MLEC: 'initial' thoughts
The big investment banks (led by Citigroup) have clubbed together to create a colossal $75bn SIV (Structured Investment Vehicle), which the banks hope will help solve many of their problems. The fund has been set up so that banks can pool and price bank debt, as well as CDOs, CLOs, residential mortgage backed securities (and anything else they can chuck in) that they've had problems selling and pricing recently. MLEC is supposed to stand for Master Liquidity Enhancement Conduit; cynics might call it the Market Level Evading Conduit.
Banks sponsor or invest in SIVs, because they provide leveraged returns from a diversified and high quality portfolio of assets. SIVs buy (or to be more precise 'used to buy') bank capital notes.
Banks like the high returns that SIVs provide, and they definitely like the fact that SIVs remain off balance sheets. The off-balance sheet financing means SIVs require no regulatory capital, whilst providing a nice and predictable income stream for the bank.
As SIVs have grown, more and more have been created, thus creating more capacity. The huge demand for bank paper (amongst other things) from SIVs (and other forms of structured credit like CDOs) has until recently been a huge compressor of corporate bond spreads. And so, in a nicely self-perpetuating (or incestual?) manner, the tight spreads have resulted in banks' cost of capital falling. And the more SIVs they create, or the more capital the banks give them, the cheaper the banks' cost of capital becomes.
The credit crunch has meant that SIVs have been struck by their perfect storm. They cannot issue any more debt because nobody's buying it, so the SIVs cannot buy bank capital securities. Indeed, some of them have to look to sell their assets to pay their debts. And, thus, the value of these assets falls. Then banks' capital notes cost a lot more to issue, and their capital efficiency is impaired, and their returns fall.
So, what do the banks do? They bend over backwards to avoid a fire-sale of their capital notes by the SIVs, and agree to set up MLEC, an opaque, anti-free-market vehicle that enables SIVs to avoid marking their assets to market, with the ultimate aim of avoiding the re-pricing of risk of their capital notes. We'll give it a miss, thanks.
Re: MLEC: 'initial' thoughts
Lies, Damn Lies, and Argentinian Inflation Statistics
The global inflation-linked market has grown exponentially in recent years - the UK was one of the pioneers, back in the 1980s, when the authorities thought that developing the market would not only help pension funds to more accurately match their future liabilities, but also would instill discipline on the government to keep inflation low and thus keep the bond interest bill under control.
Nowadays we have significant issuance in the US, Germany, France and Italy, and a newer market in Japan. And emerging market economies have followed suit - mainly in order to give comfort to bond investors who have been badly burnt by inflation in the past.
Not much comfort in this case it seems. Happily in the UK we can wholeheartedly trust the government and the integrity of the ONS's inflation statistics. More comforting even than that though is the fact that the Bank of England is mandated to keep an independent eye on any changes to the inflation data that might be detrimental to bond holders. Any monkey business and we get our money back.
Northern Lights
The Rock has circa 5,000 employees, so some simple maths says that £20bn works out at around £4m per employee. Never has so much been lent to so few. The market capitalization of Northern Rock is £803m (at a share price of £1.915), which means that the B of E is providing 25 times as much finance to the company as its existing market cap. Wow.
Northern Rock continues to write business, and the B of E continues to facilitate this. Is this what central banks are meant to do? Fortunately the independent central bank has the financial backing of the UK Treasury, so it in turn cannot go bust as a result of this huge exposure to one shaky institution.
In the B of E's defence, the action is not just being taken to support Northern Rock employees or shareholders, but for the wider good of financial stability. But while this action is only a temporary solution, it is distorting the market adjustment processes as it enables a weak industry player to continue to produce products in a subsidised manner, which in turn damages the rest of the industry. This is an industry that the authorities have the mandate to protect.
The B of E isn't alone in its actions - the ECB is also lending, but is doing it on an anonymous basis. If you thought the B of E has been generous, the ECB has provided €136 billion of extra liquidity to markets. To put this mind boggling figure into perspective, it is about the same as Portugal or Hong Kong's GDP last year. This financial crisis is quickly transforming from 'small and temporary' to 'large and permanent'.
