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Saturday 9 May 2009
Asia’s ‘Absolute Greed’ Stocks Rally to Falter, Citigroup Says
Asian stocks are set for a “correction” as a two-month rally drives valuations higher than justified by a recovery in company earnings, according to Citigroup Inc.
Asia’s ‘Absolute Greed’ Stocks Rally to Falter, Citigroup Says
By Chua Kong Ho 8 May 2009
(Bloomberg) -- Asian stocks are set for a “correction” as a two-month rally drives valuations higher than justified by a recovery in company earnings, according to Citigroup Inc.
The MSCI Asia Pacific Index has gained 37 percent from a five-year low on March 9. The rebound has lifted the average valuation for stocks on the Asian gauge to 23.6 times profit, the highest since March 2004 and 52 percent more than shares on the MSCI AC World Index, according to data compiled by Bloomberg.
Markets are poised for a decline as valuations are higher than they should be at this point in the economic cycle, Citigroup’s Adrian Faure said. He doesn’t expect stocks to fall below their March lows, he added.
“The speed with which absolute fear has been replaced by absolute greed has been extraordinary,” said Faure, the Hong Kong-based head of Asia Pacific research at Citigroup, in a telephone interview. “I’ve not seen such a turn of events and I’ve been doing this a long time. We’ll see a correction as markets aren’t going to go up in a straight line.”
Citigroup was top-ranked in Institutional Investor magazine’s 2009 investor survey for research on Asian equities outside Japan, which was released this week. The survey, in its 16th year, surveyed more than 1,900 buy-side analysts and fund managers at 700 institutions managing an estimated $1.6 trillion in non-Japanese Asian equities.
‘On a Tear’
Stocks have been “on a tear as an awful lot of money hasn’t participated in the bounce and is being forced to chase the market,” he said. There’s still a “hangover of excesses built up over many years,” he added.
Faure, 44, was head of Asian equities research at Macquarie Securities Ltd. and the co-head of global emerging markets research at Merrill Lynch & Co., now part of Bank of America Corp., before joining Citigroup four years ago.
Faure’s views were shared by Ronald Arculli, chairman of Hong Kong Exchanges & Clearing Ltd., who said he “wouldn’t be a buyer” of stocks trading in the city.
Hong Kong’s Hang Seng Index has surged 52 percent from a four-month low on March 9, pushing the average valuation of its 42 companies to 15.5 times reported earnings, the highest level since Jan. 10, 2008.
“Stock markets tend to run ahead of economic activity,” said Arculli, who has been chairman of Asia’s third-largest bourse for two years. “There’s a lot of that with the index being at the current level.”
‘Vastly Worse’
The current global crisis is “vastly worse” than the 1930s because financial systems and economies worldwide have become more interdependent, “Black Swan” author Nassim Nicholas Taleb said yesterday, adding “this is the most difficult period of humanity that we’re going through.”
While every market looks “overbought,” Taiwan and South Korea still present the best investment opportunities in the region, Citigroup’s Faure said.
Taiwan’s Taiex Index has advanced 43 percent this year for the region’s biggest gain, on optimism that improving ties with China will lead to an inflow of foreign direct investments, and funds into the island’s stock market.
China Mobile Ltd. agreed last month to buy a 12 percent stake in Taiwan’s third-biggest phone company Far EasTone Telecommunications Co., while Taiwan’s Financial Supervisory Commission announced it will begin accepting applications from Chinese institutional investors to buy securities on the island.
“The China Mobile deal was a political deal,” Faure said. “What it tells you is that the trend of financial and economic integration with China is now irreversible. Taiwan is coming in from the cold.”
Ship Owners Forced to Pay to Carry Middle East Oil
By Alaric Nightingale
May 8 (Bloomberg) -- Ship owners are being forced to pay to carry oil from the Middle East to the U.S. for the first time in at least a decade after demand collapsed and the fleet expanded.
Supertanker owners make no rental income from the voyages and are paying $3,445 a day toward fuel costs, data from the Baltic Exchange in London show. Rental rates normally cover fuel costs. The journey to the Louisiana Offshore Oil Port from Ras Tanura, Saudi Arabia’s largest export facility, earned owners as much as $104,663 a day in July.
Some owners may be prepared to subsidize voyages as they relocate vessels to the Atlantic, Anders Karlsen, a shipping analyst at Nordea Markets in Oslo, said by phone today. The alternative would be paying all the fuel costs themselves and sailing empty. Owners could also mothball ships, Karlsen said.
“It’s a sign there’s a lot of surplus” in the fleet, Martin Stopford, managing director of Clarkson Research Studies in London, said by phone today.
The Organization of Petroleum Exporting Countries, led by Saudi Arabia and accounting for about 40 percent of global supply, agreed to cut output three times since September as demand crumbled. Oil prices have plunged 61 percent from a record $147.27 a barrel reached in July.
Twenty-one percent of the global fleet of 2,067 oil tankers is anchored, compared with an average of 16 percent across all types of vessel, data compiled by Bloomberg show. Supertankers are moving at an average speed of 9.2 knots, from as fast as 10.6 knots in July, suggesting captains are slowing down to save on fuel, the data show.
Supertanker Fleet
The supertanker fleet expanded by 21 to 520 vessels this year, according to Lloyd’s Register-Fairplay data on Bloomberg.
Rental incomes haven’t been this bad in at least a decade, said Mark Jenkins, a London-based analyst at Simpson, Spence & Young Ltd. That’s as far back as the shipbroker’s data goes.
Nippon Yusen K.K., Japan’s largest shipping line, leased the Tosa for a rate of 17.5 Worldscale points to Kuwait Petroleum Corp., according to reports today from Athens-based Optima Shipbrokers and other brokers. Worldscale points are a percentage of a nominal rate, or flat rate, for more than 320,000 specific routes.
The rate may be equal to $6,042 a day less than the shipper needs to pay its fuel and port costs, according to a calculator on the Web site of shipbroker RS Platou. Suguru Uchida, a spokesman for Nippon Yusen in Tokyo, declined to comment.
While negative returns are unusual, owners do routinely offer discounts to customers to cover the cost of moving ships into more profitable regions, Clarkson’s Stopford said.
Should the situation persist for several months, owners are likely to favor mothballing ships and removing their crews, Per Mansson, managing director of shipbroker Nor Ocean Stockholm AB in Stockholm, said by phone.
Owners of older ships may choose instead to scrap them and those with ships on order may seek to delay delivery dates, Nordea Markets’s Karlsen said.
China fears bond crisis as it slams quantitative easing
China has given its clearest warning to date that emergency monetary stimulus by Western governments risks setting off worldwide inflation and undermining global bond markets.
By Ambrose Evans-Pritchard 07 May 2009
"A policy mistake made by some major central bank may bring inflation risks to the whole world," said the People's Central Bank in its quarterly report.
"As more and more economies are adopting unconventional monetary policies, such as quantitative easing (QE), major currencies' devaluation risks may rise," it said. The bank fears a "big consolidation" in the bond markets, clearly anxious that interest yields will surge as western states try to exit their QE experiment.
Simon Derrick, currency chief at the Bank of New York Mellon, said the report is the latest sign that China is losing patience with the US and aims to diversify part its $1.95 trillion (£1.3 trillion) foreign reserves away from US Treasuries and other dollar securities.
"There is a significant shift taking place in China. They are concerned about the stability of the global financial system so they are not going to sell US bonds they already have. But they are still accumulating $40bn of fresh reserves each month, and they are going to be much more careful where they invest it," he said.
Hans Redeker, head of currencies at BNP Paribas, said China is switching into hard assets. "They want to buy production rights to raw materials and gain access to resources such as oil, water, and metals. They know they can't keep buying bonds," he said
Premier Wen Jiabao left no doubt at the Communist Party summit in March that China is irked by Washington's response to the credit crunch, suspecting that the US is engaging in a stealth default on its debt by driving down the dollar. "We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries," he said.
Days later, the central bank chief wrote a paper suggesting a world currency based on Special Drawing Rights issued by the International Monetary Fund.
Some economists say China is suffering from "cognitive dissonance" by anguishing so much over its reserves, accumulated as a result of its own policy of holding down the yuan to promote exports. Quantitative easing by the US Federal Reserve and fellow central banks may have saved China as well, since the country's growth strategy is built on selling goods to the West.
China's fears of imported inflation may reflect its concerns about over-heating. The M2 money supply rose 25pc in March on a year earlier, and there has been explosive credit growth since the government relaxed loan restraints. There are concerns that the stimulus is leaking into a new asset bubble rather than promoting job growth. The Shanghai bourse is up over 50pc since November.
* China export taxes giving U.S. a "colossal headache"
By Doug Palmer 05.07.09
WASHINGTON (Reuters) - This could be a very tough year for trade relations between China and the United States, despite pledges to work together to restore growth and fight protectionism, a U.S. government official said Wednesday.
"It was clear to me there's more problems than ever in doing business in China," the government official said, reflecting on a trip last month to China.
"I think we're going to have a very tough year ahead," he said at a discussion hosted by the Nixon Center.
China is the United States' second-largest trading partner, with two-way trade last year totaling $409.2 billion.
However, Chinese exports to the United States exceeded U.S. exports to China in 2008 by $266.3 billion, accounting for about 30 percent of the total U.S. trade deficit last year.
Persuading China to open its market to more U.S. goods is one of the three major challenges in the trade relationship, a second U.S. government official said.
The two others involve pushing back on Chinese industrial policies that favor domestic firms over foreign competitors and and China's weak enforcement of rules in areas ranging from product safety to copyrights and trademarks to labor, he said.
Both officials spoke on the condition on anonymity.
PRESIDENTIAL PHONE CALL
The frank comments followed a phone call between U.S. President Barack Obama and Chinese President Hu Jintao Wednesday to discuss ways to enhance cooperation on the global economy and health issues, as well as regional security.
Obama and Hu met for the first time last month at a summit meeting in London of developed and developing countries leaders. Obama accepted an invitation to visit China this year, and that could happen when he travels to Singapore in November for the annual Asia Pacific Economic Cooperation summit meeting, the first government official said.
The Obama administration avoided a trade fight with China last month when it decided against formally labeling Beijing as a currency manipulator, despite Obama's statements during last year's campaign that it was.
However, during a visit to Washington last week, Chinese Commerce Minister Chen Deming protested "vociferously" to U.S. Commerce Secretary Gary Locke about two new cases brought by U.S. workers and industry against Chinese imports, the first government official said.
In one case, U.S. tire workers want a three-year quotas on imports of Chinese-made tires that reached nearly $1.8 billion last year. In the other, U.S. steel companies want duties ranging up to almost 100 percent on pipes used to ship oil. Those imports from China totaled $2.6 billion last year.
China fears those big-ticket cases could encourage others if the petitioners get the relief they request.
"COLOSSAL HEADACHE"
A senior Chinese delegation objected to both cases in a April 22 meeting with the U.S. International Trade Commission, which investigates industry complaints of unfair trade and requests for import relief.
ITC Chairman Sharon Aran told the delegation it was "not appropriate" for the commission to discuss the facts of the cases with interested parties and a record of the discussion would have to be made, a commission spokeswoman said.
Meanwhile, China's use of export taxes to depress domestic prices of wire rod and inputs used to make finished goods "has become a colossal headache for us and we're struggling to find the right remedy," the second government official said.
The practice gives Chinese companies a cost advantage in producing many goods, creating a problem for many small U.S. producers who don't have the resources to file an anti-dumping or countervailing duty case asking for relief, he said.
One possibility would be for the United States to initiate dispute settlement proceedings at the World Trade Organization, but no decision on that has been made, he said.
The United States also is frustrated that China hasn't followed through a commitment to give foreign companies increased access to its huge public works market by joining the WTO's government procurement pact, he said.
