Sunday, December 13, 2009

Au revoir...

Dear Sober Look readers and friends,

Due to some rapidly changing personal circumstances, I have decided to put Sober Look on hold for the foreseeable future. It has been an amazingly rewarding experience and a privilege to be involved in this project. From the bottom of my heart I would like to thank all the readers for your support. I’ve learned a tremendous amount from your thought-provoking comments and e-mails.

Technology such as Blogger has allowed thousands of people to express their views and bring out concepts and information that the mass media often fails to do. Just because financial media reporters sometimes don’t understand concepts, doesn’t mean that the public shouldn’t understand them either. Just because the media sometimes wants to incite anger to improve ratings, doesn’t mean the anger is properly directed or even warranted. My goal with Sober Look has been to bring out alternate ways of viewing this crisis and it's sources, the economy, and the financial system.

A Bloomberg commentator Caroline Baum once said that if you want to know where the next financial crisis will come from, just look to the most popular current trends. Whether the tech IPOs and emerging markets in the 90s or the housing boom and securitization during this decade, this saying has proven to be correct again and again. These trends can persist for years until their invulnerability is no longer questioned. And then arrives an abrupt, painful, but never a fully anticipated conclusion.

The key is that the seeds of the next crisis are usually sown while the current one is still being played out. And it is often the reaction to the current crisis that sets us up for the next one. This concept is of course not limited to finance or economics, but is evident in the geopolitical arena as well. For example the Soviet occupation of Afghanistan and their ultimate defeat was a crisis that saw the birth of Al Qaeda, leading to the next geopolitical crisis.

As we look to the next decade, what are the signs of popular financial trends now emerging to haunt us in years to come? What about favorites such as China’s rapidly growing markets, commodities (particularly gold), and the ever popular US Treasuries? Economists and financial forecasters have never been so divided about the future. With rapidly growing global liquidity, continuously evolving markets, and accelerating capital flows, one thing we can be sure of - the next decade will see yet another crisis, possibly more than one.

But that doesn’t mean we should all be buying guns and store canned food in order to be prepared. With each crisis will come tremendous opportunities – from investments, to new businesses, and new jobs. The goal is to keep an open mind, keep learning, and keep questioning. And for my fellow bloggers who want to clear up misinformation, look through the hype, let others know of alternate ways of thinking, and point to the next crisis... keep on blogging. I’ll be reading.

Monday, December 7, 2009

Barney Frank's House bill H.R. 3996 - impact on secured lending

Bloomberg: [FDIC chair Sheila] Bair, in a letter to lawmakers released today, endorsed a proposal that was added last week to the regulatory overhaul legislation making its way through the House Financial Services Committee. It would require secured creditors, like repurchase agreement lenders and the Federal Home Loan Bank system, to bear losses of as much as 20 percent to cover the costs of a systemically significant bank failure.

In addition to finding a supposed way to cover costs of winding down a too-big-to-fail institution (and possibly all banks), this portion of the financial overhaul legislation will have some other consequences:

1. It will make it significantly more expensive for these institutions to borrow funds even if they post treasuries as collateral.

2. Any negative news about a specific institution or the financial system as a whole will get lenders running for the fences forcing rapid unwinds. This will make Lehman look like a gradual process.

3. It may destroy the repo market. Repo is used by money market funds, corporations, pensions, etc. to place funds on a secured basis (taking in collateral). As an institution if you have short-term cash and you don't want to deposit it with a bank (unsecured), your only option is to lend it to a bank on a secured basis via repo (taking in treasuries as collateral for example). If this option is taken away, institutions will need an alternative such as the ability to deposit cash with the Fed.

4. This will give foreign banks an unfair advantage by funneling repo lending (secured deposits) to non-US banks, making it cheaper for those banks to fund themselves.

5. US banks will try to get around these laws by creating off-shore financing vehicles that are not subject to US banking legislation, making banking supervision that much more difficult.

