Tradesense

Where is the US consumer crisis heading?

2009-08-17T19:55:00.009+05:30

It has been a while since I posted – was caught up in some personal issues and could not put my thoughts down. Having discussed many of the current hot issues including China before, it is becoming difficult to keep turning the same wheel again and again which many seem to be adept in doing. Let’s anyway look at some of the current concerns many of which were discussed earlier and then take a view.

As regards China it was identified in May 09 itself that:

…China doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot; to keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system re-stabilizes.

It’s literally forcing banks to lend - which will create a huge pile of horrible loans on top of the ones they’ve originated over the last decade (though of course we can’t see them). Don’t confuse fast growth with sustainable growth. As I’ve discussed in the past, China is suffering from Late Stage Growth Obesity. A not-inconsequential part of the tremendous growth it’s seen over the last 10 years came from lending to the US. Additionally, the quality of late-period growth was, in all likelihood, very poor, and the country now suffers from real overcapacity.

Identifying bubbles is a lot easier that timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer inflated prices persist, the harder they fall when financial gravity brings them back to earth.”

It was also noted in early June 09 that:

…However, if there is to be a risk of a credit crisis in the future in China, similar to the one that has unfolded in the United States and Europe, the country would need to lack any other possible engine of growth.

In the United States and Europe, if credit had not outpaced incomes, growth would have been close to potential growth, i.e., in view of productivity gains and growth in the working-age population, around 2.25% in the United States, 1% in the United Kingdom and 1% in the euro zone. Credit was used to ensure more robust growth than would otherwise have been recorded.

In China, the current economic recovery is driven by credit; but there are exceptional circumstances with, for instance, the decline in China’s exports due to the contraction in global trade.

In a normal regime, productivity gains are high and potential growth is robust in China, and this rules out the need for a durable increase in indebtedness to stimulate growth.

However, it may well be that the current vigorous upturn in credit, driven by the government’s instructions, with loans extended at very favorable conditions for borrowers, could lead to the reappearance of non-performing loans in banks’ balance sheets, and the Chinese government will likely have to pay for them in the future as it already has done in the past.

And in January 09 it observed that:

The $584bn.China stimulus is expected to start having some impact from the second quarter. But the main factor would be the expected revival of the western markets after the second quarter which would then give a fillip back to Chinese exports. If this for some reason does not happen or is delayed than we may see some serious dumping by China causing prices worldwide to fall and adding to the deflationary trend. This could lead to protectionist tendencies to increase leading to a global slowdown in trade with attendant political and economic consequences.

As regards the market and FED it was observed in early May 09 that:

…The feel good factor is back. Many experts opine that we have indeed put in a bottom and that with due corrections we shall now march upwards. The fact that most were talking about a recovery that would be shaped L, U, W etc., contrary to the expectations as markets usually do, many experts think the market in its wisdom has sought a V shaped recovery….

…This is not to say that some of the macro parameters have not improved. But this sharp move up of the market has its consequences. The increasing appetite for risk has seen the US 10 year yield move up to 3.2% and the mortgage rates are up from around 4.7% to around 5.2%. And as explained in a previous post sharp up moves in equities is going to make the treasury and the Fed’s trillions of borrowing more expensive pushing up the interest higher which will increase risk for taxpayers and the country dramatically. Hence while printing money the Fed and treasury have to do a fine balancing and that means the interest rates still needs to managed within reasonable levels. This is not going to be easy and is going to be a fine line to tread on, not knowing where the line is.

Now here is the catch. On the one hand this would mean funding the bailouts is going to be more and more difficult and expensive while on the other hand liquidity will find its way to other asset classes. While the short term shift in liquidity to stocks and other assets may move these markets, sooner than later the reality of high interest rates and the inability/difficulty of funding the bailouts other than through FED buying more and more treasuries (printing money or quantitative easing) will become apparent. This we have experienced many a times is a sure shot formula for asset prices to finally form a bubble and lo! we are back to square one.

To me the market players should not get euphoric with current move. The players shifting their liquidity to the market to create such sharp moves would be actually shooting at their own legs. A measured slow consolidation is required and sharp move in asset prices will put the medium to long term sustained recovery in jeopardy. This whole process will be time consuming – running into number of years and the market player’s own action on a collective basis of how they handle this liquidity is going to determine how long the markets may take to make a long term sustainable up move.

On why the seeds decoupling have been sown, it was observed in February 09 that:

…As I see the lessons learnt/being learnt during this severe downturn will have a lasting impact as these Asian countries now re-orient there industrial and fiscal policies to ensure that over dependence on exports is reduced in the years to come. Also trade within the region will now be a much greater focus as two of the most populous countries in the region ‘Chindia’ look to push their growth with policies that are much more domestic investment and consumption oriented. India always was domestic consumption story (save the IT and IT enabled services and Generic Pharmaceutical industry) and now can be regarded as a great advantage.

… the reorientation will be challenging and will take time – a decade or so. But as the US and European consumption story sees its twilight in years to come it is the Asian and some of the resource rich countries such as Brazil that will need to fill-in. And as this re-orientation sees initial success foreign capital (US and European savings) will start seeking these countries and the capital required to sustain a reasonable growth rate will find its way. The seeds for this shift – possibly a power shift too - appears to have been sown.

The point to be understood is that normal downturns/recessions happen due to businesses over investing and generally the interest rates shooting up (through central bank actions) because of inflationary concerns causing demand to ease. The overcapacity brings down prices and as inflationary concerns diminish the interest rate environment softens and we see demand picking up and capacity utilization also move northward indicating revival. The underlying money circulatory system or credit delivery generally remains in reasonable health, although specific concerns may be there.

However the genesis of the current downturn/recession is the failure of this underlying system of credit delivery and money circulation which has its own attendant consequences. The businesses and consumers got into trouble because what they thought was a given (within a certain flexibility band of size or amount and price of credit) suddenly found the ground dry and had to face tight liquidity situation and thereby cut production/purchases etc.

The former situation is akin to an organ or two malfunctioning and with some external medication which can reach the organs through the circulatory system and body’s other organs/systems responding in help, the health can be restored reasonably fast – V shaped recovery. But if the body’s circulatory system is itself damaged and is the cause for other organs malfunctioning it becomes a real challenge to restore the health of the person as the medication has to given directly to the organs in the hope that their improving condition would stimulate the circulatory system and thus the patient’s health can be restored. How this will pan out is difficult to say – L, W, U and hopefully not X.

As Washington Post notes:

“…Growth spurts can emerge, and it appears increasingly likely that the U.S. economy will grow at a solid pace in the second half of the year, as companies restock depleted inventories. But it is unclear what would come after that, given the ongoing restrictions on credit.

U.S. banks have sustained massive losses already, and a wave of soured commercial real estate loans threatens to further limit their ability to lend in the year ahead. A bigger problem looms outside of banks -- in credit markets, which account for vast chunks of mortgage lending, consumer loans and commercial real estate loans. This shadow banking system remains dysfunctional -- notwithstanding a slew of programs the Fed put in place to get it going again -- and no one is sure when or whether it will recover.

All that makes it more expensive for people or businesses to borrow money -- if they can get a loan at all -- which could serve as a powerful brake on any recovery.

"Credit fuels housing. It fuels consumer durable goods. It fuels business investment. It's in every part of the economy," ... "Credit makes recessions after a financial crisis longer, and all the signs are that [it] is happening this time as well."

…The financial crisis and recession are reversing a 30-year trend carrying Americans toward a high point in debt. The ratio of consumer debt to the nation's total economic output rose to 97 percent in the first quarter of this year from 45 percent in 1975.

Currently, Americans are saving more and paying down debt; the savings rate was 1.2 percent of disposable income in early 2008. By the second quarter of this year, that rose to 5.2 percent.

Every dollar that Americans save is one fewer dollar for consumption, which means less economic output. When the savings rate goes up by a percentage point, spending decreases by more than $100 billion…”

So what will bail out American, Chinese and other businesses that are so dependent on the US consumer? The answer to this is the growth of the merging market consumers. As noted above as the US consumer dependant economies focus more on internal consumption and make moves to improve the living standards of their populations through better infrastructure, creating more job opportunities etc., the demand for goods worldwide will start looking up over time. American businesses will have to position themselves to exploit this opportunity.

Remember what the US consumer saves has to find its way to businesses or consumers elsewhere. This capital will flow to where the growth opportunities are – the emerging markets. And as these markets start providing the depth in demand (because of sheer numbers and necessarily due to credit explosion in these countries), American businesses will find its footing in the scale that they were/are used to. This reversal of fortune is going to take a lot of time. US companies already established in these regions will be the first to experience this shift and those focused within the US will have to think globally.

Slowly the cycle will turn, but for now situation seems too challenging for comfort.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

Have Banks Learnt Anything From The Financial Crisis?

2009-06-20T18:06:00.025+05:30

With so much water having flown after the financial crisis I was wondering if anything has really changed in the way the key banks do their business. I came across an interesting Natixis special report which threw light on this and I thought I should share some of the key aspects of this report for you to make the judgment.

The report starts with a question:

What is normally expected to happen with finance after the crisis?

Consensus seems to be that after the crisis finance will be

-More regulated, and supervised by governments, especially as many banks are partially nationalized;

-Simpler, due to the disappearance of the demand for complex financial assets (ABS, structured products, complicated exotic options, etc.);

-More cautious about risk taking (reduction in risk limits, increased capital consumption, different compensation systems for trading floors, etc.).

But do the current developments reflect it? Let’s first look at existing background in which many banks are operating.

-Many banks in the United States and in Europe have been recapitalized by governments, so much so that some of them are practically nationalized.

-All these banks have also benefited from debt issuance guaranteed by the government.

-The aid provided by governments has been accompanied by conditions, generally regarding the compensation of management, traders, etc. This also entails a reduction in the volume of risk operations (proprietary trading).

It is striking to see that, in the recent period, many banks would:

− On the one hand recapitalize, in order to comply with the conditions (stress-tests) set by governments;

− On the other hand repay governments, in order to no longer be subject to constraints affecting the way they run their business (Table 1). This is particularly striking in the United States.

These banks in all likelihood want to return to an investment bank model close to the one seen before the crisis.

Table - 1

On 9 June the Treasury authorized 10 banks to repay the funds injected in the autumn of 2008 by the government, for a total amount of USD 68 bn.(Table2)

Table - 2

The recent period has been marked by a nose-dive in investor risk aversion (Chart 1), and, without delay, a return of demand for complex (toxic) assets, a demand that was believed to have disappeared for good:

-CDOs, as shown by the tightening in CDS spreads (Charts 2A and B);

-CLOs, as shown by the rise in the prices of leveraged loans (Chart 3); etc.

It is therefore not true that investors will only be interested in simple assets going forward.

Global liquidity is extraordinarily abundant (Chart 5), due to the highly expansionary monetary policies conducted since the start of the crisis on top of the previous surge in official reserves.

As soon as investor risk aversion decreased, asset price bubbles reappeared: surge in emerging-country equities (Chart 6), rise in the oil price despite the situation of excess supply in the market (Charts 7A and B).
This demonstrates:

-some banks have not changed their business model; (not wanting to learn from the previous experience).

-demand for complex financial assets has in reality remained brisk; (investors are still playing suckers).

-the excess liquidity is still causing asset price bubbles, which once more demonstrates the central banks’ responsibility in the financial chaos;(Central Banks are working hard to create another bubble).

Amen.

Disclosure: No Positions

Why the US stock market is stalling?

2009-06-07T19:38:00.009+05:30

That the US and the Global economy are moving towards stability has been indicated by the rising oil and base metal prices as well as the stock market performance from the middle of March09. The surprising jobs data at a job loss of 345k against a much higher expected number, while did reaffirm the fact that the US economy is moving back to normalcy, the stock market reaction which one would attribute to such a margin of surprise was missing. Clearly this seems to have some other implications which the players are factoring-in.

Explanations could be along these lines.

-Home prices appear to have hit bottom in some areas of the country, but construction remains weak.

-The auto industry and retailing remain in distress. The job market is likely to remain in the doldrums for many months.

-A home foreclosure crisis is growing … As more foreclosed properties land on markets, real estate prices are falling further, adding to the losses and uncertainties confronting banks.

-Wage growth has been stagnating even as gasoline and medical costs rise, putting pressure on household finances. Average hourly wages were 3.1 percent higher last month than they were in May 2008, but the month-to-month increases in April and May were just 0.1 percent, to a seasonally adjusted $18.54, from $18.52, according to the Labor Department. Wages for manufacturing workers fell 0.1 percent.

