supply by itself may not be sufficient to create inflation. In Japan, years of loose monetary policy and 'quantitative easing' have not prevented significant deflation over the last two decades. The other conditions are not currently observable. Problems within the financial system have slowed the velocity of money [[to record low levels never before seen. : normxxx]] Capacity utilisation is generally low and over capacity exists in many industries.
Excess capacity is being increased by government actions. Support for industries, such as the automobile manufacturers and housing, prevents required adjustments to capacity. At the same, government spending, for example in China, is increasing capacity in anticipation of a return of high demand. If high demand does not re-emerge, then there is a risk that excess capacity may exert severe deflationary pressures. Further trade problems, through dumping and other defensive trade tactics, may result.
In the short term, high levels of inflation appear unlikely. Only commodity supply constraints, eg, causing higher energy and food prices, have prevented outright deflation in recent times. These two items represent a high proportion of spending in emerging markets. But high energy and food costs reduce available disposable income, thereby reducing demand of other products at a time when these economies are trying to increase consumption.
Given that re-risking assumes high inflation, changes in inflationary expectations may affect asset markets and in turn the path of the recovery.
Bad Choices
The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk nor by regulators nor by governments. This experiment is now coming to an end.
In the post World War II period, the U.S. and global economy enjoyed strong growth and increasing living standards. Yet despite significantly higher debt levels most recently, economic growth and improvements in income and wealth have slowed significantly. For the U.S., the first decade of the 21st century— the noughties— have been disappointing.
Economic growth has been the slowest in the post war era. There has been no net job creation over the decade. Median income and, in particular, income levels for middle income earners declined in real terms. Household net worth, representing the value of their house, pensions and other savings, also declined.
A similar pattern is evident in many other developed economies. Emerging countries and their citizens have done better, but off significantly lower base levels. Some of the money, largely borrowed, was invested in assets that produced and will produce little, relative to the prices paid.
This includes overpriced housing (the "McMansions"), commercial real estate and consumer "must-haves." Investment in these assets distorted economic activity around the globe. The excesses must be worked-off. The problems are pervasive. Few groups— consumers, businesses, governments— or countries are unaffected.
The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and overcapacity is possible while individuals, firms and governments repair balance sheets.
Bad Love
The financial market rally may not be over. There is a chance of a melt-up before any meltdown. Riding an irrational price bubble is sometimes an optimal investment strategy even for rational investors. As an unnamed banker told Charles MacKay, author of the 1841 book, "Extraordinary Delusions and the Madness of Crowds" (1841): "When the rest of the world is mad, we must imitate them in some measure."
Governments may introduce provide further support if economic and financial setbacks occur. Further fiscal stimulus packages are likely to be unveiled. Credit Suisse's Neil Soss summed up the monetary policy position succinctly:
|
The risk of policy errors is ever present. Inopportune withdrawal of support or policy mistakes has the potential to be destabilising. High levels of volatility are likely to persist. [[Further financial "accidents" or "crises" are to be expected, accompanied by market "panics". : normxxx]]
Governments and central banks may be expected to continue to inject liberal amounts of 'botox' to cover up problems, at least, while supplies exist. In the absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward [[hopefully, to the next 'shift' of personnel: normxxx]]. This means that the unavoidable adjustments when they occur will be all the more severe and painful. The ability of policymakers to cushion the adjustment will be restricted by constrained balance sheets.
In the words of David Bowers of Absolute Strategy Research:
|
The exact trigger to end the current period of optimism is unpredictable. While several areas of stress are apparent, as Keynes observed: "The inevitable never happens. It is the unexpected always". The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson's "Girl with the Dragon Tatoo": "Armageddon was yesterday— Today we have a serious problem."
Satyajit Das is a risk consultant and author of soon to be released "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives"— Revised Edition (2010).
ߧ
Normxxx
______________
The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
No comments:
Post a Comment