Two of the nation's largest banks lined up new financing yesterday, just a day after the federal government made public the results of its "stress tests."
Also, a third bank announced its plans to raise money, while a credit-rating agency warned that a fourth would have to rely on more government bailout funds.
The flurry of activity was prompted by the stress tests on the nation's 19 largest banks and the government's conclusion that 10 of them must raise a total of about $75 billion in new capital to help them withstand possible losses in the event the recession deepens and more loans fall into default.
Each of the 19 banks has assets of at least $100 billion and was deemed by the Obama administration as "too big to fail" - that is, so big that the effects of its collapse would ripple through the financial system and cause a meltdown like the one that began early last year.
Critics of that concept have said failing banks should be closed rather being propped up with a government bailout. Eighteen of the 19 banks tested received taxpayer funds under last fall's Troubled Asset Relief Program, under which the government invested in hundreds of banks to try to revive frozen credit markets.
The White House told industry officials yesterday that it was leaning toward wanting the Federal Reserve to become the supercop for "too big to fail" companies. The administration made it clear it was not inclined to divide the job among various regulatory agencies, as suggested by industry and some federal regulators.
Treasury Secretary Timothy Geithner told the group that one organization needed to be held responsible for monitoring systemwide risk. He said such a regulator should be given better visibility into all institutions that pose a risk to the financial system, regardless of what business they were in.
Responding to Thursday's order to boost its capital, Wells Fargo & Co. said yesterday that it was raising $7.5 billion through a sale of 341 million shares of common stock at $22 apiece, boosting the amount it previously said it would raise by $1.5 billion.
Wells Fargo is based in San Francisco, but its acquisition in January of Wachovia Corp. made it the largest player in the Philadelphia area, with nearly 21 percent of deposits in the eight-county market.
The government said the bank needed to raise $13.7 billion to cushion it from another potential fall in the economy.
Also yesterday, Morgan Stanley said it would sell 167.9 million common shares for $24 each in an effort to raise gross proceeds of $4 billion. The company is also pricing an offering of $4 billion in bonds.
The New York company faces a $1.8 billion shortfall, according to the government.
Bank of America Corp., of Charlotte, N.C., said it would raise capital through asset sales, earnings in the coming quarters, and raising money from private investors. The government said the nation's largest bank needed $33.9 billion. The asset sales could bring in up to $10 billion and include its First Republic Bank unit, which it inherited when it bought Merrill Lynch & Co. late last year.
An additional $17 billion will likely be raised through the issuance of common stock.
But another of the institutions tested, GMAC L.L.C., the Detroit auto lender bailed out by U.S. taxpayers, will have to rely on the government to fill the $11.5 billion gap in capital found by regulators in the examination, Standard & Poor's Corp. predicted yesterday.
Goldman Sachs Group Inc. was one of the nine banks not required to raise more money. Company chairman Lloyd Blankfein told shareholders at their annual meeting that Goldman expected to "soon" repay the $10 billion in government loans it received last fall under TARP.
Investors Cry Foul as Some Funds Close Exits; Perils of Distressed Markets
By ELEANOR LAISE MAY 5, 2009
Some investors in 401(k) retirement funds who are moving to grab their money are finding they can't.
Even with recent gains in stocks such as Monday's, the months of market turmoil have delivered a blow to some 401(k) participants: freezing their investments in certain plans. In some cases, individual investors can't withdraw money from certain retirement-plan options. In other cases, employers are having trouble getting rid of risky investments in 401(k) plans.
When Ed Dursky was laid off from his job at a manufacturing company in March, he couldn't withdraw $40,000 from his 401(k) retirement account invested in the Principal U.S. Property Separate Account.
That fund, which invests directly in office buildings and other properties, had stopped allowing most investors to make withdrawals last fall as many of its holdings became hard to sell.
Now Mr. Dursky, of Ottumwa, Iowa, is looking for work and losing patience. All he wants, he said, is his money.
"I hate to be whiny, but it is my money," Mr. Dursky said.
The withdrawal restrictions are limiting investment options for plan participants and employers at a key time in the markets. The timing is inconvenient for the number of workers like Mr. Dursky who are laid off and find their savings inaccessible.
Though 401(k) plans revolutionized the retirement-savings landscape by putting investment decisions in the hands of individuals, the restrictions show that plan participants aren't always in the driver's seat.
Individual investors mightn't even be aware of some behind-the-scenes maneuvers causing liquidity problems in their retirement plans. Many funds offered in 401(k) plans lend their portfolio holdings to other investors, receiving in exchange collateral that they invest in normally safe, liquid holdings.
The aim is often to generate a small but relatively reliable return that can help offset fund expenses. But in recent months, many of the collateral investments have gone haywire, prompting money managers to restrict retirement plans' withdrawals from the lending funds.
Some stable-value funds also are blocking the exits. These funds, available only in tax-deferred savings plans such as 401(k)s, typically invest in bonds and use bank or insurance-company contracts to help smooth returns. But in cases of employer bankruptcy and other events that can cause withdrawals, these funds can lock up investor money for months at a time.
Investors in the Principal U.S. Property Separate Account said they understood the risk of losses, but didn't think their money could be locked up for months or years. Most participants in the 15,000 plans holding the fund haven't been able to make any withdrawals or transfers since late September.
"To sell property at inappropriately low prices in order to generate cash for a few would hurt the majority of investors and violate our fiduciary obligations," said Terri Hale, spokeswoman for Principal Financial Group Inc., the parent of the fund's manager. The fund, which had $4.3 billion in net assets at the end of April, still is making distributions for death, disability, hardship and retirement at normal retirement age.
As of April 28, redemption requests that had yet to be honored totaled nearly $1.1 billion, or roughly 26% of the fund's net assets. Principal doesn't anticipate that it will make any distributions to investors who have requested redemptions until late 2009 or beyond, Ms. Hale said. Meanwhile, the fund continues to fall, declining 25% in the 12 months ending April 30.
Some investors have lost hope of recovering their money. Judith Sterner, a 69-year-old part-time nurse, had more than $12,000 in the fund when she tried to transfer that balance to a money market last fall. But her transfer was denied, and her stake has since declined to less than $10,000.
"This $12,000 represents a year of my retirement money that I don't have," said Ms. Sterner, of Morton Grove, Ill.
Principal still allows new investors into the fund. It categorizes the U.S. Property account as a fixed-income investment, alongside much stodgier funds holding high-quality bonds. New investors are warned of potential withdrawal delays, Ms. Hale said. As for the fixed-income categorization, she said, "a substantial portion of the account return is based on income streams from rents, and its returns have been comparable to fixed-income funds."
While the problems selling real-estate investments are relatively straightforward, withdrawal restrictions related to securities lending stem from far more obscure practices.
Funds often lend out portfolio holdings, through a lending agent, to other investors. These borrowers give the lender collateral, often amounting to about 102% of the value of the securities borrowed. Some of the collateral pools in which funds invest this collateral held Lehman Brothers Holdings Inc. debt and other investments that plummeted in value or became hard to trade in the credit crunch.
Though agents who coordinate funds' lending programs share in profits from securities lending, the risk of such collateral-pool losses falls entirely on the funds that have lent the securities and, ultimately, retirement plans and other investors holding those funds.
The problems have limited retirement plans' ability to get out of securities-lending programs, though participants' withdrawals generally haven't been affected.
Retirement plans offered to employees of energy company BP PLC last fall tried to withdraw entirely from four Northern Trust Corp. index funds engaged in securities lending. Certain holdings in Northern's collateral pools had defaulted, been marked down, or become so illiquid that they could only be sold at low values, according to a BP complaint filed in a lawsuit against Northern Trust.
The BP plans halted new participant investments in the funds and asked to withdraw their cash so it could be reinvested in funds that don't lend out securities.
But under restrictions imposed by Northern Trust in September, investors wishing to withdraw entirely from securities-lending activities would have to take their share of both liquid assets and illiquid collateral-pool holdings, according to a Northern Trust court filing. BP rejected that option, and the companies still are trying to resolve the matter in court.
Northern Trust's collateral pools are "conservatively managed" and focus on liquidity over yield, the company said.
State Street Corp. in March notified investors of new withdrawal restrictions in its securities-lending funds. Until at least the end of the year, plans can make monthly withdrawals of only 2% to 4% of their account balance, the notice said.
Plans wishing to withdraw entirely from lending funds will have to take a slice of beaten-down collateral-pool holdings.
"Given the current state of the fixed-income market, we felt it was prudent to put some well-defined withdrawal parameters in place," said State Street spokeswoman Arlene Roberts.
Ten Reasons Why the Stress Tests Are “Schmess” Tests and Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed
Nouriel Roubini May 8, 2009
What shall we make of the recently announced results of the stress test? Are they credible? Will they restore confidence in our battered financial system? Will the current approach to resolving the financial crisis work, be effective and minimize the fiscal costs of the financial bailout?
For a number of reasons these results are a significant underestimate of the capital/equity needs of these 19 large US banks. Also this underestimate of the losses and the current “muddle-through” approach to the banking and financial crisis may accelerate the creeping partial nationalization of the US financial system, exacerbate moral hazard distortions, not resolve the too-big-to-fail problem, increase the fiscal costs of this financial crisis, make the credit crunch last longer and lead some near insolvent financial institutions to become zombie banks. Let me explain in ten points why I hold such views (see also my two recent op-eds with Matt Richardson in the WSJ and the FT):
First, the stress tests are not stressful enough. As discussed in a previous note current levels of unemployment rates are already higher than those assumed in the more adverse scenario; and even assuming that the rate of job losses will slow down over the next few months to a 400-500K monthly range it is highly likely that the US will reach an unemployment rate of 10% by the fall of 2009, a rate of 10.5% by the end of 2009 and a rate above 11% some time in 2010; instead the parameters of the stress tests assumed that the unemployment rate would average 10.3% in the more adverse scenario in 2010, not 2009. Note also that the parameters for the more adverse scenario in the stress tests were a political compromise among the agencies involved in the stress tests; one of these agencies had found more realistic the hypothesis that the parameter for the unemployment rate in the more adverse scenario should be 12% rather than 10.3%. Moreover, the stress tests found that the 19 banks needed $185 bn of additional equity; the published figure of $75 is based on assets dispositions and capital raises of $110 bn that are still under way and, in most cases, not completed yet. Booking such increases in equity before they have occurred does not seem appropriate accounting procedure.
Second, the capital/needs of these banks depend on a race between retained earnings before writedowns/provisioning that will be positive given a high net interest rate margin and the losses deriving from further writedowns. It appears that regulators have overestimated the amount of such retained earnings for 2009-2010. The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario. Thus, ex-post capital needs will be significantly higher if net retained earnings turn out to be lower than assumed in the stress tests. While regulators resisted the banks’ attempt to use Q1 earnings (that were fudged via under-provisioning for loan losses, paper gains on securities via changes in FASB rules on mark-to-market, and accounting gains coming from the lower market value of bank liabilities) as proxy for the future profitability of banks it appears that such regulators were too optimistic in estimating what net retained earnings will be in 2009-2010.
Third, banks bargained hard to reduce the regulators estimates of needed additional equity. For example, according to press reports Citigroup was initially assessed to need an additional $30bn of equity; such figure was then reduced to $5 billion after aggressive bargaining by the bank. One can only guess how much higher were the regulators initial estimates of the banks’ capital needs and how much lower the published estimates became after the banks lobbied for lower figures.