Bank of England Highlights Risks
Merrill Lynch reveals huge write-downs
If you're an equity investor, investment banks have been a bad bet over the past few months (with the exception of Goldman Sachs). The Dow Jones is close to record highs, and yet the share prices of Bear Stearns and Merrill Lynch are 30% below the highs hit earlier this year. JP Morgan and Morgan Stanley are 15% down.
From what we've seen in the fixed income markets over the past few months, we think that the banks' problems are going to get worse before they get better. In the leveraged loan market, for example, investment banks have struggled to shift loans from the jumbo LBOs off their balance sheets following the repricing of credit risk over the past few months. They have now started to have some success, but they are doing this by selling the bonds at discounts just to shift them before the end of the year and the annual reporting season.
One saving grace for investment banks is that they offer a range of services that cover different markets through the economic cycle. If M&A activity grinds to a halt, they can afford to take the hit, fire most of their M&A team, and employ a new department in, say, distressed debt. This is a luxury that companies like Northern Rock (and to a lesser extent, Alliance & Leicester and Bradford & Bingley) don't have. As Richard argued on this blog last month, Northern Rock is in serious trouble because its entire business model is no longer valid.
Oh, and yet more terrible US housing data just out - existing home sales were -8.0% in September, way below expectations of -4.5% and the worst month since records began in 1999.
High yield market still not pricing in recession risk
Alan Greenspan made the headlines at the beginning of this year when he said that the risk of a US recession was 1 in 3, and has since said that recession risk had risen. Larry Summers (former US Treasury Secretary and Chief Economist at the World Bank) put the risk at 50/50 in September. The truly horrendous data coming from the US housing market makes us think that the risk of recession is probably greater than this.
What does this mean for high yield bonds? Well there's a very close correlation between high yield bonds and economic growth - strong economic growth coincides with strong profits, low defaults and tight high yield bond spreads (ie high yield bonds become much lower yielding bonds). When the economy is in recession, more companies are going bust and high yield spreads tend to be wide (ie investors demand a big yield to be compensated for the significant risk that their bonds will blow up).
This chart shows that high yield spreads (left hand axis) are severely out of synch with US economic growth (right hand axis, inverted). There are three possible conclusions that can be drawn from the divergence of the lines. Number 1: this credit crisis will blow over and the US growth rate will jump back to 3%. Number 2: the correlation between growth and spreads has broken down ("it's different this time"), or number 3: the high yield market is very expensive.
I favour number 3. US growth has been below trend for about a year, and yet high yield spreads actually reached their tightest ever levels in May this year. Spreads widened a bit over the summer, but are still close to all-time lows on an historical basis. And if you consider that US growth is likely to fall towards zero and possibly lower, then history suggests that the average high yield bond should yield around 12%, not 8%. A correction of this magnitude over the course of one year would result in double-digit negative returns. The European high yield market closely tracks the US market, and I remain very underweight of high yield assets across my portfolios.
The global default rate can only go one way from here
The steady decline in the default rate has been a bit of a surprise - indeed, Moody's model has been predicting a rise in the default rate for about the last two years. The likely reason for the model's error is that companies that would have gone bust in previous cycles have escaped this time. In this liquidity-fuelled cycle, investors have been perfectly happy to bend over backwards for companies. Covenants have been broken, which legally allows bond holders to bring in the receivers and sell the company's assets to recover their money, but investors have instead been happy to waive these breaches. In a worryingly large number of cases, troubled companies have been able to borrow even more money from investors to help them out of a hole.
Events of the past few months have resulted in liquidity drying up, and this almost unlimited supply of funding looks to be a thing of the past. Banks have had severe trouble getting financing lately, let alone rickety junk issuers, and the default rate should tick up as bond investors start to rein in lending.
