My Diary 378 --- Goldman isn’t Subprime Proof

My Diary 378 --- Housing Returns to Spotlight; Goldman isn’t Subprime Proof; Watching the Paint Dry and Chain Effect

February 26, 2008

Like what I wrote yesterday, the market is driven by credit issues. Over the past 24 hours, we have a temporary relief around the world and both stocks (S&P 500 +1.38%, EU now +1.5% avg) and credit markets (iTraxx AxJ HY -30bps) gained after S&P's announcement that MBIA's AAA credit rating is maintained, but with a negative outlook ($1.93bn loss last year, 1^st time in 15yr), together with a better than expected existing home sales report. Accordingly, the market feel eased a bit as VIX moved over 2% lower.

This renewed confidence translated into a sell-off in US treasuries at most durations, with the yield on both 2yr (2.01%) and 10yr (3.80%) moving up 9bps. Elsewhere, the 1M WTI oil contract moved up to $99.23/bbl, while the US Dollar was essentially unchanged, but NZD rose to the strongest since it began to trade freely in 1985. In soft markets, Chicago wheat prices rose by the most in more than 5 yrs, breaching $12 a bushel for the first time on signs that global crop production isn't keeping pace with demand. Corn and soybeans also gained close to records…… It seems like some portions of global markets are getting the animal sprits back... but I have to remind you the “Cold Mountains” ahead of us...

Today, Goldman US said in a report that large additional write downs are still possible, including Citi ($12bn), Merrill ($4bn), Lehman ($3.5bn), JPM ($3.4bn), MS ($3.1bn), and BSC ($1.4bn)….. So another $30bn money gone, if Goldman is right, not including Goldman itself’s potential $11bn losses from its VIEs and unknown losses from GSEs……My best idea is to prepare for some bad earnings this week.

Housing Returns to Spotlight

Overnight, recession fears were abated slightly due to the improved Chicago Fed Index (from Dec – 69 to Jan -58). The index is a decent recession gauge and there were fears that it would deteriorate to worse than 70, which is considered recessionary. But the key in this week is still Housing…Looking ahead to the remainder of this week, the calendar will be dominated by developments in the United States.

Yesterday, January existing home sales essentially unchanged at 4.89mn (from 4.91mn in Dec), a bit better than expected (consensus 4.80mn). US housing market data are expected to remain downbeat, based on a tumble in new home sales in January and confirmation that the decline in house prices gained speed into year’s end. The Case-Shiller 20-city index already was down 7.7% yoy in November. The OFHEO index, which excludes jumbo mortgages, may have posted its first yoy decline ever in 4Q07. In the Mortgage market, investors continue to show growing concern about the GSE's retained portfolio exposure to Sub-prime and Alt-A (Freddie Mac on Thursday, Fannie Mae on Friday).

Putting down the Housing, other US economy indicators are still worrisome.  BBG survey shows that US consumers Confidence will probably fell to a more than 4yr low this month as the labor market weakened. While it is expected that US January durable goods orders should deliver a reversal of last month’s surprising gain, pointing to --- 1) a contraction in manufacturing activity; and 2) a very subdued growth in business spending. Future markets are now pricing in a 94% chance of a 50bp cut by the Fed to 2.5% at the March 18 meeting…… Stay alert, the Spring Chilly will not go away overnight, according to Chinese proverbs…Hehe, I pick up another one from my mom last night who stopped me from packaging winter sweaters ….

Goldman isn’t Subprime Proof

Last night, MBIA's shares jumped 18% to close at $14.58 as S&P reaffirmed its AAA credit rating and the AAA rating of Ambac.The rating agency removed MBIA from CreditWatch with negative implications, assigning instead a negative outlook, implying less chance of an imminent downgrade, though it said risk remains for MBIA owing to the absolute size of possible losses and uncertainty surrounding the possible reconfiguration of the company. In reality, I can see why the market got excited about S&P’s action, but the outlook or the sector has not changed. Monolines will remain under pressure requiring additional capital injections, a run-off of their structured finance exposures and further sector consolidation. The market also needs to contend with an investor base that won't know the depth of capital required until the US housing and mortgage market has found a bottom…… When and where is the bottom, at least not before 4Q08, I think?