Fourth, the estimates of additional losses on loans - $445 bn - appear to be relatively reasonable even if they could end up being significantly higher in a weaker macro scenario. But estimates of losses on securities - $154bn – are most likely too low. And the results of the stress scenario do not provide details on how much regulatory forbearance has been provided in the estimate of losses on securities; while current market values of some securities may be lower than long term values given an illiquidity premium many banks still keep many of these securities in the level 2 and 3 buckets and use a mark-to-model, rather than a mark-to-market approach to value these assets. Certainly in the last year regulators have been lenient and provided plenty of forbearance – on top of expensive formal guarantees of hundreds of billions of toxic assets for several banks – to reduce the amount of revealed losses on securities. Also, if one were to bring forward to today the writedowns/charge-offs for 2009-2010 estimated by the US regulators (an exercise that the IMF has done for all US banks in its recent Global Financial Stability Report) the TCE ratio for these 19 banks – and all US banks - would be effectively 0.1% today. So, the US regulators estimates of equity needs of these 19 banks are heavily depended on what net earnings before writedowns will be in 2009-2010.
Fifth, estimates of net retained earnings before writedowns are massively beefed up by the direct and indirect subsidies that the government is providing to the financial system: with the Fed Funds rate and deposit rates now close to 0% and with banks having been able to borrow since last year about $350 bn at close to 0% interest rates given the FDIC guarantee on new borrowings the bank can now earn a fat net interest rate margin that is a direct subsidy to financial institutions. The Fed is also losing a fortune on its three Maiden Lane funds that purchased toxic assets of Bear Stearns and AIG. On top of this major US financial institutions got a massive direct subsidy from the bailout of AIG. Overall, the US government has committed – between liquidity supports, recapitalization, insurance of bad assets, guarantees – over $13 trillion of resources to the financial system and already provided $3 trillion of such resources to the financial institutions. The financial system is already effectively a ward of the state in spite of the fact that all these direct and indirect subsidies have bailed out both the shareholders and the unsecured creditors of financial institutions. Even taking into account the fact that not all of these resources will represent a net long term loss to the US taxpayer even a conservative estimate of the net subsidy to the banks’ shareholders and unsecured creditors may be above $500 bn.
Sixth, in estimating equity needs of these 19 banks the regulators correctly used a measure of capital – Tangible Common Equity or TCE – that is narrower than Tier 1. Tier 1 capital includes many forms of capital – on top of tangible common equity – that are of poor quality as a buffer against losses or outright fishy: preferred equity and in particular intangible assets and goodwill. While Tier 1 capital of US banks was – at the end of 2008 – about $1,550 common tangible equity was only about $560 bn. The regulators estimated equity needs of the 19 banks based on a TCE ratio of 4% (as a percent of tangible assets). However, even 4% implies a leverage ratio for these banks of 25. The IMF instead – properly – considered a scenario where the TCE ratio is increased to 6% that is equivalent to a leverage ratio of 17 that represent the average leverage ratio for all US banks in the mid-1990s before leveraged shot up in the latest credit bubble. A capital adequacy ratio is also certainly necessary for these banks as they are systemically important: every academic analysis of systemic risk suggests that banks that are systemically important should have much higher capital in order to internalize the externalities deriving from too-big-to-fail distortions. And while Basel criteria for capital adequacy have not been yet revised to include this need for additional capital for too-big-to-fail banks the G20 and the FSF have already acknowledge the need to charge more capital for such large institutions.
Indeed, some national regulators have already moved to increase the capital required from their own banks: for example Switzerland has already unilateral imposed a 16% capital ratio for its systemically important banks to be phased in by 2013, a ratio that is double the Basel criteria of 8% for Tier 1 and Tier 2. Thus, it would have been appropriate that US regulators request that these 19 banks – that are all deemed to be systemically important – should aim to achieve a TCE ratio of at least 6% - not 4% - equal to the one prevailing in the mid-1990s for all US banks (not just the systemically important ones). The capital needs of all US banks would have been an additional $225 bn (based on IMF estimates) if the TCE ratio were to be increased from 4% to 6%. For these 19 banks a 6% TCE ratio – the minimum justifiable for systemically important institutions – would imply about an additional $100 bn of common equity compared to the estimates of the regulators.
Seventh, considering even only the need for a higher TCE ratio for too-big-to-fail banks – let alone the implications of other factor discussed above that would have increased the estimates of capital needs for US banks – all 19 banks would have required higher TCE. Giving a clean bill of financial health to half a dozen too-big-to-fail banks – including JP Morgan Chase and Goldman Sachs – that have survived this financial crisis only because of the massive direct and indirect subsidies received from the US government is a public disservice in two ways: first, it does not recognize that these banks survived the crisis only because of the government subsidies (liquidity, insurance, guarantees, recapitalization); second, it ignores the fundamental fact that too-big-to-fail banks should have much more tangible common equity than the one that they currently hold. It is reckless behavior by regulators to ignore the too-big-to-fail distortion that derives from excessively low capital ratios and not to start demanding from such systemically important banks additional capital to control for this negative externality.
Indeed, the problem with the current approach to the financial crisis is that the too-big-to-fail problem has become an even-bigger-to-fail problem and that moral hazard distortions from government bailouts have been sharply increased via trillions of dollars committed to backstop the financial system. First, while some significant support of the financial system was necessary and desirable to stop bank runs, reduce serious refinancing risks and avoid a more severe credit crunch the extent of the support and subsidy of the financial system has created the mother of all moral hazard distortions. Second, the current approach to crisis resolution has led to an even-bigger-to-fail problem because of the government inducing relatively less weak institutions to take over weaker ones. JP Morgan took over Bear Stearns and then WaMu; Bank of America took over Countrywide and then Merrill Lynch; and Wells Fargo took over Wachovia. And in the battle for Wachovia Citigroup aggressively fought Wells Fargo not because Wachovia was a sound banks (it was indeed insolvent and bust); it did so because taking over Wachovia would have made a too-big-to-fail Citi an even-bigger-to-fail bank with greater likelihood of government bailout. To put two weak – or near-zombie - banks together is like having two drunks trying to hold each other to stand straight. To resolve this even-bigger-to-fail problem a strategy of taking over near-insolvent institutions and then break them up in smaller, systemically-not-important pieces would have been appropriate. Alternatively, charging much higher capital ratios on too-big-to-fail banks – as optimal according to economic theory - would incentivize them to break themselves up in smaller pieces. But neither approach has been so far followed by US policy makers; and we have thus created the mother of all moral-hazard driven bailout distortions.
Eighth, the figures published by the US regulators are estimates of losses and capital/equity needs of the top 19 banks (those with assets above $100bn). Smaller US banks will have similar losses and capital needs. Based on the results of the stress tests some bank analysts have estimated that 60% of top 100 US banks (beyond the 19 ones in the stress tests) will need more capital/equity. Note that while large US banks (those with more than $4 billion in assets) have about 49% of their total assets into real estate assets the percentage of real estate assets for small US bank (those with assets below $4 bn) is about 63%. Thus, the losses for such smaller banks may end up being larger (as a % of their total assets) than the ones of large banks. The IMF recently estimated the additional capital needs of all US banks to be $275 bn if the TCE ratio is to increased to 4% and $500 bn if the TCE ratio has to go back to 6% (it average level for all US banks before the credit bubble of the last decade).
Ninth, the current muddle through approach to the banking crisis is predicated on the assumption that forbearance and time will heal most wounds of most systemically important banks: generous assumptions on net retained earnings before writedowns – and hope that the economy will rapidly recover - will allow banks to earn their way out of their current massive capital shortages. But while the government will now let banks found to need more equity to raise such equity in the next six months the ability of such banks to do that will be very limited: very few private investors would want to provide capital to a bank with massive expected writedowns, large capital needs and where such private capital investments will be further significantly diluted by a government that will need to increasingly convert its preferred shares into common equity. As it is the government will already soon own 36% of Citigroup and more in the future if Citi needs much more capital and is unable to raise it from private sources. A similar fate awaits Bank of America that now needs to fill an equity gap of almost $35bn.
Tenth, to avoid creating Japanese-style zombie large banks that are near insolvent and kept alive by trillions of dollars of government bailout support it would have been better to take different approaches that minimize the long-term government ownership or control of the financial system. There were three possible alternative approaches that made more sense.
One option would be a temporary nationalization of such near insolvent large banks: take them over, wipe out common and preferred shareholders, have unsecured creditors take some of the losses (haircuts on their claims and/or conversion of their claims into equity), separate good and bad assets and sell a clean-up bank – possible after breaking it up to create smaller pieces that are not too big to fail - as fast as possible to the private sector. This was the strategy followed for Indy Mac that was taken over last summer by the FDIC and sold back to a group of private investors in about six months. Such temporary nationalization option is feasible and orderly even for systemically important banks as long as Congress is willing to pass soon the new insolvency regime for large financial institutions.
A second option would be the approach favored by a number of economists of separating each troubled bank into a good bank and a bad bank and placing bad assets and unsecured claims into the bad bank while providing significant equity into the good bank to the unsecured creditors that would have losses on their bad bank claims. This solution combines separating good and bad assets and converting unsecured claims into equity and it minimizes the fiscal costs of a distressed bank resolution.
A third option would be to induce unsecured creditors – under the threat of a receivership that becomes credible once a special insolvency regime for too-big-to –fail banks is implemented - to convert their claims into equity. Then, the bad assets of the bank can be taken off the balance sheet of the bank via the PPIP program or a number of other alternative ways to separate good and toxic assets.
Each one of these three proposed solutions implies that unsecured creditors of banks take some losses and convert their claims into equity. Instead, the paradoxical result of the current US approach is that – in order to avoid a temporary nationalization of insolvent banks and in order to prevent unsecured creditors of banks from taking any losses – the result is a creeping and increasing partial nationalization of the financial system: the government will have to inject more preferred shares into troubled banks and convert more of its preferred shares into common equity. So, even without a temporary government takeover of the insolvent banks, we will end up with a longer-term partial government ownership of many large banks. To avoid this creeping partial nationalization inducing the banks creditors to convert their claims into equity would be a more sensible solution that minimizes the fiscal costs of the crisis, reduces the moral hazard of government bailouts and keeps more of the banking system into private hands.
The logic of the current muddle through approach is clear (leaving aside the fact that Wall Street is still partially capturing the US regulators and policy makers): providing unlimited liquidity and deposit guarantees to avoid bank runs and refinancing risks; subsidize banks and their rebuild of capital via near zero funding rates, a steep intermediation curve and rising net interest rate margins; hope that the economy recovers faster than otherwise expected (as the green shoots are rising) so that eventual bank losses are lower; hope that forbearance and time will heal most wounds by reducing the eventual level of charge-offs and writedowns and letting bank rebuilt capital via earnings before provisions; ignore moral hazard distortions in the short run while the banking crisis is still simmering and try to reduce such distortions in the medium term with a new and better regime of supervision and regulation of financial institutions; avoid takeovers of large institutions that would be disorderly in the absence of a special insolvency regime for such large banks; avoid the risk that, even in the presence of such special insolvency regime, unintended consequences of a takeover of a large bank lead to Lehman-like consequences; hope that fiscal costs of massive subsidies and bailouts of banks are contained if a virtuous cycle of economic recovery and restoration of confidence in the financial system rapidly emerges; subsidize restoration of securitization (with the TALF) and subsidize the separation of toxic assets from the banks’ balance sheet via government leverage and non-recourse loans (PPIP); avoid a more severe credit crunch via sensible supervisory and regulatory forbearance (mark-to-market suspension of FASB rules; closing regulators’ eyes on the true value of loans and assets; avoid forcing banks to recapitalize too fast and let capital adequacy ratios to slip in the short run; etc.); deal with the too-big-to-fail problem only if/when the crisis is over with higher capital charges once banks can better afford them ; eventually reform the system of regulation and supervision of the financial system.