Another indicator that defaults should pick up is that US interest rates have peaked. This chart (click to enlarge) shows that the global default rate has traditionally risen (and sometimes significantly) following the last Fed rate hike of a cycle. The observation makes sense - when the Fed believes it's time to start slashing rates, the economy is usually a mess and monetary policy is too tight. Tight monetary policy means that there is little liquidity, it is expensive for companies to raise new finance, interest payments are high, all of which causes companies to run into difficulty.
You get a similar story when you mark the high point of the US rate cycle on a graph of high yield spreads, which isn't a shock seeing as spreads and defaults are closely correlated. As this chart shows (click to enlarge), spreads normally start widening just before the final Fed hike in the cycle. This time around though, spreads initially tightened following the final rate hike in June 2006, and the long-awaited sell off only started in June this year. High yield spreads are still very tight on an historical basis, probably because the default rate is still so low. Spreads should widen in tandem with a rising default rate.
Building pessimism in the US
The report underlines Ben Bernanke's comment earlier this week, when he said that the housing market's contraction will be a "significant drag" on US growth into next year. The Fed "will continue to watch the situation closely and will act as needed to support efficient market functioning and to foster sustainable economic growth and price stability".
As I argued on this blog in August (before the Fed cut rates by 0.5%), the Fed will have to act fast if it is to prevent a slide towards recession.
International investors sell a record amount of US assets
Perhaps most interesting of all was that Chinese investors decreased their holdings of US Treasuries by $8.8bn, while the Japanese reduced exposure to US assets by $24.8bn. Richard recently argued on this blog that a falling away of Asian support for US assets should cause the dollar to weaken.
Structured credit markets still look unattractive
UK MBS backed by residential mortgages has suffered from the US crisis and Northern Rock debacle. Bonds that were rated AAA and yielded LIBOR + 10 basis point widened out to LIBOR + 50 basis points, although AAA spreads have tightened a little recently. Some BBB rated issues that were once yielding LIBOR + 50 basis points have widened out to levels usually associated with junk. Five year BBB paper now trades at around LIBOR +200.
Even at these levels, we are generally not buyers of residential MBS. As alluded to on this blog, our view is that this crisis has further to run. Credit rating agencies have downgraded lots of lower rated ABS/MBS deals, but are yet to make their move on a considerable number of so-called AAA rated bonds. When this does happen, we expect to see yet more repricing of this area of the structured credit market, and also anticipate some repricing in corporate spreads as former AAA deals crowd out A and BBB corporate land.
Taking a longer term view, it's likely that residential MBS is going to be negatively impacted by a slowing of the housing market. Residential MBS will be hit hard if house prices fall, as delinquencies will inevitably rise. Slower repayment speeds on mortgage-backed deals will also slow the cycle of money being re-invested in new deals. ABS will not escape unscathed from a worsening consumer outlook either, as they are typically backed by things such as credit card repayments or car loans.
An area that looks a bit more appealing is the collateralised loan obligation (CLO) market - unlike CDOs, the underlying assets in CLOs consist entirely of leveraged loans, which are on the whole trading at attractive levels.
US economy could be in a worse state than data suggests
See this link for an excellent summary of the impact of recent financial developments on the US economic outlook from Janet Yelen, President of the Federal Reserve Bank of San Francisco.
She concludes:
"In determining the appropriate course for monetary policy, we must recognize that most of the data available now reflect conditions before the disruptions began and, therefore, tell us less about the appropriate stance of policy than they normally would. In addition to data lags, appropriate policy decisions must also, I believe, entail consideration of the role of policy lags--that is, the lag between a policy action and its impact on the economy. Addressing these policy complications requires not only careful and vigilant monitoring of financial market developments, but also the formation of judgments about how these developments will affect employment, output, and inflation. In other words, I believe it is critical to take a forward-looking approach—gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook."
