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Sunday, 30 March 2008

The Weekly Report - 30th March 2008

The Weekly Report

30th March 2008

Welcome to the Weekly Report. Click on the link for my update on Moral Hazard written for Livecharts earlier this week. Stress continues to increase across all markets, a fact that should make all investors stop and think about the root cause.

First up, we dig into the Flow of Funds Accounts of the United States for Q4 '07. Specifically I want to look at the growth of Domestic Non-Financial Debt:

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Remember this is a growth chart, the amounts are still rising. Without using a chart, you can see a bell curve in household debt, State and Local Govt debt and Federal Debt. Inverse to this is Business debt. There are some disturbing patterns here that bode ill for the future.

The growth in household debt is slowing rapidly, almost halving since Q1 '06 to Q4 '07. I somehow doubt Q1 '08 will show an improvement. It is clear that for consumers the debt crisis did not begin in the summer of '07 but in Q3 '06. Anyone who tries to label the MBS credit crunch as a Minsky event, an unforeseen happening that surprised the Markets, didn't look deep enough. This disinflation in the growth of consumer debt is different than the expansion we saw during the last recession. There is no support coming for the economy from a continued and increasing expansion of consumer debt. This is a consumer led recession that has ramifications for the whole system of funding used by local and national government. Without an increasing flow of taxes raised through spending, Municipal, State and National funding will be increasingly reliant on raising debt through bond issuance.

Indeed the process had already started, as can be seen by the rise in Local/State and Federal Debt to cover the shortfall in funding. As we all know the Municipal Bond (MB) Market looks like the Somme in 1916, cratered and deadly to all participants.

The figures for Q3 and 4 '07 show the sudden difficulty in raising debt experienced and the acceleration of the problem. This makes sense if viewed from MB buyer's point of view. If the MBs are issued using future tax/income flows as the underlying asset it is no wonder that, after a quick glance at slowing consumer debt, the underlying asset is no longer seen as such a secure basis for borrowing. It is exactly the same calculation used when buyers deserted the lower (and now top) rated MBS tranches, a lack of confidence in the underlying asset to perform at its historical level of return.

Business lending looks solid at first glance but if we take a longer term view, a pattern becomes evident:

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Notice the pattern? Business debt grows until hard times arrive. It is likely that falling rates (yields) become attractive and business debt is increased or rolled over on better terms. As I have shown before it is this short-sighted view that often becomes the undoing of Business. Whilst falling yields are attractive to borrowers they are the precursor of a contraction in economic performance. The Fed allows rates to drop for a reason; it is to attempt to stimulate economic growth. That stimulation is required as conditions weaken:

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We can see this in practise above, as conditions shown by the ISM readings for manufacturing (red) and non-manufacturing (black) business are interest rate sensitive (effective Fed Fund Rates- blue). Rates climbing above 5% are not conducive to a healthy business environment. Even periods of stable rates above 5% do little to help business; it demonstrates that business planning is not aided by "stability" but by low, accommodating rates. As we can see, the Fed did not pursue a new paradigm this time around. Business conditions had to show marked deterioration before the Fed cut.

Here is the conundrum for the Fed. Previous accommodating drops in rates helped to re-invigorate business after deterioration, helping employment, expansion of credit and consumerism. This time the Fed faces a problem not seen since the depression (except in Japan 1990 - present).

Lowering rates is ineffective if Banks do not lend. It is clear that Banks either are not willing or are unable to extend credit facilities to all sectors of the economy, including to each other. The Fed has attempted to address this with a series of new measures, designed to alleviate the pressures on Bank capital reserves. Banks are grateful for this but will not take new positions in credit markets. The Fed support is being used to repair and rebuild bank balance sheets by deleveraging, using cheap Fed assets and funds to roll their own positions, whilst keeping income streams high on current lending. If the Banks decide its time to clear the decks of liabilities, this process could take much longer than most expect.

Without access to lower commercial rates, businesses could find themselves unable to use credit to roll over existing debt or to use new credit for "expansion". This would be comparable to the conditions seen in Japan in the last 2 decades.

How tight are current Bank credit conditions? Put it this way, if the Fed has to enact '30s legislation to save a broker and then set up a discount window for other Primary Brokers it is clear that Banks are unwilling to help out.