However, the current muddle through approach of colossal regulatory forbearance and bailout of the financial system has some serious risks and shortcomings (see my two recent op-eds with Matt Richardson in the WSJ and the FT for an elaboration): it significantly increases the fiscal costs to the taxpayer of bailing out financial institutions (their shareholders and creditors); it creates the mother of all moral hazard distortions as literally trillions of dollars of financial resources have been used to backstop the financial system and bailout reckless bankers and traders and investors; it ends up with a persistent and possibly long-term government control and partial ownership of parts of the financial system; it does not resolve the too-big-to-fail problem as big banks are not broken up or given incentives to break themselves up; it risks to keep alive zombie banks leading to a more persistent credit crunch, economic stagnation, deflation and debt deflation; it leads to problems of medium term fiscal sustainability as the large fiscal cost of the bailout of the financial system creates serious public debt dynamics problems over time; it creates a serious exit strategy problem for monetary policy as the tripling of the monetary base and the central bank purchase of toxic and illiquid assets risks to eventually lead to price inflation or to another asset and credit bubble unless the massive creation of liquidity is mopped up as soon as the real economy recovers; and it may end up with a cosmetic reform of the regime of regulation and supervision of the financial system as soon as the financial crisis looks like beginning to bottoming out.
Indeed many Wall Street voices are starting to argue that the crisis is over, that bull times are back, that they don’t need further government support (while still being on the government dole in twenty different Fed/FDIC/Treasury bailout/subsidy programs/funds), that they can repay TARP money (using the $350 bn of funds that they borrowed at near 0% interest rates with a FDIC full guarantee of interest and principal), that the government should not over-regulate the financial system, that controls on bankers compensation are misguided, that no fundamental change of the financial system and of its regulation is needed. This is the self-serving chatter that we are starting to hear from the same reckless lenders, bankers and investors whose greed and wildly distorted bonus/compensation schemes – together with regulators that were asleep at the wheel and believing in self-regulation that means no regulation – caused the worst economic recession and financial crisis since the Great Depression. This is the new spin of those whose fake (as not being risk-adjusted) gains/profits/bonuses were privatized in the bubble times when fake wealth and bubble profits were created and whose trillions of dollars of losses have now been fully socialized and paid for by the taxpayer. Their arrogance is only second to their shameless Chutzpah.
One can only hope that policy makers will resist these siren calls can and design a reform of the regime of regulation and supervision of financial institutions (more capital, less leverage, more liquidity, incentive compatible compensation with a bonus/malus system, higher capital charges to deal with – and possibly break-up – too-big-to-fail financial institutions, global regulatory standards that prevent jurisdictional arbitrage, etc.) that reduce the risk that a financial crisis of this proportion will happen again.
It is never a wholesome day at Zero Hedge absent some brilliant prose from David Rosenberg. So let's make it a wholesome day.
Market likely to peak the end of the week
Just as the clock is winding down on my tenure at Merrill Lynch, the equity market is winding up with an impressive near-40% rally in just nine weeks. For those that were still long the equity market back at the March 9 lows, a good ‘devil's advocate' exercise would be to ask yourself the question whether you would have taken the opportunity, if the offer had been presented, to have sold out your position with a 40% premium at the time. What do you think you would have said back then, as fears of financial Armageddon were setting in? We haven't conducted a poll, but we are sure at least 90% of the longs at that point would have screamed "hit the bid!"
Are we at risk of missing the turn?
Fast forward to today, and within two months optimism seems to have yet again replaced fear. Are we at risk of missing the turn? What if this is the real deal - a new bull market? This is the question that economists, strategists and market analysts must answer.
Risk is much higher now than it was 18 weeks ago
The nine-week S&P 500 surge from 666 at the March lows to 920 as of yesterday has all but retraced the prior nine-week decline from the 2009 peak of 945 on January 6 to the lows on March 9. We believe it is appropriate to put the last nine weeks in the perspective of the previous nine weeks. To the casual observer, it really looks like nothing at all has happened this year, with the market relatively unchanged. But something very big has happened because the risk in the market, in our view, is much higher than it was the last time we were close to current market prices back in early January, for the simple reason that we believe professional investors have covered their shorts, lifted their hedges and lowered their cash positions in favor of being long the market.
Employment, output, income, sales still in a downtrend
Considering what transpired from an economic standpoint, the decline in the first nine weeks of the year was rather appropriate in the midst of the worst threequarter performance the economy has turned in roughly 70 years. The rally of the past nine weeks appears to be rooted in green shoots. While it may be the case that the pace of economic decline is no longer as negative as it was at the peak of the post-Lehman credit contraction, the reality is that employment, output, organic personal income and retail sales are still in a fundamental downtrend.
Need to see an improvement in the first derivative
We have evidence that the consumer, after a first-quarter up-tick that was frontloaded into January, is relapsing in the current quarter despite the tax relief (didn't we see this movie last year?). Not until improvement in the second derivative morphs into improvement in the first derivative with respect to the important economic data will it really be safe to declare what we are seeing as something more than a bear market rally, as impressive as it has been.
This is a bear market rally that may have run its course
The investing public is still holding tightly to their long-term resolve, but much of the buying power at the institutional level seems to have largely run its course, in our view. That leaves us with the opinion, as tenuous as it seems in the face of this market melt-up, that this is indeed a bear market rally and one that may well have run its course. We have "round-tripped" from the beginning of the year and there is real excitement in the air about how these last nine weeks represent evidence that the economy will begin expanding sometime in the second half of the year.
Growth pickup will likely prove transitory
While it is likely that headline GDP will improve as inventory withdrawal subsides and fiscal policy stimulus kicks in, our view is that whatever growth pickup we will see will prove to be as transitory as it was in 2002, when under similar conditions the market ultimately succumbed to a very disappointing limping post-recession recovery. So yes, there may well be some improvement in the GDP data, but it is based largely on transitory factors. We strongly believe it is premature to totally rule out the end of the vicious cycle of real estate deflation - residential and now commercial - that we have been experiencing since 2007. Balance sheet compression in the household sector will continue to pressure the personal savings rate higher at the expense of discretionary consumer spending. This is a secular development, meaning that we expect it will last several more years.
Chances of a re-test of the March lows are non-trivial
To reiterate, it seems to us likely that the risk in the market is actually higher today than it was back at the same price points in early January, and we say that with all deference to the stress tests (which given the less-than-dire economic scenarios, along with the changes to mark-to-market accounting, were destined to reveal healthy results). While the consensus seems gripped with the burden of trying to decide if there is too much risk to be out of the market, we actually still believe that the chances of a re-test of the March lows are non-trivial, especially if the widely touted second-half economic rebound fails to materialize.
Market may have a fully invested condition of ‘smart money'
While many pundits point to ‘dry powder' on the sidelines that is ready to be put to work, our sense is that we now have to consider the prospect that we actually have a fully invested condition of ‘smart money' in the market. If there is a risk that is not being widely discussed, it is the risk that profit-taking by the big-money investors (many who share our outlook but have been quick to take advantage of this monumental bounce in equity prices), will not be met with enough demand from the fundamental bulls. And if we ever do see the capitulation from the retail investor - this has yet to occur - then this flow-of-funds scenario can certainly trigger a re-test of the lows.
We are happy to buy these sell-offs in Treasuries
When you look at Charts 1-3, you really have to wonder whether or not the markets have been too hasty in pricing out deflation risks. There has never been a time in the post-WWII era where the 12-month trends in wages, producer costs and consumer prices were all in negative territory at the same time. This is the new reality. As the markets focus on the noise from green shoots, we are focusing our attention on the fundamental trends and the end-game. We are more than happy to buy these sell-offs in Treasuries and add scarce safe income to the portfolio. Take profits in equities and scale into Treasuries This move to 3.20% on the 10-year note resembles that inexplicable move to 5.35% back in the summer of 2007, in our view. Yes, yields are much lower today, but the inflation rate is 300 basis points lower too and the unemployment rate is 400 basis points higher. If we recall back in that summer of 2007, the equity market was hitting new highs just as bond yields were. The trade then was to take profits in the former and scale into the latter. After a near-40% surge in the S&P 500 and a near-60% surge in bond yields off their recent lows, it would seem logical to us to embark on a similar shift this time around.
Bond yields do not bottom until well into the next cycle
Even if the recession is to end soon, and that is still very debatable, bond yields do not typically bottom until we are well into the next cycle, as inflation continues to decline even after the downturn ends. So just like further upside potential in equity prices seems extremely unlikely over the near and intermediate term, further downside risk Treasury note and bond prices is also less of a risk today, in our view.
We would like to see a retest of the March 9 low
To emphasize, it could well be that we saw the market lows back on March 9. But we would like to see a successful retest before making that conclusion. The inevitable test will be the thing. But do not confuse green shoots for a sustainable recovery. After a credit collapse and asset deflation of the magnitude we just witnessed, the markets, housing prices and equities can be expected to take years to fully recover.
The data flow is less relevant this cycle than in the past
This was not a manufacturing inventory cycle, which makes the data flow less relevant than in the past. Real estate values are still deflating and the unemployment rate is still climbing; these are critical variables in determining the willingness of lenders to extend credit. And as we just saw in the Fed's Senior Loan Officer Survey, while there may be a ‘thaw' in the financial markets, banks are still maintaining tight guidelines. In fact, the weekly Fed data are now flagging the most intense declines in bank lending to households and businesses ever recorded. The best case is that this is a bear market rally All of this has not precluded an elastic band bounce from an egregiously oversold low in the S&P 500, and perhaps we will even test the 200-day moving average of 960 (as the 10-year note yield and NASDAQ just did). But we still do not believe what we are seeing fits the hallmark of a new bull market. In our view, the best case is that this is a bear market rally, but one that clearly has more legs than its predecessors this cycle.
Providing clients with a historical perspective
At this time, we believe it is necessary to provide clients with some historical perspective from the last colossal credit collapse in the 1930s, understanding that there were similarities as well as differences. It was extremely difficult for equity investors to make money in the decade following the June 1932 bottom. After the three-month rally (+75%) off the bottom in 1932, equity markets were extremely volatile and largely sideways for the next nine years. Keep in mind that the jury is still out as to whether the March 2009 lows were in fact the bottom, as was the case in 1932.
If March 9 was the low, what does it mean for the outlook?
It doesn't say much, actually. The same goes for corporate spreads. The S&P 500 bottomed in mid-1932 and soared nearly 75% in the next three months. Anyone who bought at that point and hung on to their position saw no capital appreciation for nine years. Baa spreads also hit their widest levels at 724 basis points in mid-1932, a year later they were down to 380 basis points. While the initial the surge in the stock market and the tightening in corporate spreads from stratospheric levels presaged the bottom in GDP in the third quarter of 1932, the reality is that the Great Depression did not end until 1941 (and the next secular bull market did not commence until 1954). The prior peak in GDP was not reattained until the end of the 1930s, fully seven years after the introduction of the New Deal stimulus. By then the unemployment rate was still at 15%, consumer prices were deflating at a 2% annual rate and government bond yields were on their way to sub-2% levels.
Our preference is to stick with fixed-income securities
Be careful about jumping into the stock market with both feet after this monumental rally. Consider whether or not it would be more appropriate to take advantage of the run-up to reduce equity exposure. Our preference is to stick with fixed-income securities, which we believe will work much better from a total return standpoint, as they did for years after the economy hit bottom back in the early 1930s. When we are finally coming out of this epic credit collapse and asset deflation, we should expect that the trauma exerted on household balance sheets will have triggered a long wave of attitudinal shifts toward consumer discretionary spending, homeownership and credit. The markets have a long way to go in terms of discounting that prospect.
