Thursday, 25 September 2008

The Man Who Saved The World...or did he?

Alan Greenspan, former chairman of the Federal Reserve, was during the peak of his tenure widely known as the "saviour of financial markets" for his market friendly monetary policies. But today at the height of the greatest financial crisis since the Depression, many market commentators are less certain whether Mr Greenspan still deserves the same accolades.

Many commentators will argue that the Fed under Greenspan was "asleep at the wheel" while players in the financial industry relentlessly leveraged their businesses and blatantly ignored sound credit practices, all in the name of higher profit growth and "optimal" balance sheets, i.e. creating off-balance sheet structures or otherwise known as Special Investment Vehicles (SIVs).

David Blake, an executive of an asset management firm, argued recently in a FT column that low interest rates, as seen in the aftermath of the dotcom bubble and 9/11, and often cited as the root cause of the ensuing credit bubble are not too blame, but rather the lack of sufficient action taken when it became clear some asset price bubbles were forming. First, in 1996 Mr Greenspan already conceded about an equity bubble in his "irrational exuberance" speech. He suggested that a tightening of the margin requirement - which investors hold against financial derivative positions - would be effective in stopping the creation of an equity bubble. Second, in 1998 a commission expressed concern about the massive increase in over-the-counter (OTC) derivatives, which of course today is at the heart of the credit crisis.

In both instances the Fed did nothing about it and we have seen two major bubbles, directly related. The equity bubble at the end of the millennium was fuelled by the ease of lending by brokers to buy more shares. When the bubble finally burst another wave of investors interest started in the housing market. We have had a tremendous rally in housing prices and mortgage lenders securitized and packaged mortgages; thereby "spreading their credit risk". Greenspan himself said housing was a safe investment, while the mortgage-backed securitisation market was seen as very effective in spreading credit risk amongst market players.

Even subprime lending - the root cause of the current financial crisis - was regarded as innovative since many marginal applicants could now have qualified to buy their own homes. Apparently, mortgage lenders could afford such high-risk lending because innovative credit models ensured the spreading of risk.

Well, today it seems that nothing can survive the longevity of good old-fashioned credit practices. The innovative, mortgage-backed securitisation market and derivatives did not stood the test of time; it was a miraculous failure to say the least and the stability of the whole financial system is at great risk.

Wednesday, 17 September 2008

The Crisis Intensifies

Wow! What a week on financial markets as it seems that the once "too-smart-to-fail" US financial sector is after all fallible. We are witnessing a "one-in-a-hundred-year" type of event as wave upon wave of solvency and liquidity crises are hitting the beleaguered US investment banks and lately the insurance giant, AIG.
The US government stood firm in the case of Lehman Brothers; no bailout or aid this time, as they did with Bear Stearns, Freddie Mac and Fannie Mae, but rather let the market forces run its natural course. So it did and Lehman Brothers, once the 4th largest investment bank, has filed for bankruptcy. At the same time it was announced that the mighty Merrill Lynch agreed to be taken over by Bank of America in a deal worth $50bn - maybe that announcement was even a bigger shock to the market than Lehman's demise. By then all the market participants realised that nobody was safe anymore.
Then merely two days later it became clear that AIG was on the brink of failure with no obvious aid to their liquidity crisis. At the end the US government had to come to the rescue - the systemic risk was just too big with AIG, besides being a counterparty to many credit default swaps, it has widespread links to the real economy, business interests in 130 countries and over 100,000 employees.
With government's interventions in the bailout of US financials, at a considerable cost to taxpayers, it is no wonder that Nouriel Roubini recently stated that America from now on should be known as the "USSRA - "United Socialist State Republic of America"!
Roubini, among a few other level-headed commentators have been warning for some time that a financial tsunami is bound to happen in view of the unregulated credit practices, "unlimited" leveraging and pure greediness, i.e. to grow bigger and faster at all costs. Sad to say, but not surprisingly, these "doomsayers" have been right all along. Common sense prevails in the market place at the end, not so-called "high IQ products".
Is this the end of this crisis? No, I don't think so - still a lot of money will be written off. Some commentators think at least another $500bn, others even more. Beware: hedge fund investors. "Normality" will return after we have seen a dramatic shakeup in the industry. New players - maybe those that in the past have been considered "too boring and conservative" - will emerge as the new industry leaders.
Then, do not be surprised to see a lot of "financial" engineers returning to professions where they should have been in the first place - namely the engineering and construction industry where the occurrence of extreme events (black swans) are not as likely as it do occur in financial markets which most often render mathematical and risk models null and void.

Sunday, 14 September 2008

Beware: The Black Swans

The imploding of the US housing market bubble has resulted in one of the worst credit crunch crises yet with well over $500bn already written off by financial institutions thus far. How much more will the crisis cost investors? Well, analysts predict at least another $500bn, but more likely double that, are to be written off in the near future. We have already seen the demise and bailout of financial giants such as Bear Stearns, Freddie Mac and Fannie Mae and lately the bankruptcy filing of one of the largest investment banks, Lehman Brothers while Merrill Lynch has agreed to be taken over by Bank of America.

Surprisingly, the economies of the US and the Euro zone have shown some resilience thus far. Although most commentators are expecting recessionary economic conditions in these regions, unemployment figures have not risen dramatically, nor have economic output dramatically declined.