Letter from Toyko
Elsewhere, whilst Japan has slipped back into deflation this year, we see this as a temporary trend. In particular there is a lot of criticism about the statistical methods used by the authorities. The price of housing and rents (a quarter of the CPI) is referenced on increasingly rare wooden homes, rather than the condo blocks where most people live. A regulated rebalancing of mobile phone bills away from handset subsidies towards lower monthly tarrifs will also have a massive deflationary impact in months to come, even though the net cost to consumers is likely to be a wash. And we learnt that the inflation stats haven't coped well with the grocers reducing portion sizes (e.g. on pot noodle meals) whilst keeping prices unchanged (which should show up as inflation, but doesn't). Positive inflation should be back in 2008 - another reason to underweight JGBs, although we think the nacent index-linked market looks to have value.
What could derail a Japanese recovery? Well 40% of Japanese GDP by value added is from the auto sector, and another 40% from electronics. Both of these sectors are big exporters, and a recession in the US would likely see Japanese growth slow back to below trend. The other risk is political - the radicals (economically liberal, global facing) appear to have been defeated and there is a risk of a return to "big government" and pork barrel politics (pointless state funded road building projects to appease regional interests). Further rises in the oil price would also be bad news for a nation which doesn't have any of it - although it is somewhat protected by having 50% of domestic power generated from nuclear.
Finally, no trip to Japan would be complete without a gadget update. The next generation of TV screens are organic, and just 3 millimetres thin (and the picture quality is amazing); electronic purses have taken off dramatically for smaller purchases (Japan Rail runs one of the most popular schemes - you simply touch a pre-loaded card on a scanner to pay - no PINs or signatures); and Sony's latest, er, thing, is called the Rolly, and it appeared to be a combination of dancing robot, lightshow and stereo speaker. Yours for 40,000 Yen (about £175).
High 'real' interest rates will slow the UK economy
When the Bank of England meets every month, market commentators always focus on the nominal interest rate. But what many people fail to realise is that it's not the nominal interest rate that matters, it's the real interest rate (ie nominal interest rates minus the inflation rate). If nominal interest rates rise from 5% to 6%, but inflation jumps from 2% to 4%, then real interest rates have actually fallen. Consumers will react by borrowing more, not less.
I was bearish on UK bonds through 2006 and the first half of 2007. Even though the Bank of England has steadily increased nominal interest rates from a low of 3.5% in 2003, real interest rates were at the same level in 2006 (about 2%). In reality, monetary policy at the beginning of this year was just as expansionary as in 2003, but four years ago the Bank of England was trying to avert recession and was worried about deflation. The Bank of England needed to raise rates this year, and it was little surprise that it has done so.
Since May this year, however, real interest rates have climbed rapidly higher. Even though the Bank of England has only raised nominal interest rates by 0.25% since May, the drop in inflation has meant that real interest rates have jumped by 1% (as shown by the yellow line on the graph). If you measure real interest rates using 3 month LIBOR, which is the rate at which banks lend to eachother and is therefore the rate that matters most to the man on the street, then real interest rates have jumped by 1.2% (as shown by the green line).
In reality, therefore, there has been a dramatic tightening of monetary policy over the past few months. High real interest rates will serve to reduce consumer borrowing, cut corporate investment, slow the housing market, and slow the economy. There is currently no need for the Bank of England to raise interest rates, and the next movement is likely to be downwards. The timing depends on how quickly and to what extent US woes afflict the UK, and how the UK housing market pans out (see my previous blog comment)
Head Scratching Stuff
It would seem unlikely that both markets can ultimately be proven right. Whilst the equity market is no doubt aware that there are real pitfalls ahead, it appears supremely confident that central banks will be willing and able to reinflate their economies. I’m not so sure.
As an aside I spent a few days in the US last week trying to gauge the tone in the US bond market. The mood it must be said was somewhat mixed. Some argued that what we are seeing is more a mid cycle slowdown and were hesitant to talk too much about the dreaded ‘R’ word. Readers of this blog will be acutely aware of our bearish thoughts and I must admit the bulls failed to convince me otherwise.
Since Jim’s teleconference (see here) the asset backed and interbank markets have so far failed to normalise and US housing data has continued to come in below consensus (August pending home sales fell -6.5% yesterday). I fail to see how this withdrawal of liquidity and continued poor housing data won’t have wider implications for the US economy.