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Asia’s ‘Absolute Greed’ Stocks Rally to Falter, Citigroup Says
By Chua Kong Ho
8 May 2009
(Bloomberg) -- Asian stocks are set for a “correction” as a two-month rally drives valuations higher than justified by a recovery in company earnings, according to Citigroup Inc.
The MSCI Asia Pacific Index has gained 37 percent from a five-year low on March 9. The rebound has lifted the average valuation for stocks on the Asian gauge to 23.6 times profit, the highest since March 2004 and 52 percent more than shares on the MSCI AC World Index, according to data compiled by Bloomberg.
Markets are poised for a decline as valuations are higher than they should be at this point in the economic cycle, Citigroup’s Adrian Faure said. He doesn’t expect stocks to fall below their March lows, he added.
“The speed with which absolute fear has been replaced by absolute greed has been extraordinary,” said Faure, the Hong Kong-based head of Asia Pacific research at Citigroup, in a telephone interview. “I’ve not seen such a turn of events and I’ve been doing this a long time. We’ll see a correction as markets aren’t going to go up in a straight line.”
Citigroup was top-ranked in Institutional Investor magazine’s 2009 investor survey for research on Asian equities outside Japan, which was released this week. The survey, in its 16th year, surveyed more than 1,900 buy-side analysts and fund managers at 700 institutions managing an estimated $1.6 trillion in non-Japanese Asian equities.
‘On a Tear’
Stocks have been “on a tear as an awful lot of money hasn’t participated in the bounce and is being forced to chase the market,” he said. There’s still a “hangover of excesses built up over many years,” he added.
Faure, 44, was head of Asian equities research at Macquarie Securities Ltd. and the co-head of global emerging markets research at Merrill Lynch & Co., now part of Bank of America Corp., before joining Citigroup four years ago.
Faure’s views were shared by Ronald Arculli, chairman of Hong Kong Exchanges & Clearing Ltd., who said he “wouldn’t be a buyer” of stocks trading in the city.
Hong Kong’s Hang Seng Index has surged 52 percent from a four-month low on March 9, pushing the average valuation of its 42 companies to 15.5 times reported earnings, the highest level since Jan. 10, 2008.
“Stock markets tend to run ahead of economic activity,” said Arculli, who has been chairman of Asia’s third-largest bourse for two years. “There’s a lot of that with the index being at the current level.”
‘Vastly Worse’
The current global crisis is “vastly worse” than the 1930s because financial systems and economies worldwide have become more interdependent, “Black Swan” author Nassim Nicholas Taleb said yesterday, adding “this is the most difficult period of humanity that we’re going through.”
While every market looks “overbought,” Taiwan and South Korea still present the best investment opportunities in the region, Citigroup’s Faure said.
Taiwan’s Taiex Index has advanced 43 percent this year for the region’s biggest gain, on optimism that improving ties with China will lead to an inflow of foreign direct investments, and funds into the island’s stock market.
China Mobile Ltd. agreed last month to buy a 12 percent stake in Taiwan’s third-biggest phone company Far EasTone Telecommunications Co., while Taiwan’s Financial Supervisory Commission announced it will begin accepting applications from Chinese institutional investors to buy securities on the island.
“The China Mobile deal was a political deal,” Faure said. “What it tells you is that the trend of financial and economic integration with China is now irreversible. Taiwan is coming in from the cold.”
Ship Owners Forced to Pay to Carry Middle East Oil
By Alaric Nightingale
May 8 (Bloomberg) -- Ship owners are being forced to pay to carry oil from the Middle East to the U.S. for the first time in at least a decade after demand collapsed and the fleet expanded.
Supertanker owners make no rental income from the voyages and are paying $3,445 a day toward fuel costs, data from the Baltic Exchange in London show. Rental rates normally cover fuel costs. The journey to the Louisiana Offshore Oil Port from Ras Tanura, Saudi Arabia’s largest export facility, earned owners as much as $104,663 a day in July.
Some owners may be prepared to subsidize voyages as they relocate vessels to the Atlantic, Anders Karlsen, a shipping analyst at Nordea Markets in Oslo, said by phone today. The alternative would be paying all the fuel costs themselves and sailing empty. Owners could also mothball ships, Karlsen said.
“It’s a sign there’s a lot of surplus” in the fleet, Martin Stopford, managing director of Clarkson Research Studies in London, said by phone today.
The Organization of Petroleum Exporting Countries, led by Saudi Arabia and accounting for about 40 percent of global supply, agreed to cut output three times since September as demand crumbled. Oil prices have plunged 61 percent from a record $147.27 a barrel reached in July.
Twenty-one percent of the global fleet of 2,067 oil tankers is anchored, compared with an average of 16 percent across all types of vessel, data compiled by Bloomberg show. Supertankers are moving at an average speed of 9.2 knots, from as fast as 10.6 knots in July, suggesting captains are slowing down to save on fuel, the data show.
Supertanker Fleet
The supertanker fleet expanded by 21 to 520 vessels this year, according to Lloyd’s Register-Fairplay data on Bloomberg.
Rental incomes haven’t been this bad in at least a decade, said Mark Jenkins, a London-based analyst at Simpson, Spence & Young Ltd. That’s as far back as the shipbroker’s data goes.
Nippon Yusen K.K., Japan’s largest shipping line, leased the Tosa for a rate of 17.5 Worldscale points to Kuwait Petroleum Corp., according to reports today from Athens-based Optima Shipbrokers and other brokers. Worldscale points are a percentage of a nominal rate, or flat rate, for more than 320,000 specific routes.
The rate may be equal to $6,042 a day less than the shipper needs to pay its fuel and port costs, according to a calculator on the Web site of shipbroker RS Platou. Suguru Uchida, a spokesman for Nippon Yusen in Tokyo, declined to comment.
While negative returns are unusual, owners do routinely offer discounts to customers to cover the cost of moving ships into more profitable regions, Clarkson’s Stopford said.
Should the situation persist for several months, owners are likely to favor mothballing ships and removing their crews, Per Mansson, managing director of shipbroker Nor Ocean Stockholm AB in Stockholm, said by phone.
Owners of older ships may choose instead to scrap them and those with ships on order may seek to delay delivery dates, Nordea Markets’s Karlsen said.
China fears bond crisis as it slams quantitative easing
China has given its clearest warning to date that emergency monetary stimulus by Western governments risks setting off worldwide inflation and undermining global bond markets.
By Ambrose Evans-Pritchard
07 May 2009
"A policy mistake made by some major central bank may bring inflation risks to the whole world," said the People's Central Bank in its quarterly report.
"As more and more economies are adopting unconventional monetary policies, such as quantitative easing (QE), major currencies' devaluation risks may rise," it said. The bank fears a "big consolidation" in the bond markets, clearly anxious that interest yields will surge as western states try to exit their QE experiment.
Simon Derrick, currency chief at the Bank of New York Mellon, said the report is the latest sign that China is losing patience with the US and aims to diversify part its $1.95 trillion (£1.3 trillion) foreign reserves away from US Treasuries and other dollar securities.
"There is a significant shift taking place in China. They are concerned about the stability of the global financial system so they are not going to sell US bonds they already have. But they are still accumulating $40bn of fresh reserves each month, and they are going to be much more careful where they invest it," he said.
Hans Redeker, head of currencies at BNP Paribas, said China is switching into hard assets. "They want to buy production rights to raw materials and gain access to resources such as oil, water, and metals. They know they can't keep buying bonds," he said
Premier Wen Jiabao left no doubt at the Communist Party summit in March that China is irked by Washington's response to the credit crunch, suspecting that the US is engaging in a stealth default on its debt by driving down the dollar. "We have lent a massive amount of capital to the United States, and of course we are concerned about the security of our assets. To speak truthfully, I do indeed have some worries," he said.
Days later, the central bank chief wrote a paper suggesting a world currency based on Special Drawing Rights issued by the International Monetary Fund.
Some economists say China is suffering from "cognitive dissonance" by anguishing so much over its reserves, accumulated as a result of its own policy of holding down the yuan to promote exports. Quantitative easing by the US Federal Reserve and fellow central banks may have saved China as well, since the country's growth strategy is built on selling goods to the West.
China's fears of imported inflation may reflect its concerns about over-heating. The M2 money supply rose 25pc in March on a year earlier, and there has been explosive credit growth since the government relaxed loan restraints. There are concerns that the stimulus is leaking into a new asset bubble rather than promoting job growth. The Shanghai bourse is up over 50pc since November.
Tough year ahead for US-China trade-US official
* Aide sees more problems doing business in China
* China pressuring U.S. on tire, steel cases
* China export taxes giving U.S. a "colossal headache"
By Doug Palmer
05.07.09
WASHINGTON (Reuters) - This could be a very tough year for trade relations between China and the United States, despite pledges to work together to restore growth and fight protectionism, a U.S. government official said Wednesday.
"It was clear to me there's more problems than ever in doing business in China," the government official said, reflecting on a trip last month to China.
"I think we're going to have a very tough year ahead," he said at a discussion hosted by the Nixon Center.
China is the United States' second-largest trading partner, with two-way trade last year totaling $409.2 billion.
However, Chinese exports to the United States exceeded U.S. exports to China in 2008 by $266.3 billion, accounting for about 30 percent of the total U.S. trade deficit last year.
Persuading China to open its market to more U.S. goods is one of the three major challenges in the trade relationship, a second U.S. government official said.
The two others involve pushing back on Chinese industrial policies that favor domestic firms over foreign competitors and and China's weak enforcement of rules in areas ranging from product safety to copyrights and trademarks to labor, he said.
Both officials spoke on the condition on anonymity.
PRESIDENTIAL PHONE CALL
The frank comments followed a phone call between U.S. President Barack Obama and Chinese President Hu Jintao Wednesday to discuss ways to enhance cooperation on the global economy and health issues, as well as regional security.
Obama and Hu met for the first time last month at a summit meeting in London of developed and developing countries leaders. Obama accepted an invitation to visit China this year, and that could happen when he travels to Singapore in November for the annual Asia Pacific Economic Cooperation summit meeting, the first government official said.
The Obama administration avoided a trade fight with China last month when it decided against formally labeling Beijing as a currency manipulator, despite Obama's statements during last year's campaign that it was.
However, during a visit to Washington last week, Chinese Commerce Minister Chen Deming protested "vociferously" to U.S. Commerce Secretary Gary Locke about two new cases brought by U.S. workers and industry against Chinese imports, the first government official said.
In one case, U.S. tire workers want a three-year quotas on imports of Chinese-made tires that reached nearly $1.8 billion last year. In the other, U.S. steel companies want duties ranging up to almost 100 percent on pipes used to ship oil. Those imports from China totaled $2.6 billion last year.
China fears those big-ticket cases could encourage others if the petitioners get the relief they request.
"COLOSSAL HEADACHE"
A senior Chinese delegation objected to both cases in a April 22 meeting with the U.S. International Trade Commission, which investigates industry complaints of unfair trade and requests for import relief.
ITC Chairman Sharon Aran told the delegation it was "not appropriate" for the commission to discuss the facts of the cases with interested parties and a record of the discussion would have to be made, a commission spokeswoman said.
Meanwhile, China's use of export taxes to depress domestic prices of wire rod and inputs used to make finished goods "has become a colossal headache for us and we're struggling to find the right remedy," the second government official said.
The practice gives Chinese companies a cost advantage in producing many goods, creating a problem for many small U.S. producers who don't have the resources to file an anti-dumping or countervailing duty case asking for relief, he said.
One possibility would be for the United States to initiate dispute settlement proceedings at the World Trade Organization, but no decision on that has been made, he said.
The United States also is frustrated that China hasn't followed through a commitment to give foreign companies increased access to its huge public works market by joining the WTO's government procurement pact, he said.
A scramble for funds after results are aired
From Inquirer Wire Services
May 9, 2009
Two of the nation's largest banks lined up new financing yesterday, just a day after the federal government made public the results of its "stress tests."