-The jobs report presented a statistical puzzle. After shedding an average of more than 700,000 jobs each month during the first quarter, the economy lost 504,000 jobs in April, according to revised data, and the number was smaller still in May. Yet the unemployment rate leapt from an already high 8.9 percent, reinforcing fears it would reach double digits.

This disconnect owes to the way in which the government collects data. The number of jobs comes from a survey of employers, while the unemployment data is derived from a survey of households. In April and May, the number of people who told surveyors they were actively looking for work increased by more than one million. These people would have previously been considered outside the work force and thus excluded from the unemployment calculation. Now, they are officially back in the hunt, yet struggling to secure work.”

And to me this discomfort comes from the rising treasury yields. Says a NYT report

“The Treasury’s benchmark 10-year note fell 30/32, to 94 7/32, as investors edged away from buying government debt in the face of exploding federal deficits.

The yield, which moves in the opposite direction from the price, rose to 3.83 percent, from 3.71 percent late Thursday, and was up from 3.46 percent a week ago.

The creep toward higher interest rates represents a return to normalcy in some ways…
But higher interest rates on Treasuries make it more expensive for the government to borrow trillions in new debt, and they also raise mortgage rates for home buyers, threatening the government’s efforts to keep borrowing costs low.

But higher interest rates on Treasuries make it more expensive for the government to borrow trillions in new debt, and they also raise mortgage rates for home buyers, threatening the government’s efforts to keep borrowing costs low.”

This is something I have mentioned in my previous post as a key risk for the US market and is now emerging an important headwind.

A Miller Tabak + Co., LLC report brings out the concerns even more clearly:

“The action in the two year note today where the yield is up a dramatic 30 bps to 1.25%, the highest since mid November, is happening coincident with a move higher in yield in the fed funds futures contracts where the market has somewhat reset their expectations of what the Fed will do. The fed funds futures are pricing in a 48% chance of a 25 bps rate hike by the September 09 meeting and that is up from a 2% chance priced in just yesterday.

After today’s better than expected payroll figure being the main catalyst for today’s action in conjunction with the ever growing inflation concerns, the Fed needs to decipher what is a readjustment of growth expectations and/or what is related to inflation concerns and whether they will fight these trends in order to keep interest rates low.

Reading comments from Fed President and voting member of the FOMC Yellen within the past 15 minutes does not give much confidence that they know what’s going on and it seems that they had very little of a game plan going into their QE policy. Using quotes from DJ, she said that while buying MBS and US treasuries got off to a good start with yields heading lower, “there’s a lot that central bankers don’t know about the magnitude and duration of the effects of these policies” and “our standard monetary policy models do not incorporate financial frictions that lead to asset purchases having real effects.” She went on to say “we lack both the data and theory to provide strong guidance on these policies” and “we are sailing in uncharted waters, marking our maps with every bit of information along the way.” Yellen is a career economist and ex school professor so she’s learning first hand what its like to mess with the market. I’m worried if other Fed members are this uncertain.”

Fed not knowing what it is up to is a concern expressed before.

Another commentator albeit in a different context brings home the point regarding the long term yields.

“Listen, what really matters to energy prices these days is the perceived value of the dollar and the perceived ability of the government to stop its massive spending binge. Oil has been moving because of the disturbing widening of the yield curve that seemed to suggest that the government’s ability to keep rates down in the long end would make every dollar the government spends that they do not have more and more expensive to pay back. Oil moved because it saw the threat posed by the widening yield curve and it expressed those concerns with soaring gold and silver prices, ratcheting up copper prices. Not to mention talk in recent weeks that the untarnished best in the universe debt rating of the United States of America’s was even rumored to be downgraded.

And you Mr. Grumpy Bernanke have to go ruin it all by saying enough is enough. Why tell the Senate and Obama and the rest of America that we can’t have our cake and eat it too? I like cake! Don’t tell us that we cannot have it all like universal health care, finance Social Security, buy out auto companies, bail out Fannie and Freddie, massive stimulus packages and speculating in the green energy space and at the same time drive down the dollar and make commodity speculators rich. What kind of downer talk is that? Whenever you think that way remember there has never been anything false about hope. We have faced down impossible odds. We've been told that we're not ready, or that we shouldn't try, or that we can't afford it because our budget deficits threaten financial stability or we can’t because of our threatened ability to borrow indefinitely to fund a budget deficit that already this year is estimated to be $1.85 trillion, equivalent to 13 percent of the nation’s GDP the highest level since World War II. Or that we can’t because we are on path that will make this country bankrupt, just remember that generations of Americans have responded with a simple creed that sums up the spirit of a people. Yes we can! Yes we can! Commodity bulls all over the world thank you.”

Assuming the US authorities do get their exit strategy right and is able to balance the rate vs. growth concerns - will the global developments allow this to happen? To me it looks extremely difficult. According to a Natixix special report:

“The rise in long-term interest rates (particularly in the United States) is very bad news, since a fall in long-term interest rates was the only policy left for central banks.

What accounts for this rise?

− Inflationary risk due to the scale of monetary creation? But if expected inflation rises, there is no real inflation risk and, moreover, the US and European economies will remain very weak for a long time to come;
− Crowding-out effects due to the size of the expected public debts? But private indebtedness continues to fall and the savings rates keeps rising;
− Contagion from higher returns that can now be obtained, for instance on emerging-country equities, due to the economic recovery in Asia?

This third argument (correlation of bond yields in the United States and Europe with returns on other financial assets) seems the most reasonable in our view; it corresponds to a return of capital flows to emerging countries.”

And will emerging countries be able provide a much higher sustained returns to keep this flow sustained. To me this looks a possibility although it does tread into the decoupling argument which I had dealt in a previous post.

Natixix looks at China’s ability to sustain a 9%+ growth on the following lines. In the context of the growth in credit in China (which can be applied to many large emerging economies) it says:

“…However, if there is to be a risk of a credit crisis in the future in China, similar to the one that has unfolded in the United States and Europe, the country would need to lack any other possible engine of growth.

In the United States and Europe, if credit had not outpaced incomes, growth would have been close to potential growth, i.e., in view of productivity gains and growth in the working-age population, around 2.25% in the United States, 1% in the United Kingdom and 1% in the euro zone. Credit was used to ensure more robust growth than would otherwise have been recorded.

On the other hand:

“Productivity gains, in China, are accounted for by what are normal factors in an emerging country:

− Migration from the countryside into cities, as the productivity of migrants improves significantly, as is reflected by the income differential between cities and the countryside;

−Very high level of investment;

− Technology transfers via direct investment.

…growth can be estimated at 9% per year at least. There is accordingly no reason why it would be necessary, in a normal situation, to boost demand by credit in China, and this in fact explains the medium-term stability of the credit-to-GDP ratio in China...

...The causes of productivity gains in China are durable, and this implies that potential growth will remain robust for a long time, resulting in a situation where there is no long-run need for a sharp rise in debt ratios.

In the United States and Europe, the low level of potential growth in comparison with the robust growth one wants to achieve has led to a steep rise in debt ratios being used, and this sparked the crisis because of excess indebtedness.

In China, the current economic recovery is driven by credit; but there are exceptional circumstances with, for instance, the decline in China’s exports due to the contraction in global trade.

In a normal regime, productivity gains are high and potential growth is robust in China, and this rules out the need for a durable increase in indebtedness to stimulate growth.

However, it may well be that the current vigorous upturn in credit, driven by the government’s instructions, with loans extended at very favorable conditions for borrowers, could lead to the reappearance of non-performing loans in banks’ balance sheets, and the Chinese government will likely have to pay for them in the future as it already has done in the past.” (US & Europe are no different).

Disclosure: No Positions

Copyright © 2008-09 Tradesense

Stress Test For The Street

2009-05-10T19:13:00.009+05:30

Funny are the ways of Street…but street is most honorable…and it cannot be wrong…never fight Mr. Market. If you do you would be mauled. But in 2007 those who went against the street benefitted the most. The street does loose its head and there are those phases when not all the facts/news is factored-in. The art is to figure out as to when Mr. Market would look to redeem the honor. This becomes all the more difficult when the stakes of the mighty are involved and for some period they are able to manage the street to their ways. With the bank stress test climax the stress test for the street has begun.

NYT reports

"A day after the bank stress tests were released, two major institutions, Wells Fargo and Morgan Stanley, handily raised billions of dollars in the capital markets on Friday to satisfy new federal demands for more capital. A third, Bank of America, hastily laid out plans to sell billions of dollars in new stock.

The speed and ease with which the banks swung into action, combined with a surge in financial shares, was hailed as a sign that confidence was returning to the financial industry. The sales seemed to put to rest questions about whether big banks would be able to lure private investors, rather than have to turn to the government again.

Before the results were made public, many of the larger banks successfully pushed the government to minimize the capital they needed to raise.

…With some off to such a rapid start — Goldman Sachs raised $5 billion before the stress test results were announced — the race is now on among the most robust to repay the government money they received last fall and so escape from government control. "

Most probably they not want to loose the control over the government?

The script which I mentioned in my previous post is unfolding further. The models and inputs, it is understood were provided by the industry and it is understood that the inputs for the test were not independently checked for its veracity thoroughly. 180 examiners examining 19 banks, many with very large and global operations over eight weeks could have seen only what the banks wanted them to show. Anyone who has worked in bank operations would vouch for that. And the icing was that the banks could negotiate the capital it required! Further the scenarios for which the banks assets were stressed were according to keen observers, was a little too optimistic. Also the fact that there were leaks which now match the actual also lend credence to this stage management. It would be good to find out as to who invested in the bank issues. The quirky feeling is that TARP money in getting circulated indirectly. Competitors holding hands for a cause!

The NYT report quotes Meredith Whitney:

"But Meredith A. Whitney, a prominent banking analyst, said the results underscored the difficulties banks faced.

“The revenue environment is very different,” Ms. Whitney said. Given the recession, banks are not going to make much money from credit cards or originating mortgages, she said. And even if all the banks secured more capital, they still might not lend, holding back the economy."

The same report says:

"Despite the sobering outlook, the mood on Wall Street was generally upbeat after the rosier-than-expected assessment of the biggest banks. The stock market climbed, with the Standard & Poor’s 500-stock index gaining 2.4 percent on Friday.

“If there were holes in this, the market would have seen it,” said Stuart Plesser, an analyst at Standard & Poor’s."

I wish the market had seen the coming of sub-prime in 2005-06 and the rating agencies it appears are never going to learn! Or probably they are also the part of script!!

To me all this is blind (Treasury & Fed) leading other blinds (banks) in the hope that miraculously both will suddenly find vision. First part has been enacted to make the audience (street) believe that both indeed have sight. How far these players are willing to take this make-belief is anybody’s guess. To me the stress test for the street has only begun.

For the sake of so many retail investors I do hope that the miracle does happen.

Disclosure: No Positions

Manipulonomics

2009-05-03T21:51:00.009+05:30

The feel good factor is back. Many experts opine that we have indeed put in a bottom and that with due corrections we shall now march upwards. The fact that most were talking about a recovery that would be shaped L, U, W etc., contrary to the expectations as markets usually do, many experts think the market in its wisdom has sought a V shaped recovery. Even the bulls have been taken by surprise at the swiftness and the ease of the up move. What started as a short covering in financials following the leak of Citi’s internal memo stating profitable operations with BOA backing it up and Wells Fargo following it up with a pre-result announcement it appeared a well coordinated effort. And then there was this panic that set in – panic buying. To me this appeared a well prepared script. When you have to move anything heavy say a huge log, the initial efforts are huge and once it rolls, it rolls with slight push thereafter. Once the shorts covered, the institutions which have their hearts in their hands and have been funded by taxpayers’ bonanza needed that the market cut back its negative bias were probably instructed to move it. Sentiment is a great player in how things shape up and to prop it up surely the main focus. Once moved there were others who had their urge to take risk and the scampering started?

This is not to say that some of the macro parameters have not improved. But this sharp move up of the market has has its consequences. The increasing appetite for risk has seen the US 10 year yield move up to 3.2% and the mortgage rates are up from around 4.7% to around 5.2%. And as explained in a previous post sharp up moves in equities is going to make the treasury and the Fed’s trillions of borrowing more expensive pushing up the interest higher which will increase risk for taxpayers and the country dramatically. Hence while printing money the Fed and treasury have to do a fine balancing and that means the interest rates still needs to managed within reasonable levels. This is not going to be easy and is going to be a fine line to tread on, not knowing where the line is.

Prechter explaining his logic for Dow 1000 says:

“The primary reason I believe the Dow is going to fall that far is its Elliott wave structure, which calls for it. But I can also see a monetary reason for this event. The tremendous inflation of the past 76 years has occurred primarily by way of instrument of credit, not banknotes. Credit can implode.

