Credit Crisis 101 - Leverage

Pick up any business magazine or paper, or watch the business channels, you will find a plethora of information on the credit crisis. Sometimes, too much information overload will distract from the real issues and when we talk about the crisis, we have too many angles on the problem. Unless we zero in on the root cause (not not ascribing blame), we won't be able to get a handle on the crisis and its effects.

Let's get the blame out of the way. I have blogged about the blame game: mainly its the ratings agency, followed by Greenspan and then the Wall Street firms. If you have to describe the root of the current crisis in one word, that word has to be "leverage". If you take leverage out of the equation, if we didn't have the many new fangled acronyms, which were basically packaged loans supported by derivatives like capital platform, we would have a very mild recession. This recession is the severest we have seen since the Depression because of the leverage i.e. derivatives. Leverage implies very little capital outlay for a certain contract of service or product. If we have derivatives and leverage during the 1920s, the whole world might have collapse even more brutally.

Yes, we have more knowledge since then, we have a better understanding of fiscal and monetary policy, and some say better laws and regulation (well, there are regulators but they did not do a good job at all). Its the leverage which brought about such a recession that is much worse than any we have seen in modern times. If you want to take an account of the mess, the more reliant you were on that leverage, the more you fell as the values were nothing but book entries. The investment banks would not have been in so much trouble if they did not get greedy themselves and bought most of the instruments.

Naturally, the front line got hit the worst, the investment banks that parlayed capital up to 20x-30x leverage to issue these papers, and when they collapsed it very easy to see capital totally vanishing with just a minor drop in values. Now we are talking of properties (which these papers were based on) losing 30%-50%, hence the negative equity. Those who bought properties using these kind of easy and unchecked loans were the first to be foreclosed. Even if you did not participate in those loans, you might have benefited via rising housing values, and refinanced, you would have got hit as well. Generally the affected banks lost about 90% or more in share price while most of the broader equities lost about 50% and counting.

The rest of the world got hit because they got a corresponding inflow of liquidity emanating from these gains. Liquidity was ample. Related areas which practiced excessive leverage were hedge funds. If these funds bought emerging market shares and commodity, those prices got inflated as well, hence when it came time to de-leverage, the outflow was very severe. In particular commodity prices. Its not just a bull cycle, it was the leveraged funding which went looking for "liquid assets" to move into. Hence the very sharp rise in commodity prices in 2004-2008, and they came down just as fast. Related to commodities were the commodity ETFs which were coming out like fresh donuts. Every commodity ETF basically just fueled the rise and trend even further, causing many pension funds to specifically target a substantial weighting in commodity as a critical portfolio composition.

Unfortunately, the US consumers represents a significant engine for global demand. They are key to the US economy, and they need to buy crap from the rest of the world, so that the rest of the world have the funds to buy crap from other countries. The wealth destruction from falling share prices and more importantly, the losses from property, have caused the US consumers to tighten their consumption patterns. That has severe ramifications for the flow on effects to the rest of the world relying on exports for growth. Yes, it may not be the rest of the world that is at fault, but you still get swept up in the tsunami.

The curtailment of credit and loss in wealth from the deleveraging is what is bringing global demand to its knees. Every country has attempted to reflate, whether the sums are big enough is still debatable, I think it is, but more than just reflating you need to address the root problem. Has the deleveraging stopped? Well, banks are still holding the toxic assets, refusing to write down to a fairer market value, say twenty cents to the dollar, as that would wipe out the bank's equity. Hence NATIONALISATION is the best solution going forward. You are not going to do it, let the government do it. Nationalisation of banks = forced sale of these assets = investors have a good idea of the losses = shareholders will be wiped out but its necessary.

As big as the TARP is, it is insufficient to replace the writedowns. You want a bad bank, you need $2 trillion minimum. Already the lawmakers are balking over the TARP's $780bn, the amount for bad bank is humongous. By nationalising, you basically close a few big banks that shouldn't be allowed to continue. By propping them up, you will eventually have to pump close to $2 trillion anyway to get them on even keel.

The other major contention is that property has to stop falling in price because as it keeps down trending, investors have no idea how to put a fair value on those toxic asset losses. A better plan Obama should have included is to put a stop to the slide - put up an incentive for new home owners to buy, e.g. $25,000 for new homeowners that qualify. Its pointless to renegotiate mortgages if prices keep falling. You need genuine long term buying.

As for auto sector in the US, the crisis basically hasten their demise. Their business model does not work and is inflated. They must be bankrupted so that they can negotiate a reasonable business model with a very much reduced pension/healthcare liability overhanging the car makers. But the US auto sector is the least of global concerns.

Things are coming to a head, falling share prices will force the government's hand. Keep an eye on developments on these two front:
a) how they deal with the toxic assets properly
b) how to stop property prices from sliding further

To that end, the markets looks oversold as a lot of liquidity is on the sidelines. To activate the flow back, we need to see catalysts that would trigger (a) and (b) in the right way. Bank nationalisation would be one. Bad bank is still OK but the hurdles on raising $2 trillion will not be easy.