Also, a third bank announced its plans to raise money, while a credit-rating agency warned that a fourth would have to rely on more government bailout funds.
The flurry of activity was prompted by the stress tests on the nation's 19 largest banks and the government's conclusion that 10 of them must raise a total of about $75 billion in new capital to help them withstand possible losses in the event the recession deepens and more loans fall into default.
Each of the 19 banks has assets of at least $100 billion and was deemed by the Obama administration as "too big to fail" - that is, so big that the effects of its collapse would ripple through the financial system and cause a meltdown like the one that began early last year.
Critics of that concept have said failing banks should be closed rather being propped up with a government bailout. Eighteen of the 19 banks tested received taxpayer funds under last fall's Troubled Asset Relief Program, under which the government invested in hundreds of banks to try to revive frozen credit markets.
The White House told industry officials yesterday that it was leaning toward wanting the Federal Reserve to become the supercop for "too big to fail" companies. The administration made it clear it was not inclined to divide the job among various regulatory agencies, as suggested by industry and some federal regulators.
Treasury Secretary Timothy Geithner told the group that one organization needed to be held responsible for monitoring systemwide risk. He said such a regulator should be given better visibility into all institutions that pose a risk to the financial system, regardless of what business they were in.
Responding to Thursday's order to boost its capital, Wells Fargo & Co. said yesterday that it was raising $7.5 billion through a sale of 341 million shares of common stock at $22 apiece, boosting the amount it previously said it would raise by $1.5 billion.
Wells Fargo is based in San Francisco, but its acquisition in January of Wachovia Corp. made it the largest player in the Philadelphia area, with nearly 21 percent of deposits in the eight-county market.
The government said the bank needed to raise $13.7 billion to cushion it from another potential fall in the economy.
Also yesterday, Morgan Stanley said it would sell 167.9 million common shares for $24 each in an effort to raise gross proceeds of $4 billion. The company is also pricing an offering of $4 billion in bonds.
The New York company faces a $1.8 billion shortfall, according to the government.
Bank of America Corp., of Charlotte, N.C., said it would raise capital through asset sales, earnings in the coming quarters, and raising money from private investors. The government said the nation's largest bank needed $33.9 billion. The asset sales could bring in up to $10 billion and include its First Republic Bank unit, which it inherited when it bought Merrill Lynch & Co. late last year.
An additional $17 billion will likely be raised through the issuance of common stock.
But another of the institutions tested, GMAC L.L.C., the Detroit auto lender bailed out by U.S. taxpayers, will have to rely on the government to fill the $11.5 billion gap in capital found by regulators in the examination, Standard & Poor's Corp. predicted yesterday.
Goldman Sachs Group Inc. was one of the nine banks not required to raise more money. Company chairman Lloyd Blankfein told shareholders at their annual meeting that Goldman expected to "soon" repay the $10 billion in government loans it received last fall under TARP.
401(k)s Hit by Withdrawal Freezes
Investors Cry Foul as Some Funds Close Exits; Perils of Distressed Markets
By ELEANOR LAISE
MAY 5, 2009
Some investors in 401(k) retirement funds who are moving to grab their money are finding they can't.
Even with recent gains in stocks such as Monday's, the months of market turmoil have delivered a blow to some 401(k) participants: freezing their investments in certain plans. In some cases, individual investors can't withdraw money from certain retirement-plan options. In other cases, employers are having trouble getting rid of risky investments in 401(k) plans.
When Ed Dursky was laid off from his job at a manufacturing company in March, he couldn't withdraw $40,000 from his 401(k) retirement account invested in the Principal U.S. Property Separate Account.
That fund, which invests directly in office buildings and other properties, had stopped allowing most investors to make withdrawals last fall as many of its holdings became hard to sell.
Now Mr. Dursky, of Ottumwa, Iowa, is looking for work and losing patience. All he wants, he said, is his money.
"I hate to be whiny, but it is my money," Mr. Dursky said.
The withdrawal restrictions are limiting investment options for plan participants and employers at a key time in the markets. The timing is inconvenient for the number of workers like Mr. Dursky who are laid off and find their savings inaccessible.
Though 401(k) plans revolutionized the retirement-savings landscape by putting investment decisions in the hands of individuals, the restrictions show that plan participants aren't always in the driver's seat.
Individual investors mightn't even be aware of some behind-the-scenes maneuvers causing liquidity problems in their retirement plans. Many funds offered in 401(k) plans lend their portfolio holdings to other investors, receiving in exchange collateral that they invest in normally safe, liquid holdings.
The aim is often to generate a small but relatively reliable return that can help offset fund expenses. But in recent months, many of the collateral investments have gone haywire, prompting money managers to restrict retirement plans' withdrawals from the lending funds.
Some stable-value funds also are blocking the exits. These funds, available only in tax-deferred savings plans such as 401(k)s, typically invest in bonds and use bank or insurance-company contracts to help smooth returns. But in cases of employer bankruptcy and other events that can cause withdrawals, these funds can lock up investor money for months at a time.
Investors in the Principal U.S. Property Separate Account said they understood the risk of losses, but didn't think their money could be locked up for months or years. Most participants in the 15,000 plans holding the fund haven't been able to make any withdrawals or transfers since late September.
"To sell property at inappropriately low prices in order to generate cash for a few would hurt the majority of investors and violate our fiduciary obligations," said Terri Hale, spokeswoman for Principal Financial Group Inc., the parent of the fund's manager. The fund, which had $4.3 billion in net assets at the end of April, still is making distributions for death, disability, hardship and retirement at normal retirement age.
As of April 28, redemption requests that had yet to be honored totaled nearly $1.1 billion, or roughly 26% of the fund's net assets. Principal doesn't anticipate that it will make any distributions to investors who have requested redemptions until late 2009 or beyond, Ms. Hale said. Meanwhile, the fund continues to fall, declining 25% in the 12 months ending April 30.
Some investors have lost hope of recovering their money. Judith Sterner, a 69-year-old part-time nurse, had more than $12,000 in the fund when she tried to transfer that balance to a money market last fall. But her transfer was denied, and her stake has since declined to less than $10,000.
"This $12,000 represents a year of my retirement money that I don't have," said Ms. Sterner, of Morton Grove, Ill.
Principal still allows new investors into the fund. It categorizes the U.S. Property account as a fixed-income investment, alongside much stodgier funds holding high-quality bonds. New investors are warned of potential withdrawal delays, Ms. Hale said. As for the fixed-income categorization, she said, "a substantial portion of the account return is based on income streams from rents, and its returns have been comparable to fixed-income funds."
While the problems selling real-estate investments are relatively straightforward, withdrawal restrictions related to securities lending stem from far more obscure practices.
Funds often lend out portfolio holdings, through a lending agent, to other investors. These borrowers give the lender collateral, often amounting to about 102% of the value of the securities borrowed. Some of the collateral pools in which funds invest this collateral held Lehman Brothers Holdings Inc. debt and other investments that plummeted in value or became hard to trade in the credit crunch.
Though agents who coordinate funds' lending programs share in profits from securities lending, the risk of such collateral-pool losses falls entirely on the funds that have lent the securities and, ultimately, retirement plans and other investors holding those funds.
The problems have limited retirement plans' ability to get out of securities-lending programs, though participants' withdrawals generally haven't been affected.
Retirement plans offered to employees of energy company BP PLC last fall tried to withdraw entirely from four Northern Trust Corp. index funds engaged in securities lending. Certain holdings in Northern's collateral pools had defaulted, been marked down, or become so illiquid that they could only be sold at low values, according to a BP complaint filed in a lawsuit against Northern Trust.
The BP plans halted new participant investments in the funds and asked to withdraw their cash so it could be reinvested in funds that don't lend out securities.
But under restrictions imposed by Northern Trust in September, investors wishing to withdraw entirely from securities-lending activities would have to take their share of both liquid assets and illiquid collateral-pool holdings, according to a Northern Trust court filing. BP rejected that option, and the companies still are trying to resolve the matter in court.
Northern Trust's collateral pools are "conservatively managed" and focus on liquidity over yield, the company said.
State Street Corp. in March notified investors of new withdrawal restrictions in its securities-lending funds. Until at least the end of the year, plans can make monthly withdrawals of only 2% to 4% of their account balance, the notice said.
Plans wishing to withdraw entirely from lending funds will have to take a slice of beaten-down collateral-pool holdings.
"Given the current state of the fixed-income market, we felt it was prudent to put some well-defined withdrawal parameters in place," said State Street spokeswoman Arlene Roberts.
Ten Reasons Why the Stress Tests Are “Schmess” Tests and Why the Current Muddle-Through Approach to the Banking Crisis May Not Succeed
Nouriel Roubini
May 8, 2009
What shall we make of the recently announced results of the stress test? Are they credible? Will they restore confidence in our battered financial system? Will the current approach to resolving the financial crisis work, be effective and minimize the fiscal costs of the financial bailout?
For a number of reasons these results are a significant underestimate of the capital/equity needs of these 19 large US banks. Also this underestimate of the losses and the current “muddle-through” approach to the banking and financial crisis may accelerate the creeping partial nationalization of the US financial system, exacerbate moral hazard distortions, not resolve the too-big-to-fail problem, increase the fiscal costs of this financial crisis, make the credit crunch last longer and lead some near insolvent financial institutions to become zombie banks. Let me explain in ten points why I hold such views (see also my two recent op-eds with Matt Richardson in the WSJ and the FT):
First, the stress tests are not stressful enough. As discussed in a previous note current levels of unemployment rates are already higher than those assumed in the more adverse scenario; and even assuming that the rate of job losses will slow down over the next few months to a 400-500K monthly range it is highly likely that the US will reach an unemployment rate of 10% by the fall of 2009, a rate of 10.5% by the end of 2009 and a rate above 11% some time in 2010; instead the parameters of the stress tests assumed that the unemployment rate would average 10.3% in the more adverse scenario in 2010, not 2009. Note also that the parameters for the more adverse scenario in the stress tests were a political compromise among the agencies involved in the stress tests; one of these agencies had found more realistic the hypothesis that the parameter for the unemployment rate in the more adverse scenario should be 12% rather than 10.3%. Moreover, the stress tests found that the 19 banks needed $185 bn of additional equity; the published figure of $75 is based on assets dispositions and capital raises of $110 bn that are still under way and, in most cases, not completed yet. Booking such increases in equity before they have occurred does not seem appropriate accounting procedure.
Second, the capital/needs of these banks depend on a race between retained earnings before writedowns/provisioning that will be positive given a high net interest rate margin and the losses deriving from further writedowns. It appears that regulators have overestimated the amount of such retained earnings for 2009-2010. The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario. Thus, ex-post capital needs will be significantly higher if net retained earnings turn out to be lower than assumed in the stress tests. While regulators resisted the banks’ attempt to use Q1 earnings (that were fudged via under-provisioning for loan losses, paper gains on securities via changes in FASB rules on mark-to-market, and accounting gains coming from the lower market value of bank liabilities) as proxy for the future profitability of banks it appears that such regulators were too optimistic in estimating what net retained earnings will be in 2009-2010.
Third, banks bargained hard to reduce the regulators estimates of needed additional equity. For example, according to press reports Citigroup was initially assessed to need an additional $30bn of equity; such figure was then reduced to $5 billion after aggressive bargaining by the bank. One can only guess how much higher were the regulators initial estimates of the banks’ capital needs and how much lower the published estimates became after the banks lobbied for lower figures.