The only monetary outcome that will make sense of the Elliott wave structure is for the market value of dollar-denominated credit to shrink by over 90 percent. Given the eroded state of capital goods in the U.S. and the depletion of manufacturing capacity, it is not hard to see why all these IOUs have a deteriorating basis of repayment. The future has already been fully mortgaged; it's time to pay. But there is no money to pay, only more IOUs, which cannot be paid, either. So the credit supply (after a brief respite) will continue to shrink, which means that wealth, and therefore purchasing power, will disappear along with it. In the broadest sense, this change will constitute a collapse in the "money supply."

Apart from the sentiment angle there seems to be another perspective. The results of the bank stress tests. It was quite clear to the authorities that post these results many of the banks will need to raise more capital. Given the coziness that they have with many of these big banks – (this interesting NYT piece brings it out) and that the lawmakers may not be very inclined to commit more tax payer dollars, the need for market sentiment to improve was a necessity. The postponement of the stress test results is a result of contention between the banks and the treasury/Fed according to reports.

Also Bloomberg reports:

“Miller, a former bank examiner, said his estimate assumes regulators will require banks to maintain tangible common equity, one of the most conservative measures of capital, equal to 4 percent of their risk-weighted assets over the next two years, to withstand losses in case the recession worsens. The tests, originally scheduled for release on May 4, are set to be disclosed after U.S. markets close on May 7, according to a government official who spoke on condition of anonymity.

Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and the 16 other banks received preliminary results last week and have been debating the findings with regulators. Officials favor tangible common equity of about 4 percent of a bank’s assets and so-called Tier 1 capital worth about 6 percent, people familiar with the tests say. Tangible common equity, or TCE, is a gauge of financial strength that excludes intangibles such as trademarks that can’t be used to make payments. Tier 1 capital is a broader measure monitored by regulators.

“When you start talking about 4 percent on risk-weighted assets based on the stress test two years out, most banks will be required to raise more capital,” Miller said in an interview yesterday. “I believe it will be as high as 14.” He declined to name them.
Citigroup, which has already taken $45 billion in U.S. taxpayer funds to shore up its finances, may need to raise as much as $10 billion in new capital, the Wall Street Journal reported today, citing people familiar with the matter. Jon Diat, a spokesman for the New York-based bank, declined to comment.”

As one commentator pointed out that we are in the mess that we are due to various models for derivatives/securitization being used and now we are trying sort it out by another modeling exercise!! One has seen the efficacy of these exercises and of course the possibility that they may show what they believe should be, need not surprise.

Respected and well regarded investors also have very sharp points to make. Bloomberg reports:

“Berkshire Hathaway Inc. Vice Chairman Charles Munger, whose company is the largest private shareholder in Goldman Sachs Group Inc. and Wells Fargo & Co., said banks will use their “enormous political power” to prevent changes to the industry that would benefit society.

“This is an enormously influential group of people, and 90 percent of that influence is being spent to gain powers and practices that the world would be better off without,” Munger, 85, said yesterday in an interview with Bloomberg Television. “It will be very hard to accomplish the kind of surgery that would be desirable for the wider civilization.”

Munger said the financial companies spent $500 million on political contributions and lobbying efforts over the last decade. They have a “vested interest” in protecting the system as it exists because of the high levels of pay they were earning, he said. The five biggest U.S. securities firms, only two of which still exist as independent companies, paid their employees about $39 billion in bonuses in 2007.

“They would like to get back as closely as possible to business as usual, and they have enormous political power,” he said.”

There are some other very valid points of view that are difficult to ignore:

1. Since last fall, our financial wizards have promised $12.8 trillion in bailout funds to primarily well connected cronies. The US national debt since the birth of this great nation now stands at a comparable $11 trillion. None of these debts will ever be paid off and it’s hard to fathom how anyone believes to the contrary.

The Fed’s “balance sheet” is supposed to be the substance behind their issuance of money. This balance sheet has been comprised of smoke and mirrors for decades since the total fiat era started in 1973. Those days now look golden compared to the current makeup.

The Fed used to hold almost exclusively Treasury securities with which to perform their various “operations”. Only 24% of their holdings are now in Treasuries. The rest is a toxic soup that they’ve now taken on (mortgage backed securities, commercial paper, money market assets, failed crony paper, etc.) to keep the entire system afloat. The mortgage backed securities, for example, are really worth around 35% on the dollar. The Fed and other banks holding this junk assign pretend values of 100% on them.

The Fed balance sheet had more than doubled to $2.19 trillion since the global meltdown started. It looks like they took the “good bank – bad bank” scenario seriously but made the wrong choice. Watching the world’s most influential bank implode is a rare event.
Most local banks are FDIC insured. These banks also hold just over $200 trillion in obscure derivatives. The reserves to back up these positions are a mere 3.5% as opposed to a more normal 10% backing of solid and traditional loans. Banking gone wild.

More here…

2. The banks are back. Profits are up. Write downs are lower. The government has their back. And the worst is over.

Forget Swiss-based USB. Their huge losses were the exception…

Judging by their latest quarterly reports, big banks have finally figured out how to make money again.

Goldman Sachs, JPMorgan, Bank of America, Wells Fargo and even Citigroup all reported profits for the first quarter.

But a closer look under the hood reveals that many of the big banks reported fake earnings…

-Bank of America arbitrarily increased the value of its Merrill Lynch assets.

-Goldman Sachs bunched much of its losses into the month of December – a month it skipped reporting on this year.

JP Morgan’s bonds fell in price. And that perversely allowed the bank to increase its bottom line. This is how the New York Times explained it: “Theoretically, JP Morgan could retire them and buy them back at a cheaper price; that’s sort of like saying you’re richer because the value of your home has dropped.”

More here…

While China is being touted as a savior there is a very interesting point of view on the coming of a China bubble.

“China’s fortunes over the past decade remind me of Lucent Technologies in the 1990s. Lucent (now Alcatel-Lucent (ALU)) was selling equipment to dot-coms. At first, its growth was natural, the result of selling telecom equipment to traditional, cash-generating companies. Thereafter, it was only semi-natural: Dot-coms were able to buy Lucent’s equipment only by raising money through private equity and equity markets, since their business models didn’t factor in the necessity of cash-flow generation.

Funds to buy Lucent’s equipment therefore quickly dried up, and the company’s growth should have decelerated or declined. Instead, Lucent offered its own financing to dot-coms by borrowing and lending money on the cheap to finance the purchase of its own equipment. This worked well enough - until the time came to pay back the loans.

The US, of course, isn’t a dot-com. But a great portion of our growth came from borrowing Chinese money to buy Chinese goods - which means that Chinese growth was dependent on that very same borrowing.

Now the US (and the rest of the world) is retrenching, corporations are slashing their spending, consumers are having moments of sickening recognition - and the consumption of Chinese goods is on the decline. This is where my dot-com analogy breaks down. Unlike Lucent, China has nuclear weapon. It can print money at will, and can simply order its banks to lend; this is a communist-command economy, after all. Lucent is now a $2 stock - but China won’t go down that easily…

…China doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot; to keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system restabilizes.

It’s literally forcing banks to lend - which will create a huge pile of horrible loans on top of the ones they’ve originated over the last decade (though of course we can’t see them). Don’t confuse fast growth with sustainable growth. As I’ve discussed in the past, China is suffering from Late Stage Growth Obesity. A not-inconsequential part of the tremendous growth it’s seen over the last 10 years came from lending to the US. Additionally, the quality of late-period growth was, in all likelihood, very poor, and the country now suffers from real overcapacity.

Identifying bubbles is a lot easier that timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer inflated prices persist, the harder they fall when financial gravity brings them back to earth.”

While many key indicators may be looking better the fact that the financial system will take a lot of effort and time to straighten out should not be lost sight of. How much ever smoke screen you create at some point the realities will surface with a lot of pain.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

New Fair Value Rules – How Risky is the Game?

2009-04-04T21:00:00.012+05:30

The banks got it finally as lawmakers literally forced FASB to relax the fair value or mark-to-market rules and the market celebrated it as if by wave of magic wand all the underlying risk has magically vanished.

The Bloomberg report (linked above) says:

“Changes to fair-value, or mark-to-market accounting, approved by FASB today allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ write downs and boost net income. Firms could apply the changes to first-quarter results.”

According to a MarketWatch report:

“Another provision that the FASB board approved would allow companies to put certain illiquid debt assets, such as mortgage securities, they would otherwise have been forced to write down into a category called "other comprehensive income." As a result, financial institutions' operating income is improved because they can record a lower amount of loss in their income statements.

These are illiquid securities that are "impaired," which means companies no longer believe they can collect all the amounts due."

It is estimated that this move would help raise the bank industry earnings by about 20 percent. And what would be illiquid or distressed asset? The rule will applicable to all transactions for which there is no active market and will be considered distress unless proven otherwise!

Of course the board also called for additional disclosure. As per the above report:

“The measure also requires expanded disclosure: Corporations must provide more details, on a quarterly basis, about the methodology they used to justify putting certain assets in the "other comprehensive income" category.”

An informed writer commented thus:

“I'd argue that this won't result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let's say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven't been recognized.This market is all about imagination.

If you are a bank (or any financial), the market isn't going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.”

Another author amplified this further:

“The second thing I learned as a bank trainee, back in the good old days, was that it is impossible to learn anything useful about a bank by reading its balance sheet. Whether a bank is strong or not, depends upon the quality of its assets — information that is woefully absent from financial statements.

Once we understand that banks are insolvent and require government guarantees to continue in business, the question becomes what percentage of liabilities have government guarantees and which assets are good, or whether the government will eventually have to step in, liquidating the bank and paying off depositors, leaving zilch for shareholders.

Now accounting rules don’t require banks to list their loans, nor to indicate terms and covenants of each financial asset. You’re not told the credit rating of borrowers, or even the weighted average of credit ratings (even if you put faith in credit ratings).

Nor do accounting rules require that auditors actually evaluate the likelihood that a bank will get its money back on a particular loan, or any group of loans. Bank auditors don’t visit bank borrowers one by one and look them in the eye to see if they seem credit worthy, or whether they are drunken bums that have just blown the bank’s money at the racetrack.

Moreover, large international banks are so huge and complicated, composed of thousands of subsidiaries, affiliates, side ventures, and special deals, and subject to the risk that some obscure trader in one of hundreds of countries where they do business may be hatching up a scheme that will bring the bank to its knees tomorrow morning — these banks are so complicated that it is literally impossible to contrive any document that could possibly “protect investors” by supplying all relevant and material information.

Now, auditors don’t like to admit that bank balance sheets are bullsh*t, and that that the millions spent on auditing — for the benefit of “investors” — might just as well have been donated to charity. So they try to find some way to get someone else to give an opinion on how much bank assets are worth — at least some part of the assets.”

So are we in a better position to assess banks post the accounting changes? In other words are bank financials better than before the rule change? Remember most CEOs sometime back said things were hunky-dory and sub-prime was not a big problem! They either did not have a clue or knew but purposely suppressed facts. I do not see how this behavioral aspect can be altered by a change in accounting rule... even if they became government run banks.

Has the underlying risk really changed? Credit markets have improved because of government guarantees and not due to any change in the inherent risks the bank balance sheets carry. So it is the government manipulation that is carrying the day and how long it will last is a moot point. Remember this is a shift of risk to taxpayers and politically not very conducive for the medium to long term.

The market sooner or later has to adjust to this reality. The E part of PE can be boosted by change in accounting but given that the underlying risk has not altered much, it will have to be factored-in the PE ratio with price adjusting at some point in time. Will it allow the real E to improve because banks can lend more, only time will tell? But given the way US unemployment and savings rate are growing the demand for goods is not going to move up in a hurry and so will demand for credit.

By incremental lending the risks that banks face in an environment currently prevailing will only increase its risk at the margin. Sample this from Shadow Government Statistics:

“BLS Jobs Reporting Is Seriously Flawed, at Best. This morning’s (April 3rd) reported March jobs loss of 663,000 again was close to consensus expectations, but, as has been common in recent releases, major downward revisions to prior reporting helped to mute the current headline jobs loss significantly. In each of the six most recent monthly payroll reports, the prior month’s payroll level was revised lower. For October 2008 to March 2009 reporting, the downward revisions to the prior month’s seasonally-adjusted payroll level were respectively: 179,000, 199,000, 154,000, 311,000 (still significant net of benchmark revisions), 161,000 and 86,000. Five of the six revisions exceeded the Bureau of Labor Statistics’ (BLS) 95% confidence interval of +/- 129,000 jobs for monthly change.

