Auditor's one line report on Lehman Brothers Balance sheet:
"There are two sides to a Balance Sheet - The Left & the Right (Liabilities and Assets respectively) - on the Left side there is nothing right and on the right side there is nothing left "
My Diary 444 --- Is TARP Large Enough? Are We Near Zero? Has Hedge Fund Gone?
October 5, 2008
“Blood of Jesus vs. 700Bn
From my observation, an even bigger axe to grind in coming future is –hedge fund redemptions, plus the on-going deleveraging of financial institutions and households. This is what has kept credit spreads extremely elevated despite the passing of Q-end and suggests the risk of another financial failure remains acute. Having said that, after witnessed several Black Swans over the past few weeks, I can not help thinking about, if the TARP doesn't work, what would be the failure scenario looks like? (I hope I worried too much). In addition, I think even after the crisis is contained, it will take very long time to decompress conditions back to normal as there will be a “memory” on each of the market participants. I seriously doubt that the money markets will behave just like VIX does after a super spike. What really matters now is that about every government in the world is now behind the broken mass of the financial system, trying to arrest further damage. We can see the level of commitments keeps escalating, and at this point it seems many might deploy their full wherewithal if challenged by markets again, i.e. Irish government gives 2yr unlimited guarantee on deposits.
Another question is when the worst of the system crisis has passed, what’s next? No doubt, the answer is financial distress has or will spread into other parts of the economy. Here I have three proof of this conclusion --- 1) recent industrial data and Asia trade data suggest the US has slipped into a deep recession last month and that is before the full damage of the current crisis has been played through; 2) In addition to ISM and Construction prints, the US Sep NFP (-159K vs cons. -100K, -73K revised in Aug and -67K in July) and unemployment rate (6.1%, worse than expected) suggested that the current mess of markets could have cast aftershocks on the real economy. In fact, job losses is seen in every category except government (Yes, Paulson is hiring!) and earnings also weaker up 0.2% from 0.4% previously; 3) 138 of S&P companies cut their dividends (totalled $22.5bn) in 3Q08, an increase of 557% compared with the 21 dividend cuts in 3Q07. According to S&P index analyst Howard Silverblatt…”It is no longer just blue chip companies cutting dividends. Many of the issues are now much smaller, and more regional. The problem has trickled down…" Overall, I am not seeing a scenario where data improves off the current base. Even in normal times, this pace of decline would be alarming, suggesting something bad was happening anyway. Thus, I believe that the global coordinated rate cuts are going to get backed in the cake soon in G7.
As usual, let us take a look of market performance over the past week. Globally, equities took a nosedive with a remarkable 7.4% this week. Regional markets were mixed, rising in EU (+1.4%) but down in US (~10.3%) and
Looking ahead, I do agree that someday this will end. But that doesn't mean the worst for stocks is behind us based on several thoughts -- 1) The worst is probably ahead as spill-over effects on the global economy are mounting -- from housing, from the credit crunch, from wealth effects, and from the reverse multiplier effects of deleveraging. In reality, recessions are either already under way or about to begin in DMs, which will in turn reduce global demand. 2) Both the outcome of TARP and the likely costs are very uncertain at this stage. As Warren Buffet said, “…this does not solve all our problems. It just would have been a total disaster if it hadn't passed…'' At the meantime, the de-leveraging of the financial and household sectors in DMs will continue, exerting a contractionary impact on economic activity and inflation. 3) In addition, we have to bear in mind that the problem plaguing the financial markets lies not necessarily in the mortgage market now but in the credit markets. The credit crunch is now causing abrupt slowdowns or even declines in the availability of credit, which could to intensify the downturn till next year. 4) Maybe the only silver line is that the commodity price bubble is over, and is following the path taken by housing, credit, and equities.
As a result, I would expect that concerns over the global economic recession, fund redemption and risks/returns from equity investment will drive the global major index lower. In the near term, this market is not about fundamentals, technicals, regulators or anything, as it is all about cash and there is not enough out there. The key is to watching the tape of policy and to focus on the capital preservation as the whole
Is TARP Large Enough?
