The last month has seen a rash of activity in the US brokers and large banks, in particular, we have the departing of Stan O'Neal and Chuck Prince from Merrill and Citi respectively. This got me thinking, are there going to be more financial repercussions from the credit crunch, or have we seen the worst already?
There are two main issues with US credit markets at the moment and the two issues are inter-related. First, many mortgage lending standards were lowered in a rush to generate business. People who should not have qualified for loans were ushered into subprime mortgages, because the investment banks needed the mortgages to feed into their securitization machines. The second issue is that investors became complacent with risk and invested too heavily in the structured securities (CDOs mainly), that were built upon the shaky mortgages mentioned earlier. The great demand for yield produced products that generated yield, CDOs. What investors should have realized was that yield cannot be generated out of thin air; in fact, a AAA rated CDO tranche is definitely not the same as a AAA rated corporate bond. Unfortunately, complaceny is a human nature.
In my opinion, we have yet to see the end of the credit crunch, because the big investors have yet to mark down their holdings of CDOs. Although the big banks may have taken big baths lately (Merrill - $8.4B, Citi - $11B, MS - $3.7B), we still have a ton of CDO paper sitting on the books of investors such as pension funds and hedge funds. For one thing, these investors are not as heavily regulated as the banks, and are not required to report as frequently/succintly. For another, these investors may not be as sophisticated. Imagine, if the guys selling this stuff can lose tens of billions, what is going to happen to the guys buying this stuff?
Another indication that the credit crunch is not yet over is the reluctance of the street to actually write down these investments. We have Citigroup trying to organize the M-LEC to rescue the $80B they hold in off balance sheet SIV (Special Investment Vehicles - leveraged funds that invested heavily in CDOs). The organizers of M-LEC (Citi, BOA, Wachovia, etc) want the fund to buy assets from the locked up SIVs at 'market' prices, because they do not want to prevent a firesale. The irony is that M-LEC will only buy the highest rated securities, leaving the SIVs holding the most illiquid paper. What a great way to prevent a firesale.
This is like a game of 'don't show, don't tell'. If they don't have to sell the assets to the street, then they won't have to mark them down to their market values. This is great as long as everyone plays along. What happens at the end, when the SIVs all sell their best assets to M-LEC? Who wants to be the one holding the bag?
Apparently, State Street doesn't. This past week, in the game of 'chicken', State Street blinked first and started unwinding one of their CDOs. What is most telling is that the formerly AAA tranches were immediately downgraded by S&P to BB and CCC-. To put that in perspective, AAA is the best rating one could give. CCC- is a company currently vulnerable and dependent on favorable economic conditions to meet its commitments. How can something go from AAA to CCC overnight? Your guess is as good as mine.
In conclusion, I do not believe the credit crunch is over yet, in fact, I would be very hesitant jump into any of the financials at the moment. Much better to preserve capital and look for entry points when everything has cleared away.
-Jason
Saturday, November 10, 2007
Friday, September 28, 2007
And I quote...
From the most recent speech of Fed governor Mishkin...
"Our understanding of the sources of systemic risk immediately suggests three general principles for operating as an effective lender of last resort: (1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently."
Perhaps I am being overly critical of the role of central banks, but I would like to point out that The Federal Reserve and other central bankers around the globe have not been following their own standards.
1) While they have injected billions in liquidity, it remains to be seen whether confidence has been restored. The $40 billion Canadian ABCP market is still locked up. UK banks without credit exposure to US Subprime are failing and depositors are running for the exit. The largest deposit banks in the US (Citi, BoA, Wachovia, etc) have borrowed $500 million apiece to funnel to their investment banking arms. What confidence?
2) The last several Fed cuts in the interest rate have fueled asset bubbles rather than encourage adequate prudential supervision. In fact, it can be argued that had Greenspan not cut interest rates to 1% and held it there for too long, we would not be currently mired in a housing asset bubble of epic proportions.
3) Infrequent - If we take the word at its literal translation, it would mean that the lender of last resort should not make 'frequent' forays into the credit markets. In the past several weeks, central bankers have injected billions - billion with nine trailing zeros - into the credit markets. And every week, they have to lend more. Just this week, the US Federal Reserve has lowered the collateral standards to include mortgage securities.
So what does this all mean?