Net of revisions, the March jobs loss would have been 749,000. Net of the Concurrent Seasonal Factor Bias (CSFB), which reflects the reporting problems, the loss would have been 750,000, in line with my estimate in the March 29th Flash Update.

Payroll Survey: The BLS reported a statistically-significant, seasonally-adjusted jobs loss of 663,000 (down 749,000 net of revisions) +/- 129,000 (95% confidence interval) for March 2009, following an unrevised 651,000 jobs loss in February, but January’s jobs loss was revised from 655,000 to 741,000. Annual contraction (unadjusted) in total nonfarm payrolls continued to deepen, down 3.56% in March, versus a revised 3.10% (was 3.12%) in February. The annual decline in March was the deepest since July 1958. The seasonally-adjusted series also continued contracting year-to-year, down by 3.48% in March versus a revised 3.08% (was 3.02%) contraction in February."

Savings rates are expected to touch 10 to 12 percent.

And here is the icing on the cake. According to the above referred MarketWatch report:

“However, the battle over mark-to-market may not yet be over. Bankers are pressing lawmakers to urge FASB and its parent regulator, the SEC, to set up a procedure to retroactively recoup losses financial institutions have already taken on impaired illiquid assets.

House Financial Services Committee Chairman Barney Frank, D-Mass., told the American Bankers Association on Tuesday that he will take their concerns about reversing retrospective losses to the SEC and Congress. "They [bankers] ought to be able to go back and say they took that loss on an asset that is being held to maturity and recoup that loss," Frank said.

However, Willens said it would be extremely unusual for FASB to allow banks to go back and restate their existing earnings. "FASB doesn't traditionally do that, but Frank's pressure could make it happen," he said."

Post the new fair value rules we should have restatement of financials over the last five years so that we can compare ‘apple to apple’. Let’s see how things look if the entire ‘fair value gains’ are taken away. It would be revealing to see what PEG the markets were pricing-in and how it should re-look at it post the change in rules.

The past track record of banks in their ability and skills to value assets does not give any major comfort. The capability and the possibility of auditors doing so – the less said the better. In terms of evolving models we have seen how capable these banks were in risk modeling and managing it. It is very difficult to believe that they would do a better job this time and that such models will be neutral - not biased in their favor. The fact that bailed out banks are now looking to bid for the toxic assets under the Geithner plan says it all! In all probabilities it will now be a mutually beneficial exchange between them.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

FED Feeding the Markets – Will it Work?

2009-03-28T21:05:00.011+05:30

I understand we have seen a 3-week rally of proportions not seen since 1938 in the US. On a weekly basis the Dow closed up 6.8%, the S&P 500 6.2% and the NASDAQ 6%. On a monthly basis till now the Dow is up 10.1%, S&P 11% and the NASDAQ 12.2%. The real push came when FED announced that it would buy $300 billion in Treasuries from the market over the next 25 weeks or so to help support the economy and spur lending. Also the program to buy housing agency debt and mortgage-backed securities was extended to about $1.45 trillion.

Following this the Treasury prices surged and 10-year yields plunged about half of a percentage point, the biggest drop since the 1987 stock market crash. Also the US dollar plunged. This resulted in commodities mainly base metals and oil to move up and as the shorts covered the up move was magnified. The Giethner plan to handle bank toxic assets was also received well which gave more teeth to the rally.

Some concerns came back when as a Market Watch report says:

“On Wednesday, concerns were sparked after the United Kingdom failed to get enough bids to sell the full amount of 40-year gilts it offered, the first time this has happened in 14 years. Later in the day, a U.S. government auction of $34 billion of 5-year notes drew only tepid interest from foreign investors.”

The basic issue that arises is that will the huge funding required for the various avtars of the bailout plan succeed apart from the question marks on the plans success itself. In fact the reason for FED announcing the buyback of existing treasuries is in a way to make the Treasury sales successful. While one arm of the government buys keeping the upward pressure on prices the other sells. The deficit in 2010 is expected to be of the order of $1.25 trillion.

Says the above mentioned report:

"If the Fed is done six months from now, the Treasury market will be looking at the fiscal deficit and a huge amount of supply to come without the Fed being there" as a buyer”,…”

So the question now arises as to who buys these treasuries. Foreign buyers have become extremely wary (and many have their own set of equally grave issues to handle be it Europe or the Gulf countries) and the noise being made by the Chinese on a new world currency would be a cause for concern. Will China sell to FED and reduce its exposure? It is a certain possibility as it restructures its policy to focus inwards to the local economy and reduce dependence on exports.

This could also mean upward pressure on interest rates as the report mentioned continues:

“Ten-year yields now at 2.65% are likely to end the second quarter, in June, at 2.55%, according to a MarketWatch survey of 15 of the 16 primary government security dealers required to bid at auctions and that trade directly with the New York Federal Reserve. One firm did not reply to several requests for information.

That yield will rise to 2.84% by the end of the year, according to the survey.

Such a rise would mean investors, who in the past year have pumped more of their money into ultrasafe Treasuries and out of stocks and corporate bonds as a series of shocks rocked the U.S. financial system, would pull their money out of this corner of the bond market. Those freed-up assets could be good news for other parts of the financial markets that have lost out in the past year's flight to safety - such as stocks.”

Now here is the catch. On the one hand this would mean funding the bailouts is going to be more and more difficult and expensive while on the other hand liquidity will find its way to other asset classes. While the short term shift in liquidity to stocks and other assets may move these markets, sooner than later the reality of high interest rates and the inability/difficulty of funding the bailouts other than through FED buying more and more treasuries (printing money or quantitative easing) will become apparent. This we have experienced many a times is a sure shot formula for asset prices to finally form a bubble and lo! we are back to square one.

To me the market players should not get euphoric with current move. The players shifting their liquidity to the market to create such sharp moves would be actually shooting at their own legs. A measured slow consolidation is required and sharp move in asset prices will put the medium to long term sustained recovery in jeopardy. This whole process will be time consuming – running into number of years and the market player’s own action on a collective basis of how they handle this liquidity is going to determine how long the markets may take to make a long term sustainable up move.

Disclosure: No Positions

CDS, AIG & the rally in financials

2009-03-15T10:53:00.025+05:30

For the uninitiated here is a Wikipedia snapshot of CDS:

"A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur. However, there are a number of differences between CDS and insurance, for example:

-- the seller need not be a regulated entity;

-- in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;

-- The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. Generally, to purchase insurance the insured is expected to have an insurable interest such as owning a debt."

According to a Bloomberg report:

“Credit swaps were created by JPMorgan Chase & Co. more than a decade ago to hedge against losses from bank loans. As dealers made the contracts more standardized, hedge funds, insurance companies and asset managers began using them to speculate on the creditworthiness of companies, sending trading in the swaps up to $47 trillion in 2008, according to the latest data from the New York-based International Swaps and Derivatives Association. “

How CDS would incentivize more bankruptcy?

“Amusement-park operator Six Flags Inc. and automaker Ford Motor Co. may be pushed toward bankruptcy by bondholders trying to profit from credit-default swaps that protect against losses on their high-yield debt.

By employing a so-called negative-basis trade, investors could buy Six Flags bonds at 20.5 cents on the dollar and credit- default swaps at 71 cents. If the New York-based chain defaults, the creditors would receive the face value of the debt, minus costs. In a Feb. 27 note, Citigroup Inc.’s high-yield strategists put that profit at 6 percentage points, or $600,000 on a $10 million purchase.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year to the worst level since the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges….

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

More here...

Why CDS holders can be paid ahead of bankruptcy creditors?

As per an informative article in TPM

"…the knowledgeable people already know this. But it turns out that one of the features of the US 2005 Bankruptcy bill was to put derivative counter parties at the front of the line ahead of other creditors in bankruptcy proceedings. Actually … they don't just go to the head of the line… They got to skip the line entirely. As the Financial Times noted last fall, "the 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company's assets until a court decides how to apportion them among creditors." As the article notes, ironically, this provision which Wall Street pushed for and got to protect investment banks actually ended up hastening the collapse of Lehman and Bear Stearns last year.”

Does it have anything to do with non-disclosure of AIG’s counterparties?

TPM explains it thus:

“If AIG were to go down, derivatives counterparties would be able to seize cash/collateral while other creditors and claimants would have to stand by and wait. Depending on how aggressive the insurance regulators in the hundreds of jurisdictions AIG operates have been, the subsidiaries might or might not have enough cash to stay afloat. If policyholders at AIG and other insurance companies started to cancel/cash in policies, there would definitely not be enough cash to pay them. Insurers would be forced to liquidate portfolios of equities and bonds into a collapsing market.

In other words, I don't think the fear was so much about the counterparties as about the smoking heap of rubble they would leave in their wake.

Additionally, naming AIG's counterparties without knowing/naming those counterparties' counterparties and clients would be at best useless and very likely dangerous. Let's say Geithner acknowledges that Big French Bank is a significant AIG counterparty. (Likely, but I have no direct knowledge.) BFB then issues a statement confirming this, but stating it was structuring deals for its clients, who bear all the risk on the deals, and who it can't name due to confidentiality clauses. Since everyone knows BFB specialized in setting up derivatives transactions for state-affiliated banks in Central and Eastern Europe, these already wobbly institutions start to face runs. In some cases this leads to actual riots in the streets, especially since the governments there don't have the reserves to help out. If you're Tim Geithner, do you risk it? Or do you grit your teeth and let a bunch of senators call you a scumbag for a few more hours?”

So what does all this mean?

According to various sources on the Internet:·

--- The recipients of the largesse appear to be Goldman Sachs, Morgan Stanley, Merrill Lynch and Deutsche Bank.

--- News and banks analysts’ reports suggested that Goldman Sachs got about $25 billion of the government bailout of AIG and that Merrill Lynch was the second largest benefactor of the government largesse.

--- The earlier payouts as per The Wall Street Journal of December, citing a confidential document and people familiar with the matter, revealed that about $19 billion of the payouts went to two dozen counterparties between the government bailout in mid-September and early November. As previously reported, nearly three-quarters went to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA's Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion), the Journal reported at the time. A lot more has been doled out since then.

More than $170bn. has been committed till now and the reason why more is being committed is becoming clearer. Apart from receiving bailout money directly these very ‘super-financial-organisms’ could have their financials dented further if this route was also not kept flowing. Normally these institutions would have received only pennies on dollar on the CDS if bankruptcy was allowed. So what the government is protecting is further loss of tangible equity of these ‘hearts’ of the global financial system which can keep the ‘blood’(funds) circulating – trying to avoid a much bigger and more unbearable blood on the street. If my understanding is correct AIG’s CDS obligations exceed $500bn. And with CDS incentivizing bankruptcies be prepared for much more than the $170 bn. committed.

But the flip side is that it is preventing these ‘hearts’ from a heart attack. Apart from the technical factors the current rally in financials has after all got a fundamental perspective too!!

Is there a way out?

This Market Watch report makes it an interesting reading:

…“Bernanke said the counterparties made "legal, legitimate, financial transactions" with AIG and presumed at the time that the contracts would remain private. "That is a consideration we have to take into account," he added.

Sen. Mark Warner, D-Va., suggested that AIG's counterparties should have to take a "haircut," rather than be made whole, because some of them probably didn't do enough due diligence on whether the insurer was financially strong enough to be selling such protection.

"In effect, what we're saying is, consequently, folks who bought these instruments and that, at some point in their process, should have been doing some level of credit analysis of what AIG was selling who didn't do that credit analysis are going to still come out whole for their lack of appropriate due diligence or responsible behavior," he said.

"I'm as unhappy as you are about that, senator," Bernanke replied. "I just don't know what to do about it."

Given the current rally in the financials one can only hope despite this treatment (the largesse) to prevent a ‘heart/s attack’, its side effects do not make it fatal.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

The beginning of the bottoming process

2009-03-02T20:21:00.011+05:30

The headlines are becoming so depressing and it’s ‘given up’ tenor is making me believe that the bottoming process has started. By no means am I trying to predict the bottom or for that matter say that the worst for the markets is over. I’ am starting to sense now that the second half recovery theme is history. The tone of the optimists is tending to sort of say – ‘we probably underestimated the depth of the problem.’ And now the depth of the problem and the issues, to me, is getting a slow but definite over extension to the other side. The sense of gloom being predicted smells of converts and the conversion rate is accelerating. Sample this:

1. Financial Crisis sparks unrest in Europe
Read about a series of unrest in this region. I'am sure other regions too are reporting such instances.

2. Gold – Haring away

One is reading/hearing ‘Gold’ every where. Sure signs of panic are emerging.

