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Sunday, September 21, 2008

Financial Hodgepodge

First off, let me apologize for being MIA for a while, with all the tumult suffusing through the global markets my job has kept me quite busy. That being said let us take a moment to internally reflect on what has just happened. Ok, now lets focus on what can be done to better position us going forward.

Financial intervention to date has come in ad hoc form, first with new Fed lending facilities, then actions to facilitate the takeover of Bear Stearns, the GSE intervention, and finally last week’s decisions regarding AIG and Lehman Brothers. Without a standardized structure, the level of federal assistance, as well as the potential compensation for bearing risk, is unpredictable appears left to last-minute decision making even when it might not be. This has two consequences. First, these efforts are bound to lead to greater risk aversion among market participants. To a certain point this can be positive in reducing moral hazard, but taken to excess it can be destabilizing. This has become an increased concern over the last week—perceptions of counterparty risk have reached extreme levels and the ability of firms to attract new capital has been limited even further by concerns over potential intervention with punitive terms. Second, the lack of an agreed-upon policy makes any single intervention more difficult politically, which could constrain the Fed and Treasury in future decisions. Thus, policy may have reached a stage where a more standardized set of rules may be announced, if not legislated (hence the recent talk of RTC-esque vehicles). The need to establish the RTC is to establish a hard floor which should in essence stabilize the system (note it will stabilize it and provide a brief rally, financials will not go back to the way they were, we will still be in an extremely tight credit environment).
However, several important differences suggest that an RTC-style entity, while appropriate, is likely to be a piece of a larger solution. First, the federal government was already responsible for the costs of the S&L crisis, since it insured most S&L deposits. In contrast, the government bears little direct financial responsibility for many holders of mortgage assets in the current situation (the GSEs are the obvious exception). Without clear federal financial responsibility, the decision to establish a new agency—presumably at taxpayer risk—is more difficult. Second, the RTC was charged with consolidating assets from several hundred small banks. In the current situation, there are fewer lenders with significant assets, and they are larger. Third, in the present case, the vast majority of lenders are still going concerns rather than failed institutions which have been taken over by the government.

The RTC isn’t the only options there are at least two other viable options: Home Owner’s Loan Corporation (HLOC) or a Reconstruction Finance Corp (RFC).
The HOLC was established in 1933, under the Federal Home Loan Bank Board, to purchase and refinance mortgages. The HOLC acquired loans for two years and was wound down 18 years later. HOLC has several similarities to the refinancing program the Federal Housing Administration (FHA) is currently implementing. These programs were meant to support borrowers who could not refinance their mortgages, many of which at the time consisted of 5-year balloon loans. However, the HOLC exchanged a government-backed bond bearing 4% tax-exempt interest (less than prevailing mortgage rates) in return for mortgages, so that banks received an interest-bearing asset to replace the mortgage, albeit at a discount to the original value of the loan. By contrast, the current FHA program simply provides an outlet for borrowers to refinance into a government guaranteed loan once the previous loan has been voluntarily extinguished, also at a discount to the original value of the loan. While the risk borne by the government may be similar, the ability to purchase the loans would avoid some obstacles posed by loan-by-loan refinancing, though securitization is still likely to pose challenges.

The RFC was established in 1932 and by 1934 had purchased preferred stock from over four thousand banks. Unlike most preferred shareholders, the RFC also gained voting rights. The idea of an RFC-like approach would be to increase the level of capital in the banking sector and thereby expand the sector’s lending capacity. While most of the public discussion of remedies to the current situation has centered on how the government might purchase assets, the provision of capital to lenders may be just as important. To the extent that a program to purchase mortgage related assets is established, the sale of these assets is likely to crystallize losses and reduce regulatory capital. Some institutions would be able to absorb these losses, but others would either fall below regulatory minimums unless they are able to raise additional capital. Either way, the amount of credit these institutions would be able to extend would be diminished, with adverse consequences for growth. Providing capital would offset the significant slowing in lending now underway. From the standpoint of total credit available in the economy, providing capital that could be leveraged by ten times or so would allow the government to lend significantly more—through banks—than simply borrowing in the Treasury market and purchasing the assets directly.

