Subprime, subprime, when does it end?
Definitely an interesting time in the market… its definitely interesting for me especially working in a bank doing all the ‘credit’ risk management during this very interesting time of ‘credit’ crunch. I understand why I got a job and how its important the financial sector is in supporting the world’s economy.
Who would have thought that RAMS and Centro Property Group would have been this severely affected by the liquidity crisis in America. If you are in the industry like myself you would know that this is not laughing matter. Stress testing in any portfolio is important and this is the reason why! If you don’t hold enough provision you start writing of huge amount of bad debts! Many Bank and financial organisation are working on Basel II (the capital accord, which is the tier 1 capital for the people who are in the industry or heard about this thing called tier 1 capital)
There’s actually many cool stuff we can do the manage credit crunch/liquidity crisis. That said, nobody would have stressed tested their portfolio for 10-15 rate rises in my honest opinion.
Anyways, enough ramblings… what does this mean?
Here’s what’s happened so far…
the official
- interest rates are dropping in Europe, UK & US etc. to help ease the funding cost and ease the liquidity issue
- many banks have written off $10-100billion worth of loans/mortgages (hits straight into the Balance Sheet)
- arrears & defaulted loans cost more capital for the bank which means they many need to borrow more money to re-balance their lending ratio
- due to the lack of money in the wholesale market (big pool of money that people put when they don’t need it and borrow from when they do) there has been several interventions
- due to the seriousness of this whole thing a record $500billion in additional funds has been added to help improve liquidity (this mean things must be pretty damn serious and they most probably know something that we don’t know)
- Where does $500 billion come from?
- They print it… but printing money causes inflation (devaluation of the currency) usually the reserve bank would increase interest rate to fend of this problem … but they can’t (catch 22)
- From the reports the are hoping that this inflation is going to be a temporary thing and should disappear once this credit/liquidity crisis is over… (i hope so too)
- If not they will raise interest rate right back up!
- Interestingly, if this additional money get used up quickly (i.e. the problem is bigger than they think) then we will be left with low OFFICIAL interest rate, high inflation and the banks increasing the BANK interest rates to cover for the increase cost of funding
I don’t know about you guys… but this is definitely a very exciting time in the world economy and there is definitely many opportunity to take advantage of! in the next few months i would think that majority of the stocks (especially banking stock) are heavily under valued… (assuming this thing get fixed up) Plus all other stocks because of fear of ‘recession’…
I can go on and on and talk about this all day with you, but I hope you get the idea! CASH is KING in time of crisis & GOLD too… but thats assuming inflation doesn’t get out of hand. =P
Merry Christmas and a Happy New Year!
Yong-Long
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Global debt markets still unsettled, but coordinated central bank liquidity provision has induced a tentative recovery
Local 90-day bank bill spread over cash retreats from last Friday s 8 year high
LIBOR spreads over cash also falling, but remain well above normal
RBA minutes reveal they probably would have raised the cash rate in December if not for global debt market disruption, so
Tightening bias remains intact
Debt markets may not have settled by February, so
May cash rate increase now our base-case expectation, although
Probability assigned to another increase has dropped a few percentage points in the last couple of weeks, as
Sub-prime contagion starts to spread beyond the financial economy if it hadn t already
Global debt markets remain significantly disrupted by sub-prime contagion, but key risk premia spreads in the US are retreating, although they remain volatile and well above normal at the short end of the curve. Moreover, the drop in spreads is contingent, at least in the near-term, on the continuing success of coordinated central bank intervention to provide adequate liquidity.
The spread on local 90-day bank bill yields over cash touched 76 basis points last Friday - although by the end of the day it had retreated to 68 points. But even the lower spread was nevertheless the highest since the Y2K (remember that?) spike in the spread between Christmas 1999 and new year 2000. And only just shy of the June 1998 end of day peak of 77 basis points in the wake of the impending collapse of the high profile hedge fund, Long-Term Capital Management (LTCM) - which in turn was due to contagion (sound all too familiar?) from the Asian currency crisis a year earlier.