“People have long viewed gold, rightly or wrongly, as a hedge against high inflation and a weak dollar. So when the gold price briefly broke through the $1,000 mark in March last year, it was easily explained by fears that rising commodity prices (and, in America, a weak dollar) would feed inflation. An earlier run-up in gold prices, between 2002 and 2005, coincided with a sustained fall in the dollar. But now gold is strong even as the dollar thrives and economies face deflation.

“Gold is something you buy if you have something to lose,” ... What links today’s gold fever with the 1970s rush is negative real deposit rates. Many savers now prefer a claim on gold in a vault to one on cash in the bank. There is less risk that a counterparty blows up, and the “carrying cost” of gold in terms of lost interest is, in any case, vanishing.

How high might the gold price go? Gold bugs talk excitedly about it reaching $2,300, which would match the January 1980 peak in real terms…”

3. Next Stop for Gold $2,000 Per Ounce!

“How high can gold ultimately go? Mark my words... gold will hit $2,000 per ounce or even higher.

Recently gold has been on an absolute tear as investors are piling into the yellow metal as a safety hedge. People are still quite concerned about the current economic crisis and are unsure what will happen in the future. The financial downturn we’re experiencing has crushed conventional investments like stocks and real estate and gold has shined throughout this downturn.

Gold is certainly in full bull market mode right now. Recently it headed higher on worries of both inflation and deflation. Surprisingly, central bankers are in favor of higher gold prices because it suggests their attempts to head off deflation are starting to work.

Now, the average person is not worried about inflation or currency debasement. They are worried about the money in their bank account. That’s just one reason that gold prices are rising. People are turning to safe havens because they think their banking system is on the brink of failure and they see the stock market is in the toilet.”

4. Stress Test Mess

The idea of ‘Tangible Common Equity (TCE)’ is bizarre. These sudden discoveries are just an exhibition of the fear factor. Tier I capital was what all bankers/regulators for long have looked at - through most good and bad times.

“Judged by tier-one capital, a common measure of adequacy, America’s ten biggest banks by assets appear in reasonable shape. Typically, their ratios of tier-one capital to risk-weighted assets exceed 10%). However, the quality of their tier-one capital has crumbled. Only about half now consists of tangible common equity, the purest and most flexible form of capital which bears the “first loss” when an asset goes sour. The rest is largely preference stock, much of it government-owned, which is not truly loss-bearing. For example, the dividends on Citigroup’s government preference shares can be deferred but not cancelled, unlike those on common stock. The original Basel rules on capital adequacy sought to limit such “hybrid” capital that sits between equity and debt. But most governments like preference stock because it does not carry votes, and thus avoids nationalisation, and because the more secure dividends protect taxpayers, providing the bank does not go bust.”

Just by transferring the money from one pocket to another you cannot create more cushion for loss provisions except for the dividend flow that you may save through such conversion to common stock.

While a bank is definitely obligated to pay interest on its borrowings – it makes money/profit or not – as regards preferred to the best of my understanding the bank is obligated to pay only if it can i.e. it has sufficient reserves and/or profits to do so. If it cannot, then it can cumulate based on the terms. And if at maturity it still cannot pay – period it cannot pay.

First there is a clamor that TCE is not sufficient and then when it is provided through some level of nationalization then the allegation is that you have moved away from the ‘Right’. So this ‘damned if you and damned if you don’t’ attitude shows the paranoia in the market where all logic seems to have been lost.

5. Even the best like Mr. Buffet who has sown the seeds of success on others fears and reaped the benefits from others greed has stated in his annual letter to shareholders that:

“During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. … Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.

We're certain, for example, that the economy will be in shambles throughout 2009… and, for that matter, probably well beyond … but that conclusion does not tell us whether the stock market will rise or fall.

Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”

Such desperateness and pessimism shows that even at such levels of knowledge, experience and expertise doom and gloom conversion is happening. A definite positive sign.

Read this conversation too.

6. The protectionists mess up is starting.

“President Barack Obama’s proposed removal of tax incentives for American companies outsourcing jobs could mean that large outsourcing customers such as GE and Citibank might have to pay certain taxes on their income from international markets, making it less attractive for customers to send IT projects to cheaper offshore locations…

However, experts argue that such protectionist measures are short-sighted because many US companies derive significant revenues from outside the country, and any protectionist stance could lead to a backlash in other markets. For instance, Citigroup in 2007 generated 52% of its revenues outside the United States, and over 60% of its workforce operated from abroad, as its banking business spanned 100 countries. Citigroup’s international revenue streams kept pace through 2008, despite the financial crisis, and amounted to a whopping 74% of the total revenues.”

These signs are by no means are exhaustive but do provide some vital pointers. As I see it we are some where close to beginning of the lower part of U and the bottom formation may run for a reasonably long period and may take a more flattish shape. How long, depends upon how the politicians across the globe play their cards.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

Decoupling – have the seeds been sown?

2009-02-23T16:58:00.006+05:30

The decoupling theory – Asia and Asian markets (sans Japan) decoupling from the rest of the world – keeps surfacing from time to time – specially when the markets in Asia tend to perform better than those of US and Europe. It happened in the first two weeks of February when the Chinese and Indian markets seem to have started outperforming the US and European markets. However as the US market indices have started to challenge the November 08 lows the perception seems to be altering again. So is decoupling a possibility at all?

Prima facie it appears to be a difficult proposition. The reasoning is very sound:

“Basically, there are two stories to tell here about the sudden downturn in the global economy.

The easiest to understand is the collapse of industrial production in East Asia, where the supply chain starts in places like Taiwan and Vietnam and moves through places like China and Japan before cars, shoes, computers and flat-panel TVs arrive at stores in the United States, Western Europe and everywhere else.

… the 40 percent decline in Taiwan's industrial production at the end of last year was the "canary in the coal mine" of Team Asia's formidable export machine. At about the same time, Japan's exports fell 35 percent, Korea's 17 percent, and China's fourth-quarter gross domestic product was essentially flat -- no economic growth at all.

… never seen declines this fast and this steep, even during the Asian economic crisis ... It all reflects not only the sharp pullback in discretionary consumer spending around the world but also an equally sharp pullback in the flow of foreign investment that was used to build factories and shopping centers and has been an important driver of growth in the region.

Demand for Asian exports will pick up again before too long, but it will be a long time before they reach the levels attained at the height of the bubble economy. And it will be longer still before foreigners will be eager to invest in expanding capacity again.

Ideally, Asians would respond to this challenge by reducing their heavy reliance on exports and foreign investment and reorienting their economy more toward domestic consumption. But … that's not as simple as it sounds.

For starters, the things Asians might want to consume aren't necessarily the things they produce to export, so production would need to be reoriented and workers retrained and redeployed. And to replace the foreign investment, these economies would need to develop financial institutions that can raise and invest risk capital, which right now they don't really have. Most significantly, Asian governments would have to create safety-net programs like Social Security so people don't save so much and spend so little.

In short, the Asian downturn is probably manageable, particularly now that the Chinese government has responded with a massive stimulus package. But it will take time for the region to make the necessary adjustments to get the region humming again.”

As I see the lessons learnt/being learnt during this severe downturn will have a lasting impact as these Asian countries now re-orient there industrial and fiscal policies to ensure that over dependence on exports is reduced in the years to come. Also trade within the region will now be a much greater focus as two of the most populous countries in the region ‘Chindia’ look to push their growth with policies that are much more domestic investment and consumption oriented. India always was domestic consumption story (save the IT and IT enabled services and Generic Pharmaceutical industry) and now can be regarded as a great advantage.

As the quote above points out - the reorientation will be challenging and will take time – a decade or so. But as the US and European consumption story sees its twilight in years to come it is the Asian and some of the resource rich countries such as Brazil that will need to fill-in. And as this re-orientation sees initial success foreign capital (US and European savings) will start seeking these countries and the capital required to sustain a reasonable growth rate will find its way. The seeds for this shift – possibly a power shift too - appears to have been sown.

Disclosure - No Positions

Copyright © 2008-09 Tradesense

Warning Signal

2009-02-16T17:35:00.010+05:30

Last week’s market reaction is attributed to the lack of details in Giethner proposal. The basic issue revolves around the valuation of the bad /toxic assets. A low price while taking the asset of the bank balance sheet will also cause further charges to be taken and may require further capital. Bloomberg quoted an expert saying that … “Through this whole process, it seems as if the government needs to take a course in marketing.” It is unclear if he will come out with the details.

Thursday’s movement of US stock prices will tell us a lot about it! Just when one thought that the supports were to give way the market rebounded and bulls took-off.

And there appears to be some tactical work behind this. As one writer put it –

“I figured out why Geithner was so vague in his speech Tuesday... now each time the market is weak and about to fall off a cliff they can release another piece of "salvation" - this methodology could last for months. Why shoot your load all at once?? Genius! I tell you there must be an army of technical analysts employed somewhere in the bowels of government. Their timing is beyond impeccable; below S&P 800 and the panic would have begun.”

Any major move by the market on the down side is likely to be manipulated with timed releases/leaks it appears. Well the market will turn out to be savvier. If it reads the emerging situation is not to its liking and decides to go down – it will! Experience tells me it can find its way if that is what is right in its perception. It will probably consolidate downwards instead of making a big move.

There was a feeling that the markets were stabilizing and credit in some measure was beginning to flow. Some liquidity it appeared had started flowing towards to the equity markets as players booked profit in treasuries - treasury yields improved. But last week’s market behavior probably indicates that some more turbulence is likely. This Bloomberg report brings out the point:

“Ten-year note yields fell the most in two months as investors, disappointed at the lack of details in Treasury Secretary Timothy Geithner’s bank-bailout plan and doubtful a stimulus package will spur growth, sought the safety of government debt. Stocks tumbled. The government, meanwhile, sold a record $67 billion in notes and bonds.

The benchmark 10-year note’s yield dropped 10 basis points, or 0.10 percentage point, the most since the five days ended Dec. 19, to 2.89 percent, ... Yields on the two-year note fell three basis points, the most since the week ended Jan. 9, to 0.96 percent. Thirty-year bond yields slipped two basis points to 3.67 percent.

The 10-year note yield touched 2.04 percent, the lowest according to data going back to 1953, on Dec. 18, the same day the 30-year bond yield fell to a record 2.51 percent. The declines came two days after the Federal Reserve cut its target overnight rate to a range of zero to 0.25 percent and said it was considering buying “longer-term” Treasuries to lower consumer borrowing costs and stimulate the economy.

On Feb. 9, as the government readied the week’s auctions, the yield on the 10-year note reached 3.05 percent and the yield on the so-called long bond touched 3.76 percent. The yields were the highest since November.

The sale of 10-year notes on Feb. 11 drew a yield of 2.82 percent, while the yield at the 30-year bond auction on Feb. 12 was 3.54 percent. The sale of three-year notes on Feb. 10 drew a yield of 1.42 percent.

The Fed’s custodial holdings of Treasuries for foreign institutions including central banks rose 0.5 percent to a record $1.743 trillion, central bank data show. The holdings had slipped the week before to $1.735 trillion, the first decrease in 24 weeks.

Custodial holdings of agency securities dropped for the first time in two weeks, decreasing 0.3 percent to $817.9 billion.”

The liquidity moving to treasury securities and gold’s current behavior is definitely a warning signal.

Disclosure: No Positions

Copyright © 2008 -09 Tradesense

The currency conundrum – is it another leg up for gold?

2009-02-07T22:02:00.005+05:30

The logic in the currency markets usually has been: sell lower interest rate currency and buy higher/stronger rates. The strategy seems to have reversed now – low/zero yield seems to positive. Sample this:

“… when in Prague the Czech central bank slashed its interest rates to an all-time low, the Czech Koruna actually bounced vs. the Euro...

… 100-basis point cut to South African rates worked to stem the slide in the Rand - now trading one-third below its US-Dollar value of last February despite paying fully 1,050 basis points more...

… in London, the Bank of England took its base rate further into record-low territory at 1.0%...yet currency traders pushed the Pound Sterling to a two-week high above $1.4650...

… when the Reserve Bank of Australia cut its interest rate to a 45-year low, the Aussie Dollar bounced from near-6 year lows in response...

… after the central bank of Norway cut its target interest rate by 50 basis points to 2.50%, the Norwegian Krone turned higher after losing one-third of its value vs. the Dollar since July last year...

… when the world's No.2 behind the Fed, the European Central Bank (ECB), opted to keep its rates flat - the Euro lost 2¢ from this week's high…...despite paying returns to cash fully 200 basis points above the Dollar.”