Each of these three solutions presents an interesting alternative. The key in my mind is the process and structure the government uses to acquire these so-called assets. The most logical method would be to implement a reverse auction whereby the government could present a maximum bid (which should be something really low like $0.65 on the dollar) on a given type of asset, and accept bids starting with the lowest first until the predetermined capacity of the program is reached or the cap on bids is hit. I am a big believer that something needs to be done, something analogous to cutting off the leg to save the man type of thing.

Even though the pain in financials has been severe we must remember that financials are only a part of the bigger picture. The economic and market landscape has changed in some very important ways in the last few months. Much clearer signs of slowing in the non-US economies (particularly in the developed world) have turned what still looked at the start of the year like an environment where US weakness was dominant, to one with much more of the flavor of a global slowdown. The market has responded in two ways. First, it has downgraded non-US growth views relative to the US, pushing rates in many of the majors down relative to the US, fuelling a dollar rally and punishing equities with greater non-US exposure. Second, it has also for the first time traded across assets in ways traditionally consistent with a broad global slowdown, with commodities falling, equities underperforming bonds, cyclical stocks being hit hard, inflation breakevens dropping sharply, growth sensitive currencies being hit, and bonds doing well. My view has long been that what determines the resilience of non-US economies in US slowdowns has much less to do with the direct transmission of US weakness to the rest of the world and more to whether the underlying shocks that are driving weakness are local to the US or global in nature. And it is on that front that things have really changed.

In the early stages of the US housing market adjustment, the shocks hitting the global economy seemed primarily US-based – emanating from the collapse of the US housing bubble. The drag from this source has weighed on the non-US economy (the improving trade balance is a partial measure of how much the US has exported its slowdown to its trading partners). But much of the new pressure outside the rest of the world reflects the fact that over the last 12-18 months, a broader set of shocks has appeared.

In terms of housing vulnerability, the US, New Zealand, the UK and South Africa are already seeing real house price declines. Furthermore, within the Eurozone, Spain and Ireland have also seen house price depreciation. Although the price dynamics are less clear, China’s property market has also started to come under pressure after a long bull run. Parts of Eastern Europe in particular the Baltics, are showing sharp turns after having built up sizable imbalances. Much of continental Europe, Japan and many other Asian economies look less exposed.
On the terms-of-trade front, the split between commodity producers and consumers is clear. While the data does not fully account for the recent reversals in commodity prices, that conclusion over the last 12-18months is likely to hold even now. The biggest losers are most of North Asia (including China) and India, Turkey and the US. The biggest winners are Russia, Brazil, Malaysia, South Africa and the developed market commodity producers. These shifts have been dramatic in places, with a 43.6% rise in Russia’s terms of trade, and a sharp 24.1% decline in South Korea’s.

Looking at all these factors together, downside growth risk remains the most pronounced in the US, Japan and New Zealand. China and other NJA economies also face significant headwinds from a slowing global industrial cycle and negative terms-of-trade shocks, but there are important offsets from still generally healthy credit availability. For China and the Asian region as a whole, the underlying trend in Chinese domestic demand will be key, as external influences have flipped negative. On the other hand, the growth prospects look relatively better in several EM countries, including Brazil, Russia, Malaysia. Similarly, Canada, Norway and Australia may also have potential to outperform other G10 countries. The positive dynamics set off by earlier commodity rises are likely to remain supportive for growth in these markets for some time to come, even with the commodity pullback, as prices will still be generally higher than a year ago. With respect to asset prices more specifically, it is clearly important to differentiate between different asset classes. The relative growth outperformance of EM countries is likely to be most clearly reflected in FX space, where strong cyclical growth has been consistently rewarded. Local equity markets, on the other hand, and in particular those with commodity exposures, will be more influenced by spot commodity dynamics and global growth risk. This dynamic could well dominate local macro fundamentals, especially as long as we remain in a global deleveraging processing.

On the commodity front, The oil market is oversold, providing a compelling entry point, though near-term upside is now reduced Just as the market significantly overshot to the upside in the second quarter, it appears that the market has overshot to the downside and is now substantially oversold, as a combination of financial concerns, skepticism, and real and perceived demand weakness has pushed prices below the long-term economics of the industry.