Overall, the TARP is an attempt to get ahead of the tidal wave of failures sweeping the
Indeed, after a decade or more of lax lending practices, excessive leverage and risk-taking, unsound business models, inadequate attention to counterparty risks, and regulatory failure, we should have foreseen the collapse of Wall Street and several other global banks. Unquestionably, all these problems and more will need to be addressed over the next few years (Not in a few Quarters!), but for the immediate future the focus must be on stabilizing the system and avoiding a 1930s-style depression. I think this is the ultimate goal of the $700bn bail-out plan designed to acquire illiquid assets from US/global banks over the next two years, restoring liquidity and confidence in the financial markets so that banks are able to raise capital and to expand credit to support economic growth. Now after we get away from the issue of Congressional cooperation, the major issue is whether the scope of the plan is large enough? Many market estimates of the losses from the sub-prime and broader
Having said so, it is worth summarizing a recent IMF paper (Dresdner-Kleinwort study) that examined 42 systemic banking crises from 37 countries, for the period 1970-2007 --- “Typically, the affected economies concerned went into recession, sometimes deep recession, and saw their current account positions improve. In some of the cases considered, the currency fell ahead of the crisis (exacerbating the problem of banks with foreign currency liabilities), on some other occasions the exchange rate fell after the crisis hit, as part of the corrective medicine. Sometimes, the crisis turned out to be contagious, rapidly spreading to economies with no apparent vulnerabilities. In 32 of the 42 crises that the IMF examined banks were recapitalized by the government. In 12 crises, the recapitalization by government took the form of cash; in 14 cases, government bonds; 11 times, subordinated debt; in 6 crises, preferred shares; in 7 cases, governments purchased bad loans; in 2 crises governments extended credit lines to banks; on 3 occasions they assumed bank liabilities and in 4 cases they purchased ordinary shares of banks. Occasionally they used a combination of the above. However, the recapitalization of the banking sector would normally involve the writing off of losses against shareholders’ equity and the injection of either Tier 1 or Tier 2 capital, or both.”
Are We Near Zero?
If the IMF research is part of guide to current crisis, then the global economy is sliding into recession. Over the course of this year, the foundations of the expansion have been eroded by the ongoing stress in credit markets, a sharp run-up in inflation, and falling wealth. In the
In Euro area, there are two special problems to be addressed – 1) the strength of EUR 1H08 and 2) the rapid growth of corporate lending. While the former means that as the economy weakens, exports will be unlikely to offset softer domestic spending, the strong growth of credit means that it will be hard for the ECB to justify rate cuts, particularly with the CPI at 3.8% -- more than twice the ECB’s target of “less than but close to 2%”. 2Q08 GDP declined by 0.2% qoq and slowed from 2.1% in Q1 to 1.4% yoy. New car purchasing across EU fell by 15.7% in August, and the composite PMI fell from 48.2 to 47.0 in September. Sentiment indicators across the continent have been moving downwards, notably the German IFO index and the French INSEE. The OECD leading economic indicators are also heading downwards for all the main EU economies, implying a winter of economic contraction. To Japan, the contracted demand from US and EU is reflected in the miserable of its economic growth record since the start of 2007 and the prospects for any near-term improvement are bleak as domestic private spending has been adversely affected by decreasing corporate profits and growth in business FAI will remain sluggish. Personal consumption has also been relatively weak, due to sluggish growth in household income and higher food and energy prices.
Elsewhere, in the Emerging Asia some will experience export slowdowns (like
Putting these altogether, reduced access to credit, the negative wealth effect from declining housing and equity prices, and in some cases the loss of income from employment will all constrain consumer spending in DMs in the months ahead. Against this backdrop, the slowdown of economy was reinforced as the corporate sector responded with more aggressive cost-cutting. All these effects will be exacerbated, wherever there is an explicit banking crisis. In addition, many financial firms and households need to deleverage their B/S to avoid further losses, and to limit the burden of debt service. In combination these pressures are likely to outweigh the ability of central banks to ease monetary and credit conditions. As a result, recessions are either already under way or about to begin in the developed world, which will in turn impact demand in some of the emerging economies. These developments have prompted a sweeping downward revision of global economic forecast in the street. Global growth is expected to be close to zero from 3Q08 to 1Q09, similar to the 2001 episode, a pace that qualifies as a mild global recession.