The phenomenon was first witnessed with USD and JPY as the respective central banks raced to cut the rates to near zero. This clearly is a deflation biased view which it appears is looking to punish debtors.

Euro is likely to suffer in this sense till it announces a rate cut in March. If it also joins the zero interest band-wagon then one may wonder what’s left for the currency markets to play with? Is this is a precursor to a crisis brewing here? Does gold get a further leg up – it’s anyway a zero yield currency!

Look forward to readers views.

Disclosure: No Positions

Copyright © 2008 - 2009 Tradesense

‘Good Bank -Bad Bank’ – Is there any other way out?

2009-02-01T10:52:00.006+05:30

The proposal to take the toxic/lousy assets of the US banking system into a ‘bad bank’ and leaving the performing/good assets with the existing banks had initially received a positive response from the street wise it appears has run into a block – how to value these assets?

As one expert explains:

“Say a bank has a security it wants to sell to the bad bank. The face value is $100. The bank holds it at a value of $85. The market thinks it’s worth $65.

Banks will want the government to purchase assets for as high a price as possible, or at least to find some middle ground above depressed market values.

Buying the security at, or close to, $100 means the government would recapitalize the bank while transferring losses from shareholders to taxpayers.

Well, future taxpayers. They will be the ones who pay down the debt the government hopes to sell to fund this transfer, and make good on any losses. That debt, meanwhile, could prove stifling to the economy, and the losses pushed onto taxpayers could further undermine government finances.

‘Postpone the Pain’

“Creative pricing of toxic assets will only postpone the pain, extend the duration of the crisis, and present a bigger bill,”...

If the government purchases the security at $85, the future losses and bill to the public purse would be less. The problem is that this price could cause banks to recognize as permanent their losses on other securities. Right now, they claim those losses are temporary.

Such a move would cripple banks’ regulatory capital ratios. Plenty of banks could still fail. In that case, banks and taxpayers both get hit.

Buying the security at the market price of $65 means banks and the financial system immediately face a day of reckoning. While bank balance sheets would get unclogged, many wouldn’t be able to, or willing to, face the losses.

Nationalizing Banks

“If the government elects to pay fair market value, the bank will likely not elect to participate as capital hits would be too dear,” …

That could force the government to nationalize banks or seize them as part of the process of buying up assets. Either way, shareholders would get wiped out.”

So what we have is a ‘Damn if you! Damn if you don’t!’ situation.

According to various reports:

It is estimated that the falling US and British financial institutions have received $1trn. from the government (taxpayers), sovereign wealth funds and other investors.
Bank losses from the write-offs of bad loans and busted derivatives tally up to $1.5 trillion so far. In addition, $5 trillion to $10 trillion worth of off-balance-sheet businesses such as structured investment vehicles -- leveraged lending vehicles used by big banks to fatten their profits in boom times -- are being forced back to banks' balance sheets by regulators. Rules require banks to keep a base of real shareholder capital amounting to 10% of those funds. So banks need to find up to $1 trillion within the next year to meet that objective.
Add the $1.5 trillion in losses to $1 trillion in needed new reserves, and you can see that banks need as much as $2.5 trillion in new capital to remain solvent under current rules. Consider that the entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.
When you add the $500 billion from sovereign wealth funds to the $500 billion from the first tranche of the Troubled Assets Relief Program, it's only $1 trillion. That's already been provided. So that leaves a gap of $500 billion to $1.5 trillion.

And the feeling one gets is that nobody still has an idea on the depth of toxic assets in the system as a whole while individual institutions may have an idea about their position but may not want to disclose it fully.

The complication that has been brought in to the bailout approach is truly mind-boggling and it is becoming very clear that everyone is clueless.

Is there a simpler approach?

Now that it is very apparent that the taxpayers and public (present and future) at large are the suckers in this game and are going to foot the bill (which anyway is going to run into a few trillions of dollars), why not take a simpler approach.

The primary cause has been mortgages – and at the root are the ‘sub – prime’ mortgages. If the bad loans have been identified as they should have been by now, the government can take over these loans into its books and tell the banks that it will pay the monthly installments as per the original agreement with the borrower. If the average tenure/maturity is about 15 years say the government gets reasonable time to raise these trillions over a much longer period. As regards the banks these become performing assets and as the government instead of doling out only to the banks can also dole out to the mortgagees by giving them the actual ownership of their homes. While this would be akin to a grant and some may raise moral hazard issues, but what morality is left in the present plans? Further taxpayers and citizens will feel better knowing that they have helped fellow citizens than the unscrupulous financial institutions. Politically too it might find favor as relevant constituencies are addressed.

Given that the mortgage repayments are now to come from the government the derivatives based on the mortgages will also stabilize and the banks can reckon these mortgages in their books at face value thereby avoiding any major need for recapitalization because of loan loss provisions. The derivative products, given the government backing may turn liquid and find its value too.

Am I missing something? Look forward to your comments and response.

Disclosure: No Positions

OIL – What’s Cooking?

2009-01-18T16:39:00.022+05:30

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contago or forward premium is the order. Further the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

“Since the Eighties, WTI has ruled the global crude oil market. As it is produced and refined in the US, the world s largest consumer and importer of crude oil, it has been widely accepted as the best indicator of global demand-supply. Nymex WTI contract is the largest market for this crude oil.

Brent oil is pumped out from the North Sea and shipped to Europe, Russia and parts of Asia. Oil from Europe, Africa and the Middle East flowing to the West tends to be priced relative to this oil, i.e. it forms a benchmark. However, large parts of Europe now receive their oil from the former Soviet Union, especially through Russia.

Traditionally, Brent traded at a discount to WTI because it is less light and less sweet.”

From the charts below it can be seen that the differential between the near/front month contract between WTI and Brent started appearing toward the end of 2008. Also note the Dec09 contracts have shown very little differential.

So what’s cooking?

One explanation that I have come across is:

“…it is becoming more expensive because the North Sea oil fields are getting depleted. But that doesn’t explain its premium over WTI. On the other hand, WTI was clearly over-supplied. The problem was created by the very nature of the WTI market. The WTI market has a large number of independent producers who sell their crude based on posted price. The oil is then brought into Midland and sent to either towards the Gulf Coast refining areas or towards Cushing, Oklahoma. Cushing is an oil-trading hub and the delivery point for NYMEX light sweet crude oil futures contracts. Due to pipeline logistics, once the oil flows outwards from Midland towards Cushing, WTI can only go in one direction: towards Chicago.

So if refineries in Chicago want less oil, you can’t divert the oil towards other places where there might be more demand. In the last three months, several factors led to large supplies of oil flowing into Cushing.”

However, demand for crude has come down as it is reported that the refineries off take has fallen given that the refining margins are wafer thin or negative. This has reflected in the pump prices going up.

Now what’s happening in Cushing? NYT explains:

“A year ago, oil producers and refiners could not move their products fast enough to meet growing world demand and chase rising prices. Now, with demand and prices slumping, they are sitting on 327 million barrels at tank farms around the country, particularly at Cushing, Okla., a major storage hub and a crossroads for pipelines. That is more than 40 million barrels more in storage than this time last year, and more than 30 million barrels higher than the five-year average. The mounting buildup has come during the last 100 days or so, as consumption of oil fell behind imports and domestic production”

In this context note that:

“The International Energy Agency predicted that the worsening global economy will leave demand at 85.3 million barrels a day _ 0.6 percent lower than 2008. Demand last year is estimated to have slid 0.3 percent.

The IEA says it lowered its forecast because it has nearly halved its estimate for global economic growth to 1.2 percent.

U.S. petroleum deliveries _ a measure of demand _ fell 6 percent to 19.4 million barrels a day last year, with declines for all major products made from crude, according to the American Petroleum Institute.

The Organization of Petroleum Exporting Countries has also lowered its energy demand forecast for 2009, saying in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009 from the previous year.”

The demand destruction is further evidenced by the fact that:

“From the Indian Ocean to the South Atlantic to the Gulf of Mexico, giant supertankers brimming with oil are resting at anchor or slowly tracing racetrack patterns through the sea, heading nowhere.

The ships are marking time, serving as floating oil-storage tanks. The companies and countries leasing them for that purpose have made a simple calculation: the price of oil has fallen so far that it is due for a rise.

Some producing countries are trying to force that rise by using the tankers to withhold oil from the market, while traders are trying to profit by buying cheap oil now to store and sell at a higher price later. Oil storage has become so popular that onshore tank capacity is becoming scarce.

…noted that a trading company could buy oil at the spot price of nearly $40 a barrel, store it and sell a contract to deliver it in a year for about $60. “You pay between $6 and $10 a barrel to store it, and you can make $10 a barrel,”... “That’s why Cushing is filling up rapidly and people are leasing tankers...

… With storage tanks filling up onshore, private and national oil companies, refiners and trading companies are storing another 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years, according to Frontline Ltd., the world’s largest owner of supertankers.

The different players have different reasons for storing oil, whether onshore or offshore.”

As to why the futures are trading at such premiums the reasoning is that:

“…OPEC has announced 4.2 million barrels a day of production cuts since September, moves that investors have so far ignored. But markets may be anticipating those output cuts will start to tighten oil supplies later in the year,…

“The OPEC production cuts are going to take time to widdle away the build up in inventories," ... "But if compliance is high, that could support prices looking further out..."

Coming back to the question of WTI and Brent the question that arises is: “How can oil around the globe be priced by a small US location, which doesn’t have a safety valve to deal with a few million extra barrels of oil?” or should Brent become the benchmark as I understand it has no such logistics related bottlenecks. And therefore is Brent now reflecting a truer picture?

The jury is still out on this.

Disclosure: No Positions

Will Asia Provide Diversification?

2009-01-13T19:06:00.020+05:30

Having looked at the possible developments in China, the latest news out of rest of Asia is also not good. Factory output in Japan fell more than 8% in November the biggest drop in 55 years. It is also expected that Toyota may report the first ever loss since WWII. According to a Bloomberg report:

“Japan's economy will probably shrink at an annual 12.1 percent pace this quarter (ended Dec 08), the sharpest drop since 1974, as exports collapse,…

… “We expect negative growth will continue for a fifth straight quarter to the April-June period of 2009.

Companies surveyed said they planned to reduce output a further 8 percent this month and 2.1 percent in January. Exports slid an unprecedented 26.7 percent last month from a year earlier.

The data prompted other economists to revise their GDP projections. Bank of America Corp. now predicts an annualized 6.5 percent contraction from a 2.7 percent drop previously estimated.”

Yen at around 90 to a dollar is on a 13 year high and has accentuated Japan’s export woes.

As US and European consumers cut back on spending it is hitting countries like Taiwan and Thailand apart from China & Japan. Excess capacities have been built and unless the situation in US stabilizes the capacities in these countries are going to find it extremely difficult. If the US stimulus does not work for some reason then these countries are going to find it extremely difficult. As US moves from a leveraged and credit based society to a cash flow based, the absorption of the excess capacities may also take time.

Competitive devaluation may also start. Japan has already indicated that it plans to take steps to counter the rising Yen. It said

“…Japan was ready to intervene in the foreign-exchange market for the first time in four years. With the nation’s economy already in recession along with the U.S. and Europe, the surging yen is adding to pressure on exporters…”

Most Asian countries except Japan are expected to see a disinflation or a low inflation and not a deflation. According to a Morgan Stanley report:

“...we highlight that Singapore and Indonesia lie at the two extreme ends of the inflation spectrum. The open nature of Singapore’s economy makes it most vulnerable to build-up of slack, and hence lower pricing power. Moreover, the correction in the real estate cycle is likely to show up in CPI as rental contracts reset with a lag. In the 1998 and 2001 recessions, when GDP growth was -1.4% and -2.4%, respectively, there were three to four quarters of deflation. We expect negative inflation toward 2H09.”

Countries that have economies driven by deficits are the one that will be most affected as global liquidity shrinks and flow of foreign capital reduces compared to the leveraged era gone by.

It appears that diversification strategies will not be easy to implement even in 2009.

Disclosure: No Positions

China’s Possible Hard Landing

2009-01-12T21:17:00.008+05:30

We continue with our watch list.

China showing any signs of bottoming out is a function of how its exports perform. Reports say

“…China’s growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, as recessions in the U.S., Europe and Japan cut demand for exports, according to Shanghai- based Industrial Bank Co.

The Purchasing Managers’ Index rose to a seasonally adjusted 41.2 in December from 38.8 in November… A reading below 50 indicates output contracted.

A measure of export orders rose to 30.7 from 29 in November. The output index jumped to 39.4 from 35.5. The new-order index rose to 37.3 from 32.3. November’s levels were the lowest for each of those indexes since the survey began in 2005. …

The economic slide may intensify pressure on the central bank to keep cutting interest rates after five reductions in three months and as the government rolls out infrastructure spending...