I am not sure that I recall anyone, when the Thai baht collapsed in July
1997 joining dots all the way to Russia defaulting on its sovereign debt in August 1998, which finished off LTCM for good. The point is, contagion from a shock to the global financial system can find its way to the most unlikely places, which is the crux of the dislocation to global debt markets as extreme risk aversion continues to dictate lenders appetite to lend to each other.
The local 90-day over cash spread has dropped back further, to 57 basis points at the 10.00 Sydney fix today, while Australia s LIBOR spread over cash remains well below its US and UK equivalents.
Given that the local 90-day over cash spread is retreating even in the face of the effective reaffirmation yesterday in the minutes of the December RBA Board meeting that the central bank maintains a tightening bias, the modest drop in the spread adds to promising signs from the US.
Nevertheless, the global financial system is only ever a surprise write-down at one or more big investment banks away from being back to square one, so it is way too early to call an end to sub-prime contagion within the financial sector.
And in any case, contagion beyond the financial economy is clearly in play
- as if Centro s shareholders didn t already know. The main question is whether it will, or already is, manifesting itself as a sharp slowing in US private consumption, in which case exposure to American shopping malls would amount to infection from at least two strains of sub-prime contagion
- directly via inability to roll over maturing short-term debts in the face of global debt market disruption and indirectly if falling US house prices do in fact trigger a sharp cutback in consumer spending.
And if not for the disruption to global debt markets, the minutes of the December RBA Board meeting strongly suggest that the central bank would have followed up its November hike with another one this month in view of the outlook for inflation. But global debt market dislocation is a big if not for at the moment. Will it still be when the RBA meets for the first time in 2008 on the 5th of February, given that by then the December quarter CPI will have been published? Probably yes. At the very least the CPI would need to be a shocker to trigger a February cash rate increase if global debt markets remain unsettled, which seems likely.
But by the time the March quarter CPI is published in late April, assuming debt markets have settled and sub-prime contagion hasn t spread to China, the RBA will probably have enough ammunition to tweak monetary policy once again to limit the risk of crystallisation of upside inflation risk. The assumption about China isn t by any means controversial, but the one about debt markets having settled by May is a biggish call. Nevertheless, if risk premium spreads have not fallen markedly by the end of April, a whole new set of drivers - and probably not very skilful ones at that - will be shaping the monetary policy decision anyway.
So our base case expectation still incorporates one more 25 basis point cash rate increase, to 7.0% pa, although the probability that we assign to it is more like 60 per cent than the 75 per cent that we had a couple of weeks ago, reflecting the risk that sub-prime contagion either persists and/or gets worse. Moreover, we have pushed out the expected increase from February to May. We think that 7.0% pa is more likely than not to be the cyclical peak in the cash rate, although the risk of multiple cash rate increases is more than negligible - maybe something in the order of 25-30 per cent.
The proponents of multiple further cash rate increases will draw
inspiration from the LTCM aftermath and the post-October 1987 stock market crash emergency easings of monetary policy, both of which were quickly reversed (see last week s Snapshot).
Perhaps another piece of evidence that US debt markets may be on the mend
is to be found in the US dollar s maintenance of its hard won
stabilisation, which is now in its sixth week. One of the main risks associated with the sub-prime fallout was always, and still is, to be sure, if a simultaneous fall in all key non-cash asset prices (bonds, equities,
property and commodities) either triggers or is precipitated by a
disorderly realignment of currencies. When the big dollar was in free-fall, its realignment was in fact on the verge of disorderly, so its bottoming is a welcome respite.
But, as has been the case ever since the Asian currency crisis of 1997, the US dollar s gain is the Australian dollar s loss. The local currency s depreciation is limiting the speed of the decline in $US denominated base metal prices, but even in local currency terms their steady fall continues, although not at a precipitous rate by any means. And not at a rate fast enough to extinguish the RBA s continuing concern about the outlook for inflation - as reiterated in the very last line of the December minutes.
(See attached file: WEEKLYSNAPSHOT19DECEMBER2007.pdf)
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