Here we see the massive drop in borrowing, except for two sectors:

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Apologies if it is a bit small, here is the link to the Fed Fed Z. 1. Credit market borrowing in the Financial Sector is down from $2339.1Bn in Q3 to $1300.5Bn in Q4 '07. That's some disinflationary rate, 55.5% quarter on quarter! No wonder Banks and Primary Brokers were happy to take "liquidity injections" from SWF's and Middle/ Far East investors.

The only expansions of note were in Agency and GSE backed mortgage pool securities and Funding Corporations.

Conditions will not improve until Banks allow credit to expand. Clearly from the data above that hasn't happened into the end of '07. With the continuing use of the Fed and its expanding list of lending programmes, the "Bank of Last Resort" demonstrates that conditions continue to worsen. Until Bank lending standards are relaxed the consumer and business will remain mired with long term debt that requires servicing at rates well above those Banks are being charged by the Fed.

In effect a dollar based carry trade is in operation, with low rate debt borrowed from the Fed lent out at higher rates to all sectors of the US Economy. As we have seen in the past year the carry trade mechanism is reliant on confidence that the high rate income stream continues to flow allowing the servicing and pay down of the low yield debt.

If confidence in the income stream becomes threatened then in normal conditions the carry trade is unwound or more collateral is required to secure the short term (in this case, Fed) debt. This though is not a trade under normal conditions. The Fed can allow collateral levels to remain the same or even be relaxed even if conditions worsen.

The method being used to bailout the financial system is now open to public scrutiny. Banks and other lenders that are "vital" to the stability of the US Economy will be allowed to set their own rates on their lending whilst assured of a low burden of payment on their own borrowings.

Conditions are ripe for Banks to begin to encourage issuance of Corporate Bond debt. The following chart shows the Moody rates for AAA (purple) BAA (green) corporate bond yields and the Primary Credit Rate. I have had to join up a couple of gaps in the data, it is still worth showing:

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Primary Credit Rate at the Discount Window (left axis) is now 300pb below AAA corporate yield and 440bp below BAA.

Here is a plan that may well be put into place by the Fed, Banks and now the Primary Brokers. The Fed continues to lend at very low rates to the financial sector. The Banks and PD's begin to roll their leveraged assets into a mix of corporate bonds and higher yielding treasuries using the income stream to payback the Fed and repair the balance sheets. To further enhance the domestic dollar carry trade, the Fed raises the Fed Fund Rates, citing inflationary pressures but keeps rates at the discount windows artificially low. It might not happen in the near future but there maybe a hint that others are considering this as a possibility:

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(Chart from CLP Structured Finance)

It's too early to say "trend change" but it maybe worth watching yields to see if markets start to price in rate hikes.

Finally, two charts which are both at a critical juncture. First up is Dollar/Yen, a monthly chart. With the month close on Monday, it looks increasingly like the Dollar is in need of help. Will anyone hear the call?

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Lastly, Gold Daily chart. Gold needs to rally rapidly from here to stop a test of support at $845 area.

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That's it for this week.

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

Moral Hazard, Merrill Lynch, Goldman Sachs, Spiders and Margin requirements

Now if that title doesn't cause Google bots to have a happy hour I don't know what will?

There is a lot of talk about moral hazard being assumed in the Markets, what with the intervention of the Fed with Bear Stearns, the Bank of England with Northern Rock and the Bundesbank with a whole host of German banks.

Some ask what is there to worry about, intervention is good, stopping further havoc in the markets and adds "stability". Let's have a look at a couple of definitions of moral hazard, back to basics:

From Global Business Today: Moral hazard. "Arises when people behave recklessly because they know they will be saved if things go wrong."

From Deardorff's Glossary of International Economics: Moral hazard. "The tendency of individuals, firms, and governments, once insured against some contingency, to behave so as to make that contingency more likely. A pervasive problem in the insurance industry, it also arises internationally when international financial institutions assist countries in financial trouble."

I had a good search through my books and on the internet and I could not find one definition of accepting moral hazard as a method to protect the financial system. In every case it either specified or implied a change in behaviour that would make the event that had caused moral hazard to be invoked more likely to occur.

The main keywords used were dishonesty, questionable integrity, a lack of incentive, more risk, danger, incompetence and temptation.

Just the kind of attributes you do not want associated with the Markets in their current state. Still, it has happened, intervention in "free" market mechanisms has occurred and we now have to accept it as a reality. To protect ourselves we need to know how does the acceptance of moral hazard cause an increase in the risk of the very event that was being avoided?