…forecasts the key one-year lending rate will fall by at least 81 basis points from 5.31 percent in the first half of this year.”

Earlier it was reported that Chinese exports were down over the past year, the first year-over-year decline since 2001.

The $584bn.China stimulus is expected to start having some impact from the second quarter. But the main factor would be the expected revival of the western markets after the second quarter which would then give a fillip back to Chinese exports. If this for some reason does not happen or is delayed than we may see some serious dumping by China causing prices worldwide to fall and adding to the deflationary trend. This could lead to protectionist tendencies to increase leading to a global slowdown in trade with attendant political and economic consequences.

The politics of trade is likely to increase as it is reported that:

“Obama’s advisers are considering including a “buy American” provision in the economic-stimulus legislation that the incoming administration has made its first priority.

“We are reviewing the buy American proposal and we are committed to a plan that will save or create 3 million jobs, including jobs in manufacturing,” said Jen Psaki, a spokeswoman for Obama’s transition team.”

Experts also opine that one needs to watch the effect of this downturn on China’s labor intensive industries than the capital intensive ones as the unemployment numbers will be largely a function of this. Current urban unemployment is reported to be at 9.4%. Export sector employs about 50mn. of which 4mn. or so have been laid off. It is estimated that any fall of GDP growth rate below 5% can bring in a social unrest. According to a Time report:

“At a December speech, Premier Wen Jiabao confessed to being particularly worried about unemployed workers and university graduates. Even the head of the country's Supreme Court warned judges to take social stability into mind when passing rulings. Overseas, too, worry swelled about just how deeply China's fragile social compact might be shaken by the experience of economic hard times for the first time in 30 years. The Obama administration should have a contingency plan for "what we would do if there's a major collapse of the political order," Roderick McFarquar of Harvard, one of the world's most respected China scholars, recently told a reporter. (See photos here of China on the wild side.).”

China’s downturn can affect certain other neighboring countries too. It is in a way the assembly plant of component and part imports from Japan, South Korea etc.

Hard landing of China could therefore have far reaching effects.

Disclosure: No Positions

Copyright © 2008 Tradesense

Euro-Zone & UK - Show Time

2009-01-12T20:59:00.007+05:30

We continue with our watch list albeit I’ am not captioning it so.

Euro-zone has put together its own stimulus package. Given that the nature of the union where each country has its own typical problem and the political setup has to address its own constituencies it will interesting to watch how the union overcomes these issues keeping its common interest in view. DB research observes:

“At their recent summit the EU heads of state and government adopted the European Economic Recovery Plan put forward by the European Commission in late November. The 27 member states aim to raise 1.2% of GDP, or EUR 170 bn, to fight the recession in Europe (another EUR 30 bn will come from the EIB). The member states are free to choose instruments from a fiscal tool box in order to stimulate growth in their (national) economies. The EU has merely a coordinating role. This approach makes sense for two reasons: one is that the economic problems in the member states have quite different starting points. For instance, the United Kingdom and Spain are confronted with a serious crisis in the real estate sector, while Germany has to grapple with a slump in foreign demand. The other reason, though, is that in a single market with close economic ties it is vital that national measures do not cancel out the efforts of other member states and that these other members do not remain idle in hopes of benefiting from the economic policies implemented by their partners.”

Time Magazine has made a timely observation:

“The euro's 10th anniversary will see the euro zone take on a 16th member, Slovakia. Eight other central and East European countries have set the goal of joining within the next six years, including Poland, whose political establishment dropped its longtime opposition after a recent run on the Polish zloty. The euro has found some other unexpected converts too, thanks to the financial crisis. The Danes voted against joining the euro zone in 2000, but they are set to hold another referendum in March. Iceland — not even an E.U. member — is pondering "unilateral euroization" after seeing its krona plunge nearly 80% against the euro in September and October.

And the biggest prize of all, Britain, is said to be warming to the euro … recently claimed that London is "closer than ever before" to euro-zone entry and that "the people who matter in Britain" think it should join. That may be overstating things a bit, but a report by research group Chatham House warns that as the euro zone grows, the U.K. risks being excluded from "deeper intra-E.U. economic consultation and coordination, including in areas of significant national interest, such as financial market regulation."

It doesn't help that the pound is wilting. Two years ago, one euro was worth just £0.65. Now, humbled by bank crashes, government bailouts and a collapsing housing market that has forced massive interest rate cuts, Europe's currency is within a pence or two of parity with the pound. "The debate has changed from a total fantasy in the U.K.," … "The political obstacles still remain strong, but it has changed the perception of the U.K. as the perfect system."

…financial crisis has been a defining moment for the euro, but he cautions against too much praise. The euro is still some way from dethroning the dollar as a global currency; just 27% of global foreign exchange reserves are held in Euros compared with 62% in dollars.”

This development could be a key one to keep a tab on as it may have repercussion on majority of the asset classes.

We also need to see how the ECB responds to the US ZIRP (Zero Interest Policy). The ECB has already indicated that it will do what is necessary.

“The economy may be even weaker in 2009 than the ECB’s prediction of last month for a contraction of about 0.5 percent … The Frankfurt-based central bank will “act appropriately” and has room to do so if the slowdown threatens price stability, which the ECB defines as inflation just below 2 percent in the medium term …

The inflation rate fell to 1.8 percent last month, beneath the ECB’s target for the first time since July 2007, according to the median of 20 forecasts given by economists before a report scheduled for release in the coming week.

“If, in our assessment, the risks to price stability change further in the coming months, monetary policy could be eased further and we will act appropriately…
Bank of America Corp. is among those anticipating the economy will be weaker than the ECB projects this year with a forecast for a 2.5 percent contraction. They expect the ECB to cut its benchmark to 1.5 percent this quarter…”

Also BOE recently cut its policy interest rate by 0.5% to 1.5% - its lowest in the 314 years history. It noted that consumer spending has “weakened” the outlook for investment has “deteriorated” and the availability of credit has “tightened further.” The fact that it did not cut more aggressively as US did it appears is because it feels that with GBP’s massive depreciation import led inflation will check deflationary pressures while helping its export economy. Also its fiscal stimulus package is to be supported by a deficit that would be about 8% of GDP. It may therefore did not move to ZIRP and has kept the rate based handle. Beyond ZIRP would be quantitative easing – BOE buying government debt and releasing money into the system – which it feels may accentuate the inflationary pressures. It is also possibly looking to go slow to see if it can avoid the pains of reversal of the quantitative easing (by not adopting it) when shooting interest rate could create different set of problems to handle.

Further moves by BOE and the UK government will be based on to what degree its slight optimism (as reflected in policy action) fails. As Economist explains:

“The outlook for 2009 is dispiriting. Despite the fillip from the temporary reduction in value-added tax, consumer spending will fall sharply. Households will retrench as unemployment rises and those with jobs fear they may lose them. Spending will be hit, too, by weak stock markets and shrinking housing wealth. House prices fell by 15.9% in the year to December, according to Nationwide Building Society.

The economy will also be clobbered by cuts in capital spending. Since the prices of homes still have a long way to fall, housing investment will remain depressed. Businesses are already cutting their capital programs, with more to come in the year ahead. Capital Economics is predicting that GDP will fall by 2.5% in 2009, the biggest annual decline in the past 60 years.

A common cause of these downward pressures on the economy is the banking malaise, which has undermined equity and property markets and curtailed the routine provision of finance to business. That makes it all the more ominous that banks are expecting to restrict credit still further. A survey by the Bank of England published on January 2nd found that lenders had reduced the availability of credit to both households and companies in the three months to mid-December and expected to curb it still further in the first quarter of 2009."

Reports say that after criticizing UK for its inane Keynesian approach, Germany is backtracking is likely to announce a stimulus (estimated at euro 50bn.) backed by deficit spending. This expert observes:

“But the modest deficit-spending will do little to prevent a contraction of 2-3% in Germany’s GDP and will add to government debt. Here there was a warning on Wednesday. An auction of 10-year government bonds met with poor demand. The Bundesbank retained a third of the bonds it had planned to sell. Longer-term interest rates may be driven up.

The warning might better be heeded by the US and UK than by Germany itself. Germany’s budget is close to balance. The UK and US have projected deficits of about 8% of GDP which might easily get worse. The UK government plans to sell £146bn in debt this year. Are investors ready to take it?”

Euro-Zone & UK’s show time is fast approaching.

Disclosure: No Positions

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 10

2009-01-10T16:20:00.007+05:30

When the US treasury bubble bursts….

What will dominate?

The good news: “…When the Treasury bubble does pop, it will likely be a sign that the economy is turning around and that credit is more available again, experts said. People will sell off their Treasury holdings because they think that stocks and corporate bonds will offer better returns….”

The Bad News: “... investors could lose money even on super-safe Treasuries. A swift increase in yields would send prices plummeting. For every 1 percentage point increase in yield on a 10-year note, investors would see a corresponding 7 percentage point drop in value…This would leave investors in a tough bind - either hold onto a note with yields that could be far lower than the market rates at the time or sell it at a steep loss.”

As Economist notes

“The dilemma is just as acute for government-bond investors. The example of Japan shows that bond yields can stay low for a long time. Ten-year yields of 1-2% could well be possible. But if Japan is not the template, then those yields will look ridiculous; we are heading for a world in which fiscal deficits are exploding and governments seem to be competing to depreciate their currencies. If 2009 does see an equity-market rally, it is likely to be accompanied by a government-bond-market slump.”

There are observers who feel this is not a bubble yet and that Fed will sustain this rally. Bubbles don’t happen when many call it so - the sign would be when a number of new treasury funds are floated.

As the rescue progresses the cost of government borrowing will increase (every one agrees that such huge amounts cannot be borrowed overnight) and that it may crowd out other borrowers is a real risk. It will also increase the interest cost for businesses which might also find liquidity tight once again. If the government limits the cost of borrowing than it puts a lid on how much stimulus and other packages can do.

Monitor how this tradeoff progresses.

Disclosure: No Positions

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 9

2009-01-09T19:11:00.010+05:30

What corporate bond market does?

Economist explains as to why corporate bonds should probably rally before a genuine rally in equities begins.

“A further dilemma is whether corporate bonds will rally before equities. That would seem logical, given that bonds have a prior claim on corporate profits. In addition, companies seem likely to run their businesses for the benefit of bondholders rather than shareholders, cutting dividends to save cash, for example…there may be a selection problem: weak companies have tended to borrow, and there are very few AAA-rated companies these days. Many of the most heavily-geared companies are in the portfolios of private equity groups, rather than on the quoted market.

Nevertheless, it is hard to see how stock markets can find a bottom if corporate-bond spreads are still widening. In turn, it is hard to see corporate bonds stabilizing without a return to some kind of normality in the money markets, with banks and companies able to borrow freely again (albeit not quite as freely as they did in 2006). So, Libor is the key to a market bottom.”

Explaining the point that corporate bonds should see a rally before a real move upwards in equities a CLSA report explains:

“It is unrealistic to expect any rally in equities without there first being a rally in corporate bonds. At the four great bottoms, the price of BAA corporate credit rose before the price of equities rose.

In 1948, bond and equity markets were distorted by government caps on treasury yields and excess-profit tax on corporate profits.”

Source: Business Week

Source: CLSA

However one has to wait and see how the corporate bond market responds to poor earnings and cash flow reports over the next two quarters. Surprises may call for downgrades and the corporate bond market may reassess the risks again and price it in. This obviously would be negative for the equities.

Market Impact: 2009 Watch List – Part 8

2009-01-09T16:44:00.016+05:30

What are US Tips and Treasury yield spreads indicating?

By subtracting the yield of TIPS (Treasury Inflation Protected Securities) of a particular maturity from the yield of an ordinary Treasury note/bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

TIPS yield Curve (%)

Treasury Yield Curve (%)

Source: www.treasury.gov

As seen above the market is indicating a deflationary picture over the next five years. As of 5th January this expectation was over a 7 year period. How this expectation changes over 2009 will be interesting to monitor.

Market Impact: 2009 Watch List – Part 7

2009-01-08T07:21:00.021+05:30

How the US savings rate grows?

“Americans are starting to save again rather than relying on capital gains to do their saving for them. The government says Americans set aside $260 billion from their disposable incomes in October, up from about $70 billion a year earlier. That's a step in the right direction for the long term, even though it intensifies the short-term downward pressure on the economy because consumers aren't spending.

The effort to save more amid weak income growth and tight credit will prevent consumers from providing their usual oomph to the recovery. As a result, businesses will not be as quick to expand.