Has Hedge Fund Gone?
Having been told by several of my brokers friends from the top sell side houses that there is likely to see massive redemptions coming in the global hedge funds, I had spent quite some times to dig it out. It seems to me that the fundamental reasons for disappointed investors to withdraw money from HFs are --- 1) not only these “HEDGE” fund managers were not able to “hedge” the downside risks of client monies, but also stock hedge funds fell an average of 8.6% in Sept, the biggest one-month loss since 1990, according to Hedge Fund Research Inc.; 2) some of the strategies, like Long-Short or Credit Arbitrage, are overleveraged so that under such an unprecedented market volatility, they were killed by market-to market rule. HF managers are very painful to see they are forced to square both their long and short positions whenever during the last tick of up and down. And such an adverse impact have been exaggerated by the global wide short selling-ban rules; 3) there are huge recalls and a heavy tightening of stock lending as major lenders in US/Asia pulled their inventory back, while the remaining lenders have dramatically reduced their stock-loans, keeping ready buffer for the owners to sell.
On the back of the extreme difficulty of stock borrowing and short-selling actions, I also think that both Long funds and global FoF are moving money out of
If all these underlying trends keep moving on, it means we will see more money flowing out of
[Appendix] Commodity Bubble Has Burst
Gasoline, silver and corn drove commodities to their biggest weekly decline in more than five decades on concern that a $700 billion financial rescue plan won't prevent a
US EIA revised July oil demand lowest in 11 years U.S. oil demand in July fell to the lowest level for the month in 11 years, with consumption 736,000 barrels per day less than previously estimated and down 1.335 million bpd from a year earlier, according to the U.S. Energy Information Administration.
The commodity price bubble is over, and, even despite the weakening US dollar and the September options expiry spike, seems unlikely to exert much further inflationary influence on CPI measures in this cycle. Basically commodities are following the path taken by housing, commercial real estate, and equities. Each in turn was inflated by the credit bubble, but once they had reached unsustainable levels and/or credit had tightened appreciably, they lost value as investors’ inflated expectations were downgraded.
The surge in commodity prices made central banks and investors acutely nervous of a repeat of the 1970s style of inflation. However, such an extrapolation of recent events is likely to prove wide of the mark. First, monetary conditions in the 1970s were far more accommodative than they were even in the lead-up to the current episode of CPI inflation. Second, the recent commodity price increases were simply the final stage of the transmission of monetary policy through a series of asset markets starting with the credit and capital markets, then equities, and real estate to commodities. There will be some further impact on CPI measures, but these are residual effects, not the early stages of a new episode of inflation. Provided the monetary policies of the major central banks remain firm, there should be no additional inflation beyond what they have already permitted by reason of their earlier laxity.
Although some central banks have been lowering interest rates notably the Federal Reserve – the fact is that in most countries monetary policy, as judged by the growth of money and credit in the banking system and in the “shadow banking system,” has been tightening abruptly. Thus in the US bank credit has slowed to a negligible pace since April, and in the UK the growth of M4 lending to the non-financial sector (adjusted for securitisations) has slowed from 14.5% in late 2006 to 5.6% in July 2008. Consequently the next phase of growth in the global economy is likely to be very eak in both nominal and real terms.
Since the June issue of this Quarterly Economic Outlook the economic situation has worsened markedly due to the UScentred banking crisis. Whereas in that publication I predicted that the global economy was not going to experience a drastic downturn in terms of magnitude, but the slowdown would be prolonged, that must now be modified. The economic downturn is likely to be more serious in the developed economies, with recessions and/or a prolonged period of sub-par growth in several of the leading economies (notably the
Good night, my dear friends!