Fourth, the estimates of additional losses on loans - $445 bn - appear to be relatively reasonable even if they could end up being significantly higher in a weaker macro scenario. But estimates of losses on securities - $154bn – are most likely too low. And the results of the stress scenario do not provide details on how much regulatory forbearance has been provided in the estimate of losses on securities; while current market values of some securities may be lower than long term values given an illiquidity premium many banks still keep many of these securities in the level 2 and 3 buckets and use a mark-to-model, rather than a mark-to-market approach to value these assets. Certainly in the last year regulators have been lenient and provided plenty of forbearance – on top of expensive formal guarantees of hundreds of billions of toxic assets for several banks – to reduce the amount of revealed losses on securities. Also, if one were to bring forward to today the writedowns/charge-offs for 2009-2010 estimated by the US regulators (an exercise that the IMF has done for all US banks in its recent Global Financial Stability Report) the TCE ratio for these 19 banks – and all US banks - would be effectively 0.1% today. So, the US regulators estimates of equity needs of these 19 banks are heavily depended on what net earnings before writedowns will be in 2009-2010.
Fifth, estimates of net retained earnings before writedowns are massively beefed up by the direct and indirect subsidies that the government is providing to the financial system: with the Fed Funds rate and deposit rates now close to 0% and with banks having been able to borrow since last year about $350 bn at close to 0% interest rates given the FDIC guarantee on new borrowings the bank can now earn a fat net interest rate margin that is a direct subsidy to financial institutions. The Fed is also losing a fortune on its three Maiden Lane funds that purchased toxic assets of Bear Stearns and AIG. On top of this major US financial institutions got a massive direct subsidy from the bailout of AIG. Overall, the US government has committed – between liquidity supports, recapitalization, insurance of bad assets, guarantees – over $13 trillion of resources to the financial system and already provided $3 trillion of such resources to the financial institutions. The financial system is already effectively a ward of the state in spite of the fact that all these direct and indirect subsidies have bailed out both the shareholders and the unsecured creditors of financial institutions. Even taking into account the fact that not all of these resources will represent a net long term loss to the US taxpayer even a conservative estimate of the net subsidy to the banks’ shareholders and unsecured creditors may be above $500 bn.
Sixth, in estimating equity needs of these 19 banks the regulators correctly used a measure of capital – Tangible Common Equity or TCE – that is narrower than Tier 1. Tier 1 capital includes many forms of capital – on top of tangible common equity – that are of poor quality as a buffer against losses or outright fishy: preferred equity and in particular intangible assets and goodwill. While Tier 1 capital of US banks was – at the end of 2008 – about $1,550 common tangible equity was only about $560 bn. The regulators estimated equity needs of the 19 banks based on a TCE ratio of 4% (as a percent of tangible assets). However, even 4% implies a leverage ratio for these banks of 25. The IMF instead – properly – considered a scenario where the TCE ratio is increased to 6% that is equivalent to a leverage ratio of 17 that represent the average leverage ratio for all US banks in the mid-1990s before leveraged shot up in the latest credit bubble. A capital adequacy ratio is also certainly necessary for these banks as they are systemically important: every academic analysis of systemic risk suggests that banks that are systemically important should have much higher capital in order to internalize the externalities deriving from too-big-to-fail distortions. And while Basel criteria for capital adequacy have not been yet revised to include this need for additional capital for too-big-to-fail banks the G20 and the FSF have already acknowledge the need to charge more capital for such large institutions.
Indeed, some national regulators have already moved to increase the capital required from their own banks: for example Switzerland has already unilateral imposed a 16% capital ratio for its systemically important banks to be phased in by 2013, a ratio that is double the Basel criteria of 8% for Tier 1 and Tier 2. Thus, it would have been appropriate that US regulators request that these 19 banks – that are all deemed to be systemically important – should aim to achieve a TCE ratio of at least 6% - not 4% - equal to the one prevailing in the mid-1990s for all US banks (not just the systemically important ones). The capital needs of all US banks would have been an additional $225 bn (based on IMF estimates) if the TCE ratio were to be increased from 4% to 6%. For these 19 banks a 6% TCE ratio – the minimum justifiable for systemically important institutions – would imply about an additional $100 bn of common equity compared to the estimates of the regulators.
Seventh, considering even only the need for a higher TCE ratio for too-big-to-fail banks – let alone the implications of other factor discussed above that would have increased the estimates of capital needs for US banks – all 19 banks would have required higher TCE. Giving a clean bill of financial health to half a dozen too-big-to-fail banks – including JP Morgan Chase and Goldman Sachs – that have survived this financial crisis only because of the massive direct and indirect subsidies received from the US government is a public disservice in two ways: first, it does not recognize that these banks survived the crisis only because of the government subsidies (liquidity, insurance, guarantees, recapitalization); second, it ignores the fundamental fact that too-big-to-fail banks should have much more tangible common equity than the one that they currently hold. It is reckless behavior by regulators to ignore the too-big-to-fail distortion that derives from excessively low capital ratios and not to start demanding from such systemically important banks additional capital to control for this negative externality.
Indeed, the problem with the current approach to the financial crisis is that the too-big-to-fail problem has become an even-bigger-to-fail problem and that moral hazard distortions from government bailouts have been sharply increased via trillions of dollars committed to backstop the financial system. First, while some significant support of the financial system was necessary and desirable to stop bank runs, reduce serious refinancing risks and avoid a more severe credit crunch the extent of the support and subsidy of the financial system has created the mother of all moral hazard distortions. Second, the current approach to crisis resolution has led to an even-bigger-to-fail problem because of the government inducing relatively less weak institutions to take over weaker ones. JP Morgan took over Bear Stearns and then WaMu; Bank of America took over Countrywide and then Merrill Lynch; and Wells Fargo took over Wachovia. And in the battle for Wachovia Citigroup aggressively fought Wells Fargo not because Wachovia was a sound banks (it was indeed insolvent and bust); it did so because taking over Wachovia would have made a too-big-to-fail Citi an even-bigger-to-fail bank with greater likelihood of government bailout. To put two weak – or near-zombie - banks together is like having two drunks trying to hold each other to stand straight. To resolve this even-bigger-to-fail problem a strategy of taking over near-insolvent institutions and then break them up in smaller, systemically-not-important pieces would have been appropriate. Alternatively, charging much higher capital ratios on too-big-to-fail banks – as optimal according to economic theory - would incentivize them to break themselves up in smaller pieces. But neither approach has been so far followed by US policy makers; and we have thus created the mother of all moral-hazard driven bailout distortions.
Eighth, the figures published by the US regulators are estimates of losses and capital/equity needs of the top 19 banks (those with assets above $100bn). Smaller US banks will have similar losses and capital needs. Based on the results of the stress tests some bank analysts have estimated that 60% of top 100 US banks (beyond the 19 ones in the stress tests) will need more capital/equity. Note that while large US banks (those with more than $4 billion in assets) have about 49% of their total assets into real estate assets the percentage of real estate assets for small US bank (those with assets below $4 bn) is about 63%. Thus, the losses for such smaller banks may end up being larger (as a % of their total assets) than the ones of large banks. The IMF recently estimated the additional capital needs of all US banks to be $275 bn if the TCE ratio is to increased to 4% and $500 bn if the TCE ratio has to go back to 6% (it average level for all US banks before the credit bubble of the last decade).
Ninth, the current muddle through approach to the banking crisis is predicated on the assumption that forbearance and time will heal most wounds of most systemically important banks: generous assumptions on net retained earnings before writedowns – and hope that the economy will rapidly recover - will allow banks to earn their way out of their current massive capital shortages. But while the government will now let banks found to need more equity to raise such equity in the next six months the ability of such banks to do that will be very limited: very few private investors would want to provide capital to a bank with massive expected writedowns, large capital needs and where such private capital investments will be further significantly diluted by a government that will need to increasingly convert its preferred shares into common equity. As it is the government will already soon own 36% of Citigroup and more in the future if Citi needs much more capital and is unable to raise it from private sources. A similar fate awaits Bank of America that now needs to fill an equity gap of almost $35bn.
Tenth, to avoid creating Japanese-style zombie large banks that are near insolvent and kept alive by trillions of dollars of government bailout support it would have been better to take different approaches that minimize the long-term government ownership or control of the financial system. There were three possible alternative approaches that made more sense.
One option would be a temporary nationalization of such near insolvent large banks: take them over, wipe out common and preferred shareholders, have unsecured creditors take some of the losses (haircuts on their claims and/or conversion of their claims into equity), separate good and bad assets and sell a clean-up bank – possible after breaking it up to create smaller pieces that are not too big to fail - as fast as possible to the private sector. This was the strategy followed for Indy Mac that was taken over last summer by the FDIC and sold back to a group of private investors in about six months. Such temporary nationalization option is feasible and orderly even for systemically important banks as long as Congress is willing to pass soon the new insolvency regime for large financial institutions.
A second option would be the approach favored by a number of economists of separating each troubled bank into a good bank and a bad bank and placing bad assets and unsecured claims into the bad bank while providing significant equity into the good bank to the unsecured creditors that would have losses on their bad bank claims. This solution combines separating good and bad assets and converting unsecured claims into equity and it minimizes the fiscal costs of a distressed bank resolution.
A third option would be to induce unsecured creditors – under the threat of a receivership that becomes credible once a special insolvency regime for too-big-to –fail banks is implemented - to convert their claims into equity. Then, the bad assets of the bank can be taken off the balance sheet of the bank via the PPIP program or a number of other alternative ways to separate good and toxic assets.
Each one of these three proposed solutions implies that unsecured creditors of banks take some losses and convert their claims into equity. Instead, the paradoxical result of the current US approach is that – in order to avoid a temporary nationalization of insolvent banks and in order to prevent unsecured creditors of banks from taking any losses – the result is a creeping and increasing partial nationalization of the financial system: the government will have to inject more preferred shares into troubled banks and convert more of its preferred shares into common equity. So, even without a temporary government takeover of the insolvent banks, we will end up with a longer-term partial government ownership of many large banks. To avoid this creeping partial nationalization inducing the banks creditors to convert their claims into equity would be a more sensible solution that minimizes the fiscal costs of the crisis, reduces the moral hazard of government bailouts and keeps more of the banking system into private hands.
The logic of the current muddle through approach is clear (leaving aside the fact that Wall Street is still partially capturing the US regulators and policy makers): providing unlimited liquidity and deposit guarantees to avoid bank runs and refinancing risks; subsidize banks and their rebuild of capital via near zero funding rates, a steep intermediation curve and rising net interest rate margins; hope that the economy recovers faster than otherwise expected (as the green shoots are rising) so that eventual bank losses are lower; hope that forbearance and time will heal most wounds by reducing the eventual level of charge-offs and writedowns and letting bank rebuilt capital via earnings before provisions; ignore moral hazard distortions in the short run while the banking crisis is still simmering and try to reduce such distortions in the medium term with a new and better regime of supervision and regulation of financial institutions; avoid takeovers of large institutions that would be disorderly in the absence of a special insolvency regime for such large banks; avoid the risk that, even in the presence of such special insolvency regime, unintended consequences of a takeover of a large bank lead to Lehman-like consequences; hope that fiscal costs of massive subsidies and bailouts of banks are contained if a virtuous cycle of economic recovery and restoration of confidence in the financial system rapidly emerges; subsidize restoration of securitization (with the TALF) and subsidize the separation of toxic assets from the banks’ balance sheet via government leverage and non-recourse loans (PPIP); avoid a more severe credit crunch via sensible supervisory and regulatory forbearance (mark-to-market suspension of FASB rules; closing regulators’ eyes on the true value of loans and assets; avoid forcing banks to recapitalize too fast and let capital adequacy ratios to slip in the short run; etc.); deal with the too-big-to-fail problem only if/when the crisis is over with higher capital charges once banks can better afford them ; eventually reform the system of regulation and supervision of the financial system.