As we discussed before, knee-jerk reaction regulation is not always the answer, but in this case could spell an absolute disaster for the US financial system. It behooves the US legislators to slow down their political posturing and try to understand how the finacial system actually works in practice.

Nakheel - the assets behind the bonds

Nakheel property development company that is part of troubled Dubai World is about to hand over a big chunk of land to it's bondholders. Behind door number three would be some great waterfront properties, right? Not exactly.

Bloomberg: Nakheel PJSC creditors may win the right to seize a strip of barren waterfront land the size of Manhattan if the company defaults on the $3.5 billion bond backing the development.
This is what the bondholders are getting - with all the construction now abandoned.

source: Nakheel

And the bonds have traded to reflect the great recovery value.

source: Bloomberg

Sunday, December 6, 2009

The Hype Award goes to FT's Henny Sender

Here is a good example of the hype style financial reporting, amazingly enough coming from the FT. In an article called Reckless banks still to pay Henny Sender writes:

Two recent judicial opinions rebuking the banks offer a window into the lending practices that fuelled the boom and the tactics that banks resorted to in a belated attempt to cut their losses. These cases highlight just how reckless the banks have been and how that recklessness may come back to haunt them – and their bottom lines.

She discusses two cases, one of which has to do with Tousa, a Florida homebuilder. Citi indeed was reckless in its lending practices with this firm. Tousa’s business was on the brink when Citi extended it a loan that allowed it to refinance an earlier loan used for some highly leveraged acquisitions.

But as financial reporters often do, she starts with a valid point, but then moves on to a case that is actually unrelated (bunching it all into one anti-banking rant). Her second example deals with Charter Communications and JPMorgan. And that’s where the logic completely breaks down.

The second case involves Charter Communications, the fourth largest cable company in the US, and one of the most hotly contested battles to confirm an operational plan in the wake of a Chapter 11 filing. The judge rejected the banks’ claim that their loans were impaired, and said the banks were holding up the company’s emergence from bankruptcy protection just to change the terms of their loans and earn more interest. The adverse ruling could deprive the banks of $1bn in tax savings, a lawyer for the banks said. The banks in this case were led by JPMorgan whose spokesman declined to comment.

What Ms. Sender either doesn’t want to discuss or is simply clueless about is that Charter loan was always solid. There was absolutely nothing reckless about lending to Charter – there has been and still is plenty of asset coverage for the senior loan. The Charter case involves an intercreditor dispute. When a company files for bankruptcy, senior lenders generally have a say in the restructuring of the firm. In Charter’s case the management sought to file and restructure without involving the senior lenders. The firm then restructured the subordinated debt and simply reinstated its existing senior loans. These loans will remain in place as they have been prior to filing. There is going to be no principal loss for lenders.

What the lenders wanted was to restructure the senior loans in order to raise the coupon. As generally happens with covenant violations or other credit agreement “triggers”, the lenders can push the company to renegotiate the terms. For some reason the judge in the case sided with the company, refusing to allow the senior lenders to the negotiating table. That means they are stuck with the original low coupon.

But the Charter case has nothing to do with “reckless” lending. Charter, in spite of being quite leveraged was (and still remains) a prudent exposure for the lenders. Attempting to increase the interest rate on this loan in a bankruptcy scenario is exactly what banks are supposed to do. The fact that JPMorgan was unsuccessful in doing so speaks more to the changing nature of Chapter 11 than to any recklessness on behalf of lenders. Just to round things off, Ms. Sender ends the story by bringing up the Enron case from way back without any clarity on how it relates to "reckless lending".

In the environment where it is fashionable to bash banks, rather than focus on unbiased journalism and independent research, nobody seems to question or contradict Ms. Sender’s story. Misinformation that stokes anger continues to sell papers after all. FT’s Henny Sender will therefore receive the Sober Look hype award. Congratulations.

