My Dairy 444 --- Is TARP Large Enough? Are We Near Zero?

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 US Dollars” --- The book, Blood of Jesus, is an insightful look at African-American religious thought at Mid-century. But to me, it tells an important phenomenon that when human being is suffering from desperation and fear, they turn to something called “Super-Power”. This is the similar psychology prevailing in the markets now as people want to believe the 700bn US Dollar bail-out plan will solve credit problems. However, I think TARP is just a “Pig with Lipstick” and you can see the Friday’s market reaction to the passage of TARP V.2 by the House was muted with SPX closed 1.5% lower. Moreover, I still saw TED spread @ 386bp vs. normal level ~50bp, while US LIBOR-OIS spread @ ~290bp vs. normal level 8bp.

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 Asia (~7%). Elsewhere, UST yields slipped with 2yr and 10yr closed to 1.58% and 3.60%, respectively. For the week, the 2yr yield slumped 51bp, a 6-month low, and 10yr fell 25bp.USD surged 3% this week, soaring nearly 6% against EUR, moving from $1.461 last Friday to $1.377 and broadly strengthening against EM currencies. The YEN bucked the trend, gaining 0.7% vs. USD. In the commodity space, prices took a big step down this week. 1MWTI oil tanked $13 to $94/bbl. Industrial and precious metals prices slumped 9% and 7%, respectively. Agriculture prices plunged 13%.

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 America now is “FOR SALE”…Well as the market remains macro and policy driven, I will wave the usual discussion over each asset classes…

Is TARP Large Enough?

Overall, the TARP is an attempt to get ahead of the tidal wave of failures sweeping the US financial system. But if one looks back, despite of all actions taken by the US authorities, LIBORs have remained well above the policy rates throughout the year, indicating sustained stress on bank B/S. In the past two weeks, the escalating deterioration of credit quality at several commercial banks and I-banks has caused a massive sell-off that threatened a complete meltdown of the US financial system. And there was a generalized flight to quality as investors fled MMFs (withdrawing $298bn last week according to iMoneynet.com) and institutions backed away from inter-bank lending. Even a temporary guarantee for the assets of US MMFs was not enough to overcome the panic. As investors lost confidence in financial institutions, financial companies saw their access to liquidity/CPs and capital markets increasingly impaired and their stock prices drop sharply.

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 US housing and structured credit crisis point to losses in excess of US$1trn. If markets do not quickly gain confidence in the viability of the plan, then further bankruptcies among financial institutions are possible, along with the associated disruptions that counterparty failures always imply. This would extend the credit crunch, deepen the downturn, increase the losses, and delay economic recovery.

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 US, 2Q08 GDP was revised upwards to 3.3%, with 3.1% from net exports and all the domestic activities added up only 0.2% only. Moreover, since the end of summer tax rebates, unemployment rate has risen steeply in recent months with NFP declining at avg 76K/month, and consumer confidence has been severely dented. Consumer net worth has declined by a total of $2.7trn since it peaked in 3Q07 and in house price future implies that US consumer spending will remain under pressure, even though the gasoline price is coming lower. Further more there is over $300bn of ARM mortgage-holders are facing rate hikes over 2009.

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 China) due to the recession in the developed economies. This is especially true for commodity importers and where the inflation is largely related to food or enegy prices rather than a generalized price surge. But apart from that, high underlying growth rates and savings rates imply that these Asian countries will be the “first out of the gate” when the global economy eventually recovers.

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 Asia into US, especially when the deleveraging process continues (Sell Long, Cover short). Signs of such money outflows include 1) long only funds are selling big liquid large-Cap stocks like Chinese Banks, HK Properties and Conglomerates as redemptions are picking up; 2) over the past week, we have seen the short covering rally in China Property stocks (Underweight) vs. the sell off in IPPs or HK Props (Overweight); 3) According to EPFR Global, ytd net redemptions total US$15b, or 7.3% of Asian funds' AUM - In 2001, 8.4% was redeemed. If we apply this % to the current fund redemptions, it will imply US$2.4b more foreign money to be withdrawn from now till year-end.

If all these underlying trends keep moving on, it means we will see more money flowing out of Asia ahead as there is usually 3-month notice periods for redemption. Thus, we have not seen the bottom of stock market yet, given reduced market liquidity, slowing earning growth and still elevated risk premium. Lastly, let us take a look at regional valuation metrics, MXCN is trading at 9.3XPE09 and 14.4% EPSG, CSI300 at 11.6XPE09 and 18.2% EPSG, MXHK at 11.5XPE09 and 5.8% EPSG, compared with MSCI AxJ at 9.9XPE09 and 7.9% EPSG…

[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 U.S. recession, dragging down global demand. Futures measured by the CRB Index of 19 raw materials tumbled 10 percent this week, the most since at least 1956. A ``very weak'' non-farm payrolls number could see commodities ``remain under pressure,'' Walter de Wet, a Standard Bank Group Ltd. analyst in Johannesburg, said in an e-mailed comment late yesterday. Commodities also fell as the euro slumped 5.8 percent against the dollar, the biggest one-week drop since the 15- nation currency was created in 1999, on signs that Europe's economy is slowing. Manufacturing contracted in the U.K. at the fastest pace in 16 years last month, while European retail sales fell an annual 1.8 percent rate in August and France slipped into a recession in the third quarter, the first in 15 years.

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 US, UK, Australia, and the eurozone). The silver lining in these dark clouds is that the commodity-indu ced surge of inflation experienced during 2008 should not be very severe or prolonged, and headline inflation should fall quite rapidly next year as global demand weakens. In the US renewed rate cuts remain more likely than the reverse. In the eurozone rate cuts should be expected between now and the end of March by the ECB despite the hawkish rhetoric of ECB council members. Equally in the UK the Bank of England is likely to switch to rate cuts over the same time horizon.

Good night, my dear friends!