However, the current muddle through approach of colossal regulatory forbearance and bailout of the financial system has some serious risks and shortcomings (see my two recent op-eds with Matt Richardson in the WSJ and the FT for an elaboration): it significantly increases the fiscal costs to the taxpayer of bailing out financial institutions (their shareholders and creditors); it creates the mother of all moral hazard distortions as literally trillions of dollars of financial resources have been used to backstop the financial system and bailout reckless bankers and traders and investors; it ends up with a persistent and possibly long-term government control and partial ownership of parts of the financial system; it does not resolve the too-big-to-fail problem as big banks are not broken up or given incentives to break themselves up; it risks to keep alive zombie banks leading to a more persistent credit crunch, economic stagnation, deflation and debt deflation; it leads to problems of medium term fiscal sustainability as the large fiscal cost of the bailout of the financial system creates serious public debt dynamics problems over time; it creates a serious exit strategy problem for monetary policy as the tripling of the monetary base and the central bank purchase of toxic and illiquid assets risks to eventually lead to price inflation or to another asset and credit bubble unless the massive creation of liquidity is mopped up as soon as the real economy recovers; and it may end up with a cosmetic reform of the regime of regulation and supervision of the financial system as soon as the financial crisis looks like beginning to bottoming out.
Indeed many Wall Street voices are starting to argue that the crisis is over, that bull times are back, that they don’t need further government support (while still being on the government dole in twenty different Fed/FDIC/Treasury bailout/subsidy programs/funds), that they can repay TARP money (using the $350 bn of funds that they borrowed at near 0% interest rates with a FDIC full guarantee of interest and principal), that the government should not over-regulate the financial system, that controls on bankers compensation are misguided, that no fundamental change of the financial system and of its regulation is needed. This is the self-serving chatter that we are starting to hear from the same reckless lenders, bankers and investors whose greed and wildly distorted bonus/compensation schemes – together with regulators that were asleep at the wheel and believing in self-regulation that means no regulation – caused the worst economic recession and financial crisis since the Great Depression. This is the new spin of those whose fake (as not being risk-adjusted) gains/profits/bonuses were privatized in the bubble times when fake wealth and bubble profits were created and whose trillions of dollars of losses have now been fully socialized and paid for by the taxpayer. Their arrogance is only second to their shameless Chutzpah.
One can only hope that policy makers will resist these siren calls can and design a reform of the regime of regulation and supervision of financial institutions (more capital, less leverage, more liquidity, incentive compatible compensation with a bonus/malus system, higher capital charges to deal with – and possibly break-up – too-big-to-fail financial institutions, global regulatory standards that prevent jurisdictional arbitrage, etc.) that reduce the risk that a financial crisis of this proportion will happen again.
Brilliant Prose From David Rosenberg
By Tyler Durden
May 07, 2009
It is never a wholesome day at Zero Hedge absent some brilliant prose from David Rosenberg. So let's make it a wholesome day.
Market likely to peak the end of the week
Just as the clock is winding down on my tenure at Merrill Lynch, the equity market is winding up with an impressive near-40% rally in just nine weeks. For those that were still long the equity market back at the March 9 lows, a good ‘devil's advocate' exercise would be to ask yourself the question whether you would have taken the opportunity, if the offer had been presented, to have sold out your position with a 40% premium at the time. What do you think you would have said back then, as fears of financial Armageddon were setting in? We haven't conducted a poll, but we are sure at least 90% of the longs at that point would have screamed "hit the bid!"
Are we at risk of missing the turn?
Fast forward to today, and within two months optimism seems to have yet again replaced fear. Are we at risk of missing the turn? What if this is the real deal - a new bull market? This is the question that economists, strategists and market analysts must answer.
Risk is much higher now than it was 18 weeks ago
The nine-week S&P 500 surge from 666 at the March lows to 920 as of yesterday has all but retraced the prior nine-week decline from the 2009 peak of 945 on January 6 to the lows on March 9. We believe it is appropriate to put the last nine weeks in the perspective of the previous nine weeks. To the casual observer, it really looks like nothing at all has happened this year, with the market relatively unchanged. But something very big has happened because the risk in the market, in our view, is much higher than it was the last time we were close to current market prices back in early January, for the simple reason that we believe professional investors have covered their shorts, lifted their hedges and lowered their cash positions in favor of being long the market.
Employment, output, income, sales still in a downtrend
Considering what transpired from an economic standpoint, the decline in the first nine weeks of the year was rather appropriate in the midst of the worst threequarter performance the economy has turned in roughly 70 years. The rally of the past nine weeks appears to be rooted in green shoots. While it may be the case that the pace of economic decline is no longer as negative as it was at the peak of the post-Lehman credit contraction, the reality is that employment, output, organic personal income and retail sales are still in a fundamental downtrend.
Need to see an improvement in the first derivative
We have evidence that the consumer, after a first-quarter up-tick that was frontloaded into January, is relapsing in the current quarter despite the tax relief (didn't we see this movie last year?). Not until improvement in the second derivative morphs into improvement in the first derivative with respect to the important economic data will it really be safe to declare what we are seeing as something more than a bear market rally, as impressive as it has been.
This is a bear market rally that may have run its course
The investing public is still holding tightly to their long-term resolve, but much of the buying power at the institutional level seems to have largely run its course, in our view. That leaves us with the opinion, as tenuous as it seems in the face of this market melt-up, that this is indeed a bear market rally and one that may well have run its course. We have "round-tripped" from the beginning of the year and there is real excitement in the air about how these last nine weeks represent evidence that the economy will begin expanding sometime in the second half of
the year.
Growth pickup will likely prove transitory
While it is likely that headline GDP will improve as inventory withdrawal subsides and fiscal policy stimulus kicks in, our view is that whatever growth pickup we will see will prove to be as transitory as it was in 2002, when under similar conditions the market ultimately succumbed to a very disappointing limping post-recession recovery. So yes, there may well be some improvement in the GDP data, but it is based largely on transitory factors. We strongly believe it is premature to totally rule out the end of the vicious cycle of real estate deflation - residential and now commercial - that we have been experiencing since 2007. Balance sheet compression in the household sector will continue to pressure the personal savings rate higher at the expense of discretionary consumer spending. This is a secular development, meaning that we expect it will last several more years.
Chances of a re-test of the March lows are non-trivial
To reiterate, it seems to us likely that the risk in the market is actually higher today than it was back at the same price points in early January, and we say that with all deference to the stress tests (which given the less-than-dire economic scenarios, along with the changes to mark-to-market accounting, were destined to reveal healthy results). While the consensus seems gripped with the burden of trying to decide if there is too much risk to be out of the market, we actually still believe that the chances of a re-test of the March lows are non-trivial, especially if the widely touted second-half economic rebound fails to materialize.
Market may have a fully invested condition of ‘smart money'
While many pundits point to ‘dry powder' on the sidelines that is ready to be put to work, our sense is that we now have to consider the prospect that we actually have a fully invested condition of ‘smart money' in the market. If there is a risk that is not being widely discussed, it is the risk that profit-taking by the big-money investors (many who share our outlook but have been quick to take advantage of this monumental bounce in equity prices), will not be met with enough demand from the fundamental bulls. And if we ever do see the capitulation from the retail investor - this has yet to occur - then this flow-of-funds scenario can certainly trigger a re-test of the lows.
We are happy to buy these sell-offs in Treasuries
When you look at Charts 1-3, you really have to wonder whether or not the markets have been too hasty in pricing out deflation risks. There has never been a time in the post-WWII era where the 12-month trends in wages, producer costs and consumer prices were all in negative territory at the same time. This is the new reality. As the markets focus on the noise from green shoots, we are focusing our attention on the fundamental trends and the end-game. We are more than happy to buy these sell-offs in Treasuries and add scarce safe income to the portfolio. Take profits in equities and scale into Treasuries This move to 3.20% on the 10-year note resembles that inexplicable move to 5.35% back in the summer of 2007, in our view. Yes, yields are much lower today, but the inflation rate is 300 basis points lower too and the unemployment rate is 400 basis points higher. If we recall back in that summer of 2007, the equity market was hitting new highs just as bond yields were. The trade then was to take profits in the former and scale into the latter. After a near-40% surge in the S&P 500 and a near-60% surge in bond yields off their recent lows, it would seem logical to us to embark on a similar shift this time around.
Bond yields do not bottom until well into the next cycle
Even if the recession is to end soon, and that is still very debatable, bond yields do not typically bottom until we are well into the next cycle, as inflation continues to decline even after the downturn ends. So just like further upside potential in equity prices seems extremely unlikely over the near and intermediate term, further downside risk Treasury note and bond prices is also less of a risk today, in our view.
We would like to see a retest of the March 9 low
To emphasize, it could well be that we saw the market lows back on March 9. But we would like to see a successful retest before making that conclusion. The inevitable test will be the thing. But do not confuse green shoots for a sustainable recovery. After a credit collapse and asset deflation of the magnitude we just witnessed, the markets, housing prices and equities can be expected to take years to fully recover.
The data flow is less relevant this cycle than in the past
This was not a manufacturing inventory cycle, which makes the data flow less relevant than in the past. Real estate values are still deflating and the unemployment rate is still climbing; these are critical variables in determining the willingness of lenders to extend credit. And as we just saw in the Fed's Senior Loan Officer Survey, while there may be a ‘thaw' in the financial markets, banks are still maintaining tight guidelines. In fact, the weekly Fed data are now flagging the most intense declines in bank lending to households and businesses ever recorded. The best case is that this is a bear market rally All of this has not precluded an elastic band bounce from an egregiously oversold low in the S&P 500, and perhaps we will even test the 200-day moving average of 960 (as the 10-year note yield and NASDAQ just did). But we still do not believe what we are seeing fits the hallmark of a new bull market. In our view, the best case is that this is a bear market rally, but one that clearly has more legs than its predecessors this cycle.
Providing clients with a historical perspective
At this time, we believe it is necessary to provide clients with some historical perspective from the last colossal credit collapse in the 1930s, understanding that there were similarities as well as differences. It was extremely difficult for equity investors to make money in the decade following the June 1932 bottom. After the three-month rally (+75%) off the bottom in 1932, equity markets were extremely volatile and largely sideways for the next nine years. Keep in mind that the jury is still out as to whether the March 2009 lows were in fact the bottom, as was the case in 1932.
If March 9 was the low, what does it mean for the outlook?
It doesn't say much, actually. The same goes for corporate spreads. The S&P 500 bottomed in mid-1932 and soared nearly 75% in the next three months. Anyone who bought at that point and hung on to their position saw no capital appreciation for nine years. Baa spreads also hit their widest levels at 724 basis points in mid-1932, a year later they were down to 380 basis points. While the initial the surge in the stock market and the tightening in corporate spreads from stratospheric levels presaged the bottom in GDP in the third quarter of 1932, the reality is that the Great Depression did not end until 1941 (and the next secular bull market did not commence until 1954). The prior peak in GDP was not reattained until the end of the 1930s, fully seven years after the introduction of the New Deal stimulus. By then the unemployment rate was still at 15%, consumer prices were deflating at a 2% annual rate and government bond yields were on their way to sub-2% levels.
Our preference is to stick with fixed-income securities
Be careful about jumping into the stock market with both feet after this monumental rally. Consider whether or not it would be more appropriate to take advantage of the run-up to reduce equity exposure. Our preference is to stick with fixed-income securities, which we believe will work much better from a total return standpoint, as they did for years after the economy hit bottom back in the early 1930s. When we are finally coming out of this epic credit collapse and asset deflation, we should expect that the trauma exerted on household balance sheets will have triggered a long wave of attitudinal shifts toward consumer discretionary spending, homeownership and credit. The markets have a long way to go in terms of discounting that prospect.
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