The supply side of the market still remains severely constrained. As evidenced this past July at $140/bbl, oil producers raced to squeeze as much supply out of the system as possible, yet created only a very modest inventory cushion despite a substantially weaker demand environment. It is this lack of a significant inventory build in July followed by draws in August and a likely draw in September that is one of the key drivers behind a potential fourth quarter rebound in oil prices, as it leaves the market vulnerable to any type of shock. One of the more anomalous aspects of the recent market has been the deep level of contango that has persisted in the face of stock draws. The only dynamic that can explain this pricing anomaly is de-stocking, both physical (the stock of real barrels) and financial (the "stock" of paper barrels), which is just another aspect of the industry-wide de-leveraging that is taking place. The initial impact of physical and financial de-stocking is negative to prices as (1) physical players run down oil stocks to reduce working capital, they reduce their demand for physical prompt crude which creates a prompt contango in the forward curve, and (2) financial players sell out of paper positions to reduce credit exposure and/or cover losses. However, the medium- to longer-term impact of de-stocking to both price and volatility is explosive as it reduces the physical cushion and market liquidity to deal with any future supply or demand shock.

The argument against this vulnerability to a shock is that demand is weak and that any shocks are likely to only have a very small impact. The We weakness in demand has resulted from two transient drivers: (1) current Chinese de-stocking that resulted from forward buying in June and July ahead of both a shift in tax regime and the Olympics, which helped to create the surge in prices earlier this year (significantly overshooting even the bullish forecasts) and then the subsequent collapse to current levels, and also (2) the sharp decline in US crude oil runs due to the two back-to-back hurricane strikes on US Gulf Coast refineries. These two events, combined with financial concerns, largely explain the two-stage pullback in oil prices in the recent period. Using the diesel refinery margin as a proxy for Chinese demand for diesel, as most of the pre-August buying was in low sulfur diesel, the collapse in the diesel margin dragged oil prices from $145/bbl to $115/bbl, which was followed by a short period of consolidation. The hurricanes then struck, which knocked out a massive amount of US refinery demand, creating the second leg down from $115/bbl to $100/bbl and below that was exacerbated by the overlay of heightened financial concerns. This second leg down, however, widened refinery margins, which sets the stage for a rebound in prices once the shuttered refineries restart. While both of these events substantially reduce the current demand for crude oil, they do little to reduce end-use demand for refined products which remain much more stable. The recent sharp rise in prompt refinery margins around the world provides further evidence that end use demand remains stronger than refinery level demand.

On top of these transient negative demand factors, the market is trading with a very high level of skepticism, which has made the market moribund to nearly every bullish headline that has surfaced since early August – loss of Azeri crude oil (10 mmb), problems with Angolan platforms (15 mmb) and more recently real and substantial hurricane supply losses (a net loss of 56 mmb) and a dangerous escalation of civil unrest in Nigeria. Eventually, this string of events will be felt as demand rebounds in the fourth quarter against a small inventory cushion and very little spare production capacity; however, given the current trading bias, it will likely take a real physical catalyst that generates real physical demand to turn the market.

We are now nearly nine years into this current bull market in oil and have nearly no new supplies to show. This stands in sharp contrast to the 9th year of the bull market of the 1970s when Alaska, Mexico and the North Sea were all new projects in the ramp up phase with great prospects in front of them (see below). Today, try and name three new projects in the pipeline that have that same type of potential over the next five years (hint, it can’t be done). Without supply growth and continued economic expansion, demand will need to experience more and deeper adjustments that will only come through higher or more volatile prices in the future.

So what does this all mean for oil prices? I have not done enough research to predict with any level of confidence where prices will go, but I don’t think it will be down (or at least not much further). I know Goldman Sachs is predicted prices $125 by year end. While this could be possible it just says to me given the recent pullback in E&P players, it might be time to start acquiring (I know I have said this before, as prices have fallen further the argument has just gotten stronger). If any readers have any argument against investing in E&P players at these prices please let me know.

Not to cut this post short but I am tired of writing so I will quickly state some viewpoints:

Market will continue to be very volatile and will likely drop as crummy Q3 earnings are reported in October and November. There will be a pull back in select banking players as some have run up a little too much (i.e. WFC and maybe ZION). I would look to put money in wide-moat companies as the consumer will be dominating the news over the next few months. Pay particular attention to spending data, if the consumer pulls back we are headed for very-very tough times.

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