Things are so bleak now that it gives me room to be optimistic that certain things will happen when you are forced into a corner. These are very difficult decisions, do you have the political will to nationalise banks.

Another potential positive catalyst will be Geithner roping in private equity and hedge funds to start buying up the toxic assets. Pricing will be an issue but the government is keen to get these funds to take off some of these assets via special funding, which may be hard to come by for hedge funds and private equity funds now. Geithner has a strong hand now, by forcing banks to sell the toxic assets to these funds or else face nationalisation. Geithner has seen his credibility being eroded quickly with his conceptual plan that lacked details and a pricing mechanism for the toxic assets. He can restore much of it by moving fast to move the toxic assets. Yes, banks will have to do massive writedowns, and many may be barely solvent, but that's part and parcel of what needs to be done.

Despite all the bad news, I am more hopeful than most as things are coming to a head - and tough decisions are forthcoming, which will be good for the markets.

p/s photos: Natasha Hudson

Brazen Commentary By BIS

The latest commentary by the highly respected Bank of International Settlements:

Overview: global financial crisis spurs unprecedented policy actions Financial stability concerns took centre stage once again over the period between end-August and end-November. In the wake of the mid-September failure of Lehman Brothers, global financial markets seized up and entered a new and deeper state of crisis. As money market funds and other investors were forced to write off their Lehman-related investments, counterparty concerns mounted in the context of large-scale redemption-driven asset sales. The ensuing sell-off affected all but the safest assets and left key parts of the global financial system dysfunctional. With credit and money markets essentially frozen and equity prices plummeting, banks and other financial firms saw their access to funding eroded and their capital base shrink, owing to accumulating mark to market losses. Credit spreads surged to record levels, equity prices saw historic declines and volatilities soared across markets, indicating extreme financial market stress. Government bond yields declined in very volatile conditions, as recession concerns and safe haven flows increasingly outweighed the impact of anticipated increases in fiscal deficits. At the same time, yield curves steepened from the front end, reflecting repeated downward adjustments in policy rates.

Emerging market assets also experienced broad-based price declines, as depressed levels of risk appetite and associated pressures in the industrialised world spilled over into emerging financial markets. With confidence in the continued viability of key parts of the international banking system collapsing, the authorities in several countries embarked on an unprecedented wave of policy initiatives to arrest the plunge in asset prices and contain systemic risks. Market developments over the period under review went through four more or less distinct stages. Stage one, which led into the Lehman bankruptcy in mid-September, was marked by the takeover of two major US housing finance agencies by the authorities in the United States. Stage two encompassed the immediate implications of the Lehman bankruptcy and the wide-spread crisis of confidence it triggered. Stage three, starting in late September, was characterised by fast-paced and increasingly broad policy actions, as responses to the crisis evolved from case by case reactions to a more international, system-wide approach. In the fourth and final stage, from mid-October, pricing patterns were increasingly dominated by recession fears, while markets continued to struggle with the uncertainties surrounding the large number of newly announced policy initiatives.

Lehman Brothers bankruptcy triggers confidence crisis In this environment of tension over the continued viability of Lehman Brothers, financial market developments entered a completely new phase. The spotlight was now being turned on the ability of key financial institutions to maintain solvency in the face of accumulating losses. The trigger for this new and intensified stage of the credit crisis came on Monday 15 September. That day, following failed attempts by the US authorities to broker a takeover by another financial institution over the weekend, Lehman Brothers Holdings Inc filed for bankruptcy protection, one of the biggest credit events in history.

p/s photos: Janet Hsieh Yi Fen

US Treasury Yields Near Zero

WASHINGTON - THE panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero.

Due to stampeding demand for safe short-term investments, the US Treasury's four-week and three-month bills on Friday yielded an effective rate of 0.01 per cent - down sharply from 1.515 per cent and 1.785 per cent, respectively, in early September.

Other Treasuries are also showing record low yields. The 10-year bond yield fell as low as 2.505 per cent and the 30-year bond yield slid to 3.005 per cent at one point on Friday. The six-month bond yielded a mere 0.20 per cent.

The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil.

'Investors seem to be content to sell stocks and park into the bonds for now,' said Mr Greg Michalowski of the financial website FXDD.

Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default.

Other factors include worries about deflation and the overall trend in interest rates, with the Federal Reserve having cut its base lending rate to a historic low of 1.0 per cent, and further reductions possible.

But Mr Bob Eisenbeis, analyst at Cumberland Advisors, said the unprecedented low yields are a sign of 'dysfunction' in markets.

Eisenbeis said US municipal bonds are paying upwards of 6.0 per cent tax-free and corporate bonds even more, but that fears of default and a lack of knowledge about underlying bond quality have led investors to shun these alternatives.