In my opinion, either the central bankers are stupid, or they are trying desperately to prop up the markets in hopes that the gummed up markets will loosen themselves in time. I prefer to believe the latter.
If the credit markets are still locked up, then we can reasonably expect the next several months to be extremely volatile. Either the other shoe falls, or things calm down enough for normal lending to occur. In either scenario, it will be an interesting period indeed.
-Jason
"Our understanding of the sources of systemic risk immediately suggests three general principles for operating as an effective lender of last resort: (1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently."
Perhaps I am being overly critical of the role of central banks, but I would like to point out that The Federal Reserve and other central bankers around the globe have not been following their own standards.
1) While they have injected billions in liquidity, it remains to be seen whether confidence has been restored. The $40 billion Canadian ABCP market is still locked up. UK banks without credit exposure to US Subprime are failing and depositors are running for the exit. The largest deposit banks in the US (Citi, BoA, Wachovia, etc) have borrowed $500 million apiece to funnel to their investment banking arms. What confidence?
2) The last several Fed cuts in the interest rate have fueled asset bubbles rather than encourage adequate prudential supervision. In fact, it can be argued that had Greenspan not cut interest rates to 1% and held it there for too long, we would not be currently mired in a housing asset bubble of epic proportions.
3) Infrequent - If we take the word at its literal translation, it would mean that the lender of last resort should not make 'frequent' forays into the credit markets. In the past several weeks, central bankers have injected billions - billion with nine trailing zeros - into the credit markets. And every week, they have to lend more. Just this week, the US Federal Reserve has lowered the collateral standards to include mortgage securities.
So what does this all mean?
In my opinion, either the central bankers are stupid, or they are trying desperately to prop up the markets in hopes that the gummed up markets will loosen themselves in time. I prefer to believe the latter.
If the credit markets are still locked up, then we can reasonably expect the next several months to be extremely volatile. Either the other shoe falls, or things calm down enough for normal lending to occur. In either scenario, it will be an interesting period indeed.
-Jason
Monday, September 17, 2007
The Fed's No-Win situation
It seems to me, no matter what the Fed decides to do tomorrow (lower short term rates by 0/25/50 bps), the stock market is bound to go lower.
Let say the Fed does nothing or only lowers the rate by 25 bps. Market participants will hammer the stockmarkets worldwide in response to what they view as an inadequate action by the Fed to rescue a clearly ailing US economy. The 'Greenspan put' (the idea that the Fed will come to the rescue of the economy at any time) will be laid to rest at last and the markets could be looking at a prolonged decline until the next catalyst appears.
If on the other hand, the Fed lowers the rate by 50 bps or more, markets will rally in the short term. But this will only be temporary. If the data driven Bernanke Fed decides to make such a drastic reduction in the overnight rate, then things must look bad indeed. If we go back to economics and the business cycle, when interest rates start declining, it is an indication of a top or a recession. Stocks do not go up until the later stages of a recession, and we are far from that point.
Remember, with crude trading near $80, inflationary pressures are still present. Also, the majority of ARMs do not reset until early 2008. There will be more pain before things look better.
-Jason
Let say the Fed does nothing or only lowers the rate by 25 bps. Market participants will hammer the stockmarkets worldwide in response to what they view as an inadequate action by the Fed to rescue a clearly ailing US economy. The 'Greenspan put' (the idea that the Fed will come to the rescue of the economy at any time) will be laid to rest at last and the markets could be looking at a prolonged decline until the next catalyst appears.
If on the other hand, the Fed lowers the rate by 50 bps or more, markets will rally in the short term. But this will only be temporary. If the data driven Bernanke Fed decides to make such a drastic reduction in the overnight rate, then things must look bad indeed. If we go back to economics and the business cycle, when interest rates start declining, it is an indication of a top or a recession. Stocks do not go up until the later stages of a recession, and we are far from that point.
Remember, with crude trading near $80, inflationary pressures are still present. Also, the majority of ARMs do not reset until early 2008. There will be more pain before things look better.
-Jason
Thursday, September 13, 2007
Disclaimer
This blog is a personal blog for me, Jason Chen, to share my views on the world markets with my friends, family, and anyone else who wish to subscribe. The big disclaimer is that I am not - in any shape or form - suggesting anyone follow my investment strategies. If anyone does try to emulate my investment strategies, they do so entirely at their own risk.
- J
- J
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