The fall in oil and commodity prices saw disposable income improve and has pushed the savings rate to 2.8% which is an improvement from the 2005-07 figures of less than 1%. The refinancing of the mortgages at lower rates may also help in this process and can also be used to retire credit card debts."

Source: Business Week

This may appear as a negative factor from a consumer spending point of view as in many of the past downturns they have provided the push for recovery as they could borrow at low rates to lend. However in the current context given the individual leverage levels and falling income levels the psyche may not allow such a process.

Source: HSBC

The positive is that it will help soften the effect on the cost of stimulus that has to be paid at a future date. An increasing savings rate will help cushion the leverage risk that the US as a country has and is likely to see a substantial jump in the near future. Increase of this rate to the long term average of 7 to 8% will augur well for the future. How the US consumers tradeoff, is a must watch.

Disclosure - No Positions

Market Impact: 2009 Watch List – Part 6

2009-01-08T07:15:00.006+05:30

How US Retail landscape shape up?

“…This spending slump, which started in early 2008, has already claimed a number of retail casualties. Prominent national chains such as Linens 'n Things, Steve & Barry's, KB Toys, Whitehall Jewelers and Shoe Pavilion have gone out of business.

Still others such as No. 2 electronics seller Circuit City are barely surviving, hoping to find a lifeline while in bankruptcy protection.

But after suffering one of the worst year-end shopping seasons in decades - November and December combined can account for half of merchants' annual profits and sales - experts predict that many more chains will disappear.

The International Council of Shopping Centers estimates that chain store closings could exceed 3,100 in just the first half of the year…..another 73,000 stores will close in the first half of 2009."

Need to watch as to what happens to the bailout retailers are pitching for.

Disclosure - No Positions

Copyright © 2008 Tradesense

India's Enron - Satyam

2009-01-08T06:25:00.015+05:30

Just a diversion from our watch list continuation as Indian market was hit by a scandal where a respected (till yesterday) Chairman of the company Satyam Computer Services (NYSE:SAY) resigned on Wednesday, saying profits had been inflated over the last several years. The Indian market tanked as a result and the Indian IT sector - specially the services sector, may see tremendous pressure. So will the Indian auditing/accounting fraternity. It appears India will soon have its own Sarbanes-Oxley equivalent.

The ramification of this is that there could be many other companies both in India and other markets that would have stretched itself due to peer pressure and Street pressure and have cooked their books. Now in times of stress many companies and promoters are not able to find the cash to continue hiding. While others who did well genuinely may be tempted to cook books in these times of stress.

In a sense this has watch list implication that we have been discussing. Look at the Audited Annual Reports due for 2008 carefully to find apparent signs of window dressing. Banks would be the most vulnerable.

Following is the text of his letter, which was released by the Bombay Stock Exchange.

Note: references using Indian numerical system of crores and lakhs have been converted to Western system.
-------------------------------------------------------------
To the Board of Directors
Satyam Computer Services Ltd.

From B. Ramalinga Raju
Chairman, Satyam Computer Services Ltd. January 7, 2009

Dear Board Members,
It is with deep regret, and tremendous burden that I am carrying on my conscience, that I would like to bring the following facts to your notice:

1. The Balance Sheet carries as of September 30, 2008
a. Inflated (non-existent) cash and bank balances of 50.40 billion rupees ($1.04 billion) (as against 53.61 billion reflected in the books).
b. An accrued interest of 3.76 billion rupees which is non-existent.
c. An understated liability of 12.30 billion rupees on account of funds arranged by me.
d. An overstated debtors position of 4.90 billion rupees (as against 26.51 billion reflected in the books)

2. For the September quarter (Q2) we reported a revenue of 27.00 billion rupees and an operating margin of 6.49 billion rupees (24 pct of revenues) as against the actual revenues of 21.12 billion rupees and an actual operating margin of 610 million rupees (3 percent of revenues). This has resulted in artificial cash and bank balances going up by 5.88 billion rupees in Q2 alone.

The gap in the Balance Sheet has arisen purely on account of inflated profits over a period of last several years (limited only to Satyam standalone, books of subsidiaries reflecting true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly (annualized revenue run rate of 112.76 billion rupees in the September quarter, 2008, and official reserves of 83.92 billion rupees). The differential in the real profits and the one reflected in the books was further accentuated by the fact that the company had to carry additional resources and assets to justify higher level of operations -- thereby significantly increasing the costs.

Every attempt made to eliminate the gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in a take-over, thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten.

The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. Maytas' investors were convinced that this is a good divestment opportunity and a strategic fit. Once Satyam's problem was solved, it was hoped that Maytas' payments can be delayed. But that was not to be. What followed in the last several days is common knowledge. I would like the Board to know:

1. That neither myself, nor the Managing Director (including our spouses) sold any shares in the last eight years -- excepting for a small proportion declared and sold for philanthropic purposes.

2. That in the last two years a net amount of 12.30 billion rupees was arranged to Satyam (not reflected in the books of Satyam) to keep the operations going by resorting to pledging all the promoter shares and raising funds from known sources by giving all kinds of assurances (Statement enclosed, only to the members of the board). Significant dividend payments, acquisitions, capital expenditure to provide for growth did not help matters. Every attempt was made to keep the wheel moving and to ensure prompt payment of salaries to the associates. The last straw was the selling of most of the pledged share by the lenders on account of margin triggers.

3. That neither me, nor the Managing Director took even one rupee/dollar from the company and have not benefitted in financial terms on account of the inflated results.

4. None of the board members, past or present, had any knowledge of the situation in which the company is placed. Even business leaders and senior executives in the company, such as, Ram Mynampati, Subu D, T.R. Anand, Keshab Panda, Virender Agarwal, A.S. Murthy, Hari T, S.V. Krishnan, Vijay Prasad, Manish Mehta, Murali V, Sriram Papani, Kiran Kavale, Joe Lagiola, Ravindra Penumetsa; Jayaraman and Prabhakar Gupta are unaware of the real situation as against the books of accounts. None of my or Managing Director's immediate or extended family members has any idea about these issues.

Having put these facts before you, I leave it to the wisdom of the board to take the matters forward. However, I am also taking the liberty to recommend the following steps:

1. A Task Force has been formed in the last few days to address the situation arising out of the failed Maytas acquisition attempt. This consists of some of the most accomplished leaders of Satyam:, Subu D, T.R. Anand, Keshab Panda and Virender Agarwal, representing business functions, and A.S. Murthy, Hari T and Murali V representing support functions. I suggest that Ram Mynampati be made the Chairman of this Task Force to immediately address some of the operational matters on hand. Ram can also act as an interim CEO reporting to the board.

2. Merrill Lynch can be entrusted with the task of quickly exploring some Merger opportunities.
3. You may have a restatement of accounts' prepared by the auditors in light of the facts that I have placed before you.

I have promoted and have been associated with Satyam for well over twenty years now. I have seen it grow from few people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries. Satyam has established an excellent leadership and competency base at all levels. I sincerely apologize to all Satyamites and stakeholders, who have made Satyam a special organization, for the current situation. I am confident they will stand by the company in this hour of crisis.

In light of the above, I fervently appeal to the board to hold together to take some important steps. Mr. T.R. Prasad is well placed to mobilize support from the government at this crucial time. With the hope that members of the Task Force and the financial advisor, Merrill Lynch (now Bank of America) will stand by the company at this crucial hour, I am marking copies of this statement to them as well.

Under the circumstances, I am tendering my resignation as the chairman of Satyam and shall continue in this position only till such time the current board is expanded. My continuance is just to ensure enhancement of the board over the next several days or as early as possible.

l am now prepared to subject myself to the laws of the land and face consequences thereof.
(B. Ramalinga Raju)

Copies marked to:
1. Chairman SEBI
2. Stock Exchanges

Source Yahoo.co.in

Disclosure - No Positions

Market Impact: 2009 Watch List – Part 5

2009-01-06T20:02:00.006+05:30

How the financial health of the Big Three progresses?

With a 35% drop in sales reported by the big three auto companies the financial stress on them has only increased further. This will have its impact on employment as production is reduced. According to NYT G.M.’s chief market analyst, Michael C. DiGiovanni, said that the automaker was predicting industry sales of 10.5 million to 12 million vehicles for the year.

They recently received federal loans which provided some confidence to the market. The US automaker bailout is trickier than it may appear. The conditions that have been imposed - as an expert observed - are “structured for bankruptcy”. By end of March they will to prove that they are viable. By this time they need to negotiate with their creditors to have their debt modified or reduced by two thirds at the minimum. They also need have new agreements with their vendors with new conditions more favorable to them. The compensation and benefits of workers and executives also needs to be lowered. Putting all this together they need to show that they are viable. And if they are unable to deliver they need to repay the loan. This, most observers doubt if can be achieved in such a short period. This would be then a pre-packaged bankruptcy. Their only hope is for Obama to show them leniency.

The key questions are:

Will a pre-packaged bankruptcy be considered to allow them to renegotiate their outstanding loans and work out better arrangements with their dealers and the United Auto Workers?

How much will government interfere in the running of their businesses?

How will the government make it easier for them to do business? E.g. addressing the fifty-state fuel economy and exhaust emission regulations.

Signs of how long the government is willing to stand by these companies given that the whole process to stabilize may require anything between 3 to 5 years and may require upward of $100 bn. over this period.

Will all three be supported equally or the government might want to weigh which has the best chance? It could impact many shareholders which are pension funds and college endowments. It could feed the unemployment numbers also in a big way.

Will a higher federal gasoline tax be imposed to make people move to more fuel efficient cars?

GMAC, the lending arm of GM received $6bn.rescue package which was received by the market with bullishness. As one expert summarized:

GMAC is however not so well capitalized for it to push lending in a big way. Fed while approving for it become a bank holding co. has also asked it improve its capital adequacy by raising $30bn. Of the $6bn., 1bn. is going to GM to subscribe to GMAC rights issue. It has 5bn. of TARP money. For the balance capital requirement (apart from the $9bn. it had as of September) it concluded a debt for debt-and-preferred exchange offer, the deadline for which it had to extend several times. It says enough bondholders swapped their debt for it to meet the Fed’s capital requirement, but that doesn’t leave it with a huge amount of excess cash to leverage into new loans, or act as a buffer against future losses. The fear is that it may have to make more trips to make to the government as it is still loosing money.

There is a fear therefore that GMAC may add to the taxpayer bill further and there a pre-packaged bankruptcy would be a wiser option.

Watch the events unfold keenly as it will have massive ramifications from a market point of view.

Disclosure - No Positions

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 4

2009-01-05T18:52:00.010+05:30

How Quickly US home prices stabilize?

Needless to say a very important factor as the genesis of the current crisis is attributed to the bubble this sector. It has seen a record decline of 18% in October08 on a year on year basis. As observed:

“The 20-city S&P Case-Shiller index has posted losses for a staggering 27 months in a row. In October, 14 of the 20 cities set fresh price decline records.

…Housing problems are at the core of our economic problems," … "yet, of the government interventions made during 2008, few were focused on housing."

Foreclosures have been worrisome

"October was really the first month to feel the full brunt of the credit crunch," ... "Up until the Lehman Brothers [bankruptcy filing on September 15], everyone felt relatively optimistic.

Plus, in many of the free-falling cities the majority of real estate sales consist of distressed properties such as foreclosed homes and short sales. These houses tend to sell at a steep discount to the rest of the market, and when they account for a large proportion of all sales, they can exaggerate the depth of price declines.”

Mortgage modifications have not helped

“…a recent report issued by the U.S. Comptroller of the Currency (OCC) found that 53% of borrowers who had their mortgages modified in the first half of 2008 were already at least two months delinquent again. The report covered 60% of the outstanding primary mortgages.

Modifications that don't involve some kind of principal reduction or somehow lower payments substantially "just don't work very well…We need to see lenders get much more aggressive when it comes to loan modifications.”

The effect of lowering interest rate need to reflect in new home sales

“…And although interest rates are currently extremely low - the 30-year fixed-rate averaged 5.14% … that's doing more to help people refinancing existing mortgages than it is to help new home buyers.

"Buyers still have to have a 20% down payment," … "and, in this environment, it can be hard to meet that criterion."

Experts observe that the tumble in homebuilding is expected to bottom out by midyear, but house prices will fall an additional 9.8% by yearend 2009, after a nearly 20% decline in 2008.

At the current levels the latent demand would surely be there. However no body would want to buy and see their equity go down. Therefore price stabiliszation would be the driver for home buying to start in right earnest. Keep you ears to the ground!

Copyright © 2008 Tradesense