However, which events could cause a deep economic recession, especially among the major economic forces of the world? First, it is of course a global financial meltdown, which the US Federal Reserve is trying to prevent at all costs. Wolfgang Munchau, columnist of the Financial Times, reckons that the $6,000 bn credit default swap market, for example, poses huge risks as non-payments by counterparties would lead to enormous uncovered exposures by supposedly insured parties.

The second possibility is a dollar crisis. At the moment interest rates are kept low by the Fed to stimulate economic growth in the midst of the credit crisis and will probably be maintained at those levels for some time. What will happen if US inflationary expectations will rise significantly above the prevailing interest rates? Despite the prominent role of the US dollar in global financial affairs or its dominant position in countries’ foreign reserves, it is not unlikely that a flight of global investors from the US will result in vicious circle of a falling US dollar, rising US inflation and interest rates, bank failures and a deep recession (depression?).

The materialising of either scenarios seems rather unlikely at the moment. In fact, the dollar has strengthened considerably against the euro in recent months as investors globally have increased their allocations to ‘flight-to-quality’ investments, like US treasury bonds. But then, not even a year ago, very few commentators, if any, would have predicted that stalwarts such as Bear Stearns and Lehman Brothers (and Merrill Lynch) would have ceased to exist by today.

Tuesday, 9 September 2008

The Rescue of The Twins

On Sunday, September 7, the US government finally announced that the two beleaguered and insolvent GSEs, Fannie Mae and Freddie Mac with a total debt of $5.3 trillion, will be placed into ‘conservatorship’ (read nationalised). The US government will immediately acquire a $1bn stake in each in the form of preferred equity with the option to expand its stake to $100bn in each company. The new preferred equity is senior to existing preferred and common shareholders, but junior to existing senior and subordinate debt holders. Creditors’ interest and principal payments are furthermore secured by a lending facility.

From the action plan announced it seems that the winners are debt holders, but preferred and common shareholders are big losers because they won’t receive any dividends, at least in the foreseeable future. Hence, sharp losses and further writedowns are expected to continue for such shareholders.

The reaction to the announcement is mixed. Some commentators argue that the plan will have a positive impact on credit markets. Others are more critical; nothing can prevent the US housing market to continue its slump and subsequent further losses in the securitisation markets.

Another concern is that the increase in government debt would start affecting the US sovereign credit rating (currently AAA). The expected rise in Treasury supply could depress bond prices if demand does not rise in line with supply.

Click on the video link below for some comments on the rescue plan.

Assessing The Plan
Assessing The Plan

Thursday, 4 September 2008

The Health of the US Banking Sector

The FDIC (Federal Deposit Insurance Corporation) which provides protection to checking and savings deposits up to $100,000 per depositor, recently released their latest “Quarterly Banking Profile”. The results look ‘pretty dismal’ as Q2 earnings were 87% below the Q2 2007 level ($5bn versus $37bn) as loss provisions rocketed to $50bn. The number of troubled banks on the FDIC’s watch list increased to 117, up from 90 in Q1.

While the banking industry’s ‘coverage ratio’ (ratio of loss reserves to noncurrent loans) dropped to a 15-year low, banks would have little choice to shore up their reserves in forthcoming quarters. Importantly, this will come at the cost of future earnings growth.

Globally, the total writedown of losses in the recent housing market and credit crunch crisis exceed $500 bn. Thus far primary dealers were at the forefront of the writedowns. Institutions like the IMF estimated earlier that the total losses would eventually amount to $1 trillion ($1,000 bn), while Nouriel Roubini, a widely respected economist, estimated a global $2 trillion loss. Interestingly, foreigners hold about 40% of asset-backed US securities. With a 20% markdown of these assets about $475bn will be lost abroad.

An additional worry is the fate of Fannie Mae and Freddie Mac, where banks and insurance companies are major holders of their $36bn preferred shares, but which have been downgraded heavily thus year. Government intervention is imminent, but it is unlikely that existing shareholders will not have to write off some losses.

Tuesday, 2 September 2008

A Flood of Liquidity

Many economists and market commentators in recent months have expressed their concern that the US Federal Reserve's policies of managing the credit crunch crisis will lead eventually to more inflation and perhaps even bigger problems to solve in the future. The Fed has intervened in the credit crisis by taking unusual steps such as making credit facilities available to investment banks and facilitating the takeover of Bear Stearns.
George Magnus, senior economic advisor at UBS, however recently argued in a Financial Times article that inflation should really be of lesser concern, but what is important now is for the Fed to provide sufficient liquidity in the market to prevent a systemic meltdown such as was seen during the depression of the 1930s.
Magnus is of the opinion that unusual events merit unusual solutions, especially where systemic risk is prevailing. Furthermore, he lists a number of reasons why the criticism against the Fed's actions is largely unfounded: First, US long-term bond rates do not discount an expectation that inflation will spiral out of control. Second, the credit crisis remains largely a US problem with up to 117 of their banks in trouble as it becomes more difficult to raise capital. The consequential sell off of assets to shore up the balance sheets of banks highlights the severity of the downturn and justifies the Fed's actions. Third, consumers will find it increasingly difficult to access credit. With a slowdown in consumer spending expected the worries about inflationary pressures will become unfounded.
Thus, while the Fed's actions may be seen by some as inappropriate one must bear in mind the severity and extent of the credit crisis and its possible ramifications. In this context one former central banker is quoted: "it is after depression and unemployment have subsided that inflation become dangerous".