A newly emerged bad name today in the BBG is named VIEs, also known as conduits, had $784bn in outstanding CP as of last week, according to Moody's and the Fed. One type of VIE that's already been forced to unwind or seek bank financing is the SIV. Like SIVs, VIEs often issue CPs to finance themselves and because banks agree to back VIEs with lines of credit, they have to buy commercial paper or notes when no one else will. Well-known during Eron’s collapse, accounting rules allow financial firms to keep VIEs off their balance sheets as long as they're not the ones that stand to gain or lose the most from the entity's activities. With bond issuers start to lose their AAA ratings, Wall Street firms may be forced to return those assets to their books with losses…… this time it may involve the “Sub-prime Proof” firm – Goldman Sachs, which said last month it may incur as much as $11.1 billion of losses from the instruments. Adding to that number, VIEs may contribute to another $88 billion in losses for banks roiled by the collapse of the housing market, according to bond research firm CreditSights Inc.

Nowadays, it seems that a clearer picture is emerging of the damage caused by the credit crunch…… if you finally seem the Goldman on the warning call. Furthermore, with the combination of a slowing global economy and a continued correction in financial asset values, indices that track leveraged loans, CMBS, and RMBS have lost between 5-48% for the Nov FY firms and 6-38% for the Dec FY firms)…… This has substantial impact on S&P 500 earnings…With over 90% of S&P 500 companies' Q4 reports coming in, the aggregate earnings for the index are down about 21%. If financial companies were removed from the calculation, the S&P's aggregate earnings would show a 12.4% annualized gain for the 4Q07, according to Thomson Financial…… Remember, the financial sector is very important as they tend to lead the broader market in both directions

Bottom-line: despite recent rate cuts, credit concerns should remain the dominant theme driving relative performance in financial sector and even the broader markets……

Watching the Paint Dry and Chain Effect

Sitting here in HK today definitely feels like watching paint dry. HK market feels very directionless and fragile and it seems being stuck in a range of 22000-24000. Brokers kept telling the stories of Asian funds seeing record redemptions and there are massive downgrades across the street and big earnings slash like it's the end of the world.  Mainland China side, A-share market have fallen about 1/3 from its peak, and I still believe the risk of further de-rating is rising even though the market holds a view that the Chinese economy will achieve a soft landing. Historically, during the Asian financial crisis, China's market corrected 80% from the Oct '97 top to the Aug '98 bottom despite 8% GDP growth and a stable currency, while the rest of Asia fell into recession and their currencies declined significantly. Why the mismatch between the macro and micro? - The reason is that GDP growth is more a function of output but not necessarily a function of profits. While we can achieve good top-line GDP growth by maintaining high investment growth, such growth may well be achieved at the expense of bottom-line profitability due to potential inventory buildup and margin pressure.

Interestingly, after over 20% plunge ytd, it seems that CSRC has reached its tolerance limits and formally responded to the huge refinancing plans / rumors in the market …Ping An (RMB160bn) and SPDB (RMB40bn) confirmed…The regulator requires companies to prudently consider the amount, timing and affordability of offerings before deciding on secondary fund raisings. And CSRC will strictly examine applications from listed companies seeking to sell additional shares.…The wordings temporarily ease the market concern, but not enough to change the vulnerable market sentiment as the SH A-shares only up 1.09%, while CSI300 is flat @4515.

Sectors wise, there should have a chain effect after Baosteel's 20% price hikes. The medium question --- Will such a price jump be sustainable and eventually impact the demand side, given that a substantial amount of new flat steel capacity is commissioned, plus falling exports are redirected back into the domestic market. In the down steam, machinery companies are starting to consider price increase as steel accounted for 50% of their raw material costs and industry average net profit margin is around 5.5% in 2007. Regarding the Auto sector, steel price hikes will drive up production cost of self-made auto parts. The negative impact is larger on commercial vehicles due to a larger percentage of self-made auto parts. The large-to-medium buses and mid/high-ended sedans will have better growth visibility in 2008 and core auto part producers with a decent pricing power will be fine, including Denway. Moreover, the profit margin of power equipment sector is very sensitive to the steel price since steel is 70% COGS & margin is thin, while there should have lesser impact on the white good as steel only account for 10-15% of material cost…… Well, the rise in Steel does hammer a chain of down streams sectors….

Good night, my dear friends!