One reason for the surge in demand for Treasuries, said Mr Eisenbeis, is the Federal Reserve's decision to flood financial markets with liquidity including through other central banks.

Many central banks and commercial banks are reluctant to use this cash for traditional lending, and are buying Treasuries to ride out the storm, Mr Eisenbeis added.

A big question for the market is whether the Treasury market has become a bubble that will burst.

Although the low rates allow Washington to borrow money cheaply, Mr Eisenbeis said such a scenario could be perilous for the economy and the dollar.

'When you have this huge flood of liquidity into the marketplace, that can't last forever,' he said.

A bursting of this bubble could mean a rush out of Treasuries, forcing the government to pay higher rates on an unprecedented amount of debt.

'We would have huge increases in our costs and people wouldn't want to hold Treasury obligations anymore because of the capital losses,' Mr Eisenbeis said.

'You could have a huge switch in interest rates very quickly.' Mr Mike Larson, an analyst at Weiss Research, says the long-term bond market could be 'the biggest bubble of all', worse than the dot-com and real estate bubbles.

'Treasury bonds almost never move this far, this fast. And interest rates, which move in the opposite direction of bond prices, almost never fall this far, this fast,' Mr Larson said.

Mr Larson said the yield on the 10-year Treasury bond plunged from a mid-October high of 4.08 per cent to nearly 2.5 per cent this week, 'yielding lows not seen since the mid-1950s'. 'There are lots of reasons to believe this Treasury rally is unsustainable, and that a day of reckoning is fast approaching,' he said.

Mr Sal Guatieri, economist at BMO Capital Markets, acknowledged that 'investors are throwing money at Uncle Sam with the same conviction that they bought houses and dot-com stocks in their heydays'. But he argued that if inflation is quashed and investors retain confidence in the US government, the dangers have not yet hit a boiling point.

'While Treasuries may be overpriced, they probably are not yet in a bubble,' he said.

Comments: The continued buying of US Treasuries indicates a few major conclusions:

a) the aversion to corporate bonds, the risk in corporate defaults is still high

b) the aversion to risk is very high, many are willing to accept 0% yield to be in USD

c) that the markets are unconvinced on the measures promoted by the government so far

d) the anticipation of more major corporate collapses, and maybe even more bailouts to come

e) the aversion to stocks of any kind, even US stocks, hence we are seeing no flow of funds to emerging markets for now

f) the zero yield is the most important indicator that financials and credit markets are not working properly

g) corporates will have enormous difficulty to raise funds or even renew their funding

h) the pressure has mounted significantly for governments to do a lot more to unfreeze credit markets

i) this will cause most companies to hoard cash rather than reinvest, in other words companies will be cutting back operations and capacity further, a priority will be to push down inventory

j) If investors are willing to hold zero yield Treasuries, its a telling sign that people want to be in CASH but not in a bank as they do not trust their money within any banks

doraiddd has left a new comment on your post "US Treasury Yields Near Zero":

k) this notion that us treasuries are also the safest asset class to be in will be soon proven to be the ultimate fallacy... and fantasy...

l) us treasuries are the last remaining asset bubble left. Expect the chinese, arabs and the japanese to unload soon....

m) when the panic stampede starts outta us treasuries, where u gonna hide? where u gonna run? who's gonna save you??

n) maybe perhaps king midas himself...?


Expect a trying week for stock markets globally. Not a nice way to end 2008.

p/s photos: Zhou Wei Tong

Credit Frozen & Cuban Missile

Don't ask me why or how, but there was an IMF meeting a couple of days ago in Washington DC, and me being still in New York, I had the opportunity to talk to a very senior, influential gwailo friend ... I asked for his assessment of just how bad the whole crisis had been over the last few days. His comments shocked me.

Like the rest of the world, we were shaking our heads over the daily dips of 5%-10%, but we also thought that things would stabilise once the central banks of the world got their act together. He said that on Friday, he had never been so "hapless, resigned to fate in a bad way". Mind you, my friend is on the board of two top 1,000 companies and has been on select committees on banking oversight committees. He has access to influential board members of the Federal Reserve and many of the top guys at IMF.

He said things were so ON THE EDGE last Friday, he felt the same way when the Cuban missile crisis was at its peak fervour. During the latter period, he was resigned to either side sending the nuclear missiles to each other and knowing in his heart that there is a very real chance that life as he knows it may evaporate in a matter of hours. Can you imagine a person comparing that to the the situation last Friday. He said that things were so "open and shut" that the central banks were in real danger of not being able to come up with the deposit guarantees and buying of stakes in banks. There was a real chance that all markets was going to continue to collapse further. He added that if people knew how bad things were behind the scenes, they would wobble at their knees. He said on Friday, he was willing to take a bet that the Dow Jones may hit 6,000 in the coming days.

His view has improved now. Now he thinks there is a good chance that things will work, that liquidity will return, but sees thing only returning to normal after 6 months.

p/s photo: Yuri Ebihara