Wednesday, December 2, 2009

Debt 50c on the dollar - good luck finding any

The chart below shows the amount of corporate debt that trades at a price below 50 cents on the dollar. This is simply how JPMorgan defines "distressed debt". What's impressive is how demand for fixed income product nearly eliminated this spike in a matter of months. A year ago over $200 MM of corporate debt traded at discounts of 50% or more. Now there is almost none left.

Part of this exuberance in credit stems from falling default rates:

It's a bit of a self-fulfilling prophecy. Demand for fixed income product provides opportunities for refinancing, generating liquidity, extending maturites, and reducing default rates. Falling default rates generate more interest in credit/fixed income. Of course this process can work in reverse as well.

A better way to identify recessions

In an era of rampant conspiracy theories and mistrust of institutions, many have been sceptical of the National Bureau of Economic Research decision process with respect to identifying the start and end of recessions. Not only is the pronouncement on a significant lag, but some think the timing may have a political or some other bias.

To address this issue, James Hamilton from UC San Diego developed an index that uses the GDP data to "measure" the probability of the economy being in recession at a particular time. The strength of the approach is that it uses GDP trends (as opposed to just the latest number) over recent quarters to determine the probability. It's a mechanical approach that doesn't require judgement that is embedded in the NBER's decision process, therefore taking out any real or perceived bias. The measure is also much more current and does not require one to wait several quarters before confirming the beginning on the end to a recession.

Here is how the index compares to the NBER's pronouncements:

source: Atlanta Fed

Equity vol getting cheaper vs. credit

Equity volatility continues to trade cheap to credit. The chart below compares VIX to the investment grade CDX spread.

Except for the Dubai driven spike, equity vol may be disconnecting from credit and will continue to drift lower. At some point a spread trade will become interesting - shorting investment grade credit against long equity options (or VIX futures).

Tuesday, December 1, 2009

Japan facing harsh realities of deflation

It may sound like a wonderful concept - you wake up every morning and things are a bit cheaper than before. Your money is worth just a bit more. And that is (sort of) the situation in Japan currently. The chart below shows Japan's negative inflation rate.

But then you ask yourself, if things are getting a bit cheaper, why buy now, why not wait. And some of that type of thinking is a good thing. But when everyone thinks that, then nobody is buying and the economy stagnates bringing prices further down. This is deflation and it's quite dangerous, because once you are in it, it's hard for the central bank to do anything to get the nation out of it (unlike fighting inflation where central banks have numerous tools).

Japan is now facing this dilemma:

Bloomberg: Prime Minister Yukio Hatoyama’s government stepped up calls on the Bank of Japan to prop up growth after declaring on Nov. 20 the economy was in deflation. Shirakawa, who yesterday pledged to act “promptly and decisively,” has few options given that the key overnight lending rate is at 0.1 percent and the bank is already purchasing government and corporate debt.

The broad money supply isn't growing enough as bank lending continues to be constrained.

But the real killer is the yen strength. For an economy that is export focused and has a relatively weak domestic demand growth, this is bad news.

At this rate Japan will move more manufacturing out of Japan - possibly even to the US (as the US becomes the "high end" outsourcing center). They will also be investing more abroad - all of which is not too helpful for the domestic economy.

The central bank response has been "muted" so far:

Bloomberg: The central bank yesterday said it will offer three-month loans to commercial banks at 0.1 percent under the new facility. Governor Masaaki Shirakawa stopped short of boosting the monthly target for government-bond purchases from 1.8 trillion yen, a step analysts said may be taken within months.

It's not clear commercial banks will want to borrow from BOJ at all because their ability to fund themselves is not the issue. BOJ will need to get far more aggressive to prevent an accelerating deflation (which the nation has not fully come out of for decades).

If the current trend persist, expect BOJ to take more aggressive actions to try to deflate it's currency and pump yen liquidity into the system. Quantitative easing or even direct currency intervention are quite possible.
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