Finally the technical picture continues to look unappealing - several hundred billion dollars worth of pre-committed leveraged loans have yet to be sold, there is a risk of various structured vehicles having to unwind, and new issuers need to come to market.
Is the UK housing market on the brink?
The housing market is the transmission mechanism between Bank of England base rates and the UK consumer. The B of E cuts interest rates to encourage borrowing, which causes house prices to rise and homeowners' pockets to swell. Higher interest rates slow the economy by restricting borrowing and suppressing the housing market. The state of the UK housing market is therefore one of the most important determinants of UK interest rates.
We have had another look at some of our favourite housing market charts, and while these suggest that the UK housing market is still fairly rosy, I believe that we are at a critical point.
The first two graphs below examine whether the UK housing market is overvalued. Graphs three and four look at two leading indicators that have proven to be very reliable at predicting the strength of the housing market half a year into the future.
1. UK house prices look expensive on a P/E measure
The housing market chart that people are most familiar with shows the average UK house price divided by average earnings, which is effectively a P/E ratio. There is no question that under this measure, UK house prices look the most expensive they've ever been. But is this an accurate measure of affordability? I believe it's more important to look at how much Joe Public is spending on mortgage payments as a proportion of income, as that's what determines whether people can afford to buy a house or not.
2. Mortgage payments still a relatively small portion of average earnings
The mortgage burden isn't that great at the moment. As at the end of June, mortgage payments formed 16.6% of average income (quarterly data). Monthly figures for the end of July have mortgage payments at 16.9%, the highest level since Q3 1992, but still not much above the long term average of 15.4% (figures go back to 1974). It's easy to see what caused the last UK housing market crash - UK interest rates were increased to 15% in October 1989, and as a result, mortgage payments had soared to 26.7% of average income by Q2 1990.
3. Mortgage approvals suggest demand for houses will remain strong
Lead indicators suggest that UK house prices will remain buoyant over at least the next half year. This chart shows the number of mortgage approvals taken out by individuals each month. The rationale for looking at mortgage approvals is that people who seek to take out a mortgage are almost certainly going to buy a house in the next few months. The lines have diverged a little since over the past 2-3 years, and we therefore look more at the direction of mortgage approvals rather than the absolute number in order to predict changes in UK house prices. Yesterday it was announced that the number of mortgage approvals fell to 109,000 in August (a four month low), but the drop was only slight.
4. Supply of houses is failing to meet demand
The RICS sales/stocks ratio is a very accurate indicator of future house price movements, as it encompasses both the demand and supply of houses. It is a measure of the number of sales that estate agents have made over a rolling 3 month period, divided by the total number of houses that estate agents are advertising for sale. So a high ratio indicates that a lot of houses that come onto the market are being sold straight away (demand exceeds supply), while a low ratio indicates there is a big overhang of houses on the market (excess supply). When the ratio is high, house prices have traditionally risen, and when the ratio is low, house prices have traditionally fallen. At the moment this indicator also suggests the housing market will be fairly buoyant going into 2008, although the rate of growth is likely to slow a little.
All in all, therefore, the available data suggests that there is little danger of collapse in the short term, but the story from the middle of next year could be very different.
The fallout from the credit crunch, the drying up of money markets and the Northern Rock debacle caused 3-month LIBOR (the rate that banks lend to eachother) to rise to 6.9% at the beginning of September. This rate has since fallen back to 6.3%, but it's still way above the 5.75% target rate set by the B of E. In reality therefore, banks have experienced a sudden jump in interest rates, and this will inevitably be passed onto the consumer in the form of higher mortgage rates.
Just how much mortgage rates will jump remains to be seen, but if there is a sudden move, this should be picked up in the two lead indicators mentioned above. A rise in mortgage rates will result in the number of mortgage approvals falling sharply, and the RICS sales/stocks ratio would start to decline. Any sign of this occurring will result in me taking a much more bearish view on the UK housing market.