Here are the words of a Central Banker and a Treasury official. Both have been involved in creating a moral hazard in 2 different International markets.
First up is Mervyn King of the Bank of England. Having already bailed out and the acquiesced to the nationalisation of Northern Rock (in my view against his own better judgement) this is what he had to say to Parliament on Wednesday:

"So we are discussing with the banks how a longer-term resolution of the problem might be reached,
This would be based on two principles -- that the risk of losses on banks' lending remains with bank's shareholders and that the longer-term solution "should focus on the overhang of assets and not subsidise issues of new assets.

With reference to increased lending facilities by the B of E, he said "Such lending can be only a temporary measure but it can be a useful bridge to a longer-term solution."

Mr King has been reading his definitions too. I suspect he is very worried about moral hazard leading to its conclusion and is attempting to tell the markets that reliance on a lack of perceived risk is misplaced. However, until the UK governing politicians back him up it will be seen as jawboning.

Next is Hank Paulson, US Treasury Sec who is credited with being instrumental in the Fed sponsored buyout of Bear Stearns. He takes a very different view of how moral hazard should be viewed. After praising the Fed for its "creativity" he went on:

"It would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed's liquidity facility,"
"The trade-off for this subsidized funding (for banks) is regulation tailored to protect the taxpayers from moral hazard this insurance creates."
"and the sooner we work through it, with a minimum of disorder, the sooner we will see home values stabilize, more buyers return to the housing market, and housing will again contribute to economic growth."

In Q&A after his speech he then said "financial institutions are critical to the economy and innovation precedes regulation."

No flat out refusals in this text, the use of the word "premature" in relation to permanent access to Fed liquidity implies the idea is on the table, encouraging increased risk taking. Think of it like this, you get a fallback position allowing you to take one great bet. If it fails then the Fed pick up the pieces and you walk away. If it works you join the Big Players League. If a whole sector tries it, no problem, the temporary arrangements will become permanent as to do otherwise would invoke the very problem trying to be avoided now.

Notice one other subtle difference between Mr King and Mr Paulson? It's the implied threat as to who gets hurt if the situation isn't allowed to run the course they have set out. Mr King points squarely to shareholders, there will be no offer to buy shares of busted banks. Not so from Mr Paulson, he threatens the public, by insinuating that if he and the Fed do not get their way, housing and the economy will suffer.

As for "innovation precedes regulation" Hank needs to look at some timings, repealed laws and the amount of lawyers it takes to change an SPV to an SIV. Threatening banks with regulation has the same effect as threatening a warmongering dictator with a major leaflet campaign.

Moving on to an interesting chart which could be titled "Dude - Where is my bear market?"

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Here we have Merrill Lynch, Goldman Sachs and SP500 Spiders on a 1 year comparison chart (Bloomberg). You can see my dismay. My bear market hasn't really started yet. It could be easily said that the credit crisis fallout is restricted to the financial sector. SPY is down around 7% (approx) from last year. It's not exactly leaping off a cliff. Think of this chart as displaying positive divergence for the S&P. Will it last is another question, divergences have an unfortunate ability to correct, as well as pointing out a disequilibrium. I shall be watching MER very closely though, it is struggling to join in with the current rally.

Of course if the S&P is reflecting a measured worth of intervention, then it is probably correctly priced. The problem is if moral hazard reaches its conclusion and the attempts to avoid the problems are unsuccessful, then the S&P will have some "catch up" to do on the downside.

Finally, instead of the market snippets this week, I want to just tip you off about margin requirements. Some of you may already know that margin levels are being raised by a number of brokers. Here is why:

"As a result of the Margin requirement changes imposed by the Exchanges, we will be revising the margin requirements on the following Futures contracts":

10 Year US T-Notes Composite (Globex-CME/CBOT)

5 Year US T-Notes Composite(Globex-CME/CBOT)

30 Year US T-Notes Composite(Globex-CME/CBOT)

Euro FX/Swiss Franc(Globex-CME/CBOT)

Euro FX/Japanese Yen Cross Rate Future (Globex-CME/CBOT)

European Rapeseed (Euronext)

Corn (Euronext)

AEX Index (Euronext)

CAC 40 Index (Euronext)

In other words add to your capital or get closed out. The question is who is going to get squeezed, longs or shorts?