The Global Financial Stability Report – An Update
(April 12, 2007)
Dear Subscribers and Readers,
As I am finishing up this commentary on Thursday morning, the S&P futures is down another 2 points or so after declining 9.52 points in trading on Wednesday. This comes as no surprise, as the market was very overbought on a short-term basis, given the fact that the S&P was up six days in a row (the Dow Jones Industrials was up eight days in a row). In terms of seasonality (insiders are restricted from selling shares during earnings season, and quarterly pension contributions for calendar-year defined benefits pension plans are due April 17th), technicals, valuations, and breadth (although volume has been very light), however, the U.S. stock market still remains healthy and on an upwards trend.
Before we begin this commentary, I want to show readers the following chart – that of the Euro-Yen Cross rate vs. its percentage deviation from its 50-day moving average from February 1999 to the present:
As readers can see, the Euro-Yen cross rate just hit another new high, and as of the close yesterday, was trading at 2.17% above its 50-day moving average – fully reversing its losses during the late February to early March period. Over the last two years, one of the effects of the Yen carry trade has been manifested in the rally of the Euro-Yen cross rate (along with the Pound-Yen, Australian Dollar-Yen, and New Zealand Dollar-Yen cross rates). Given that the Euro-Yen is now again at the overbought level, both stock and currency “investors” should start to be careful here. Should the Euro-Yen cross rate rally over the next couple of weeks to over the 165 level, then there is a good chance that this author will trim down our 100% long position in our DJIA Timing System to 50% or even lower. Yes, we are worried all right.
Okay, let us now begin this commentary. As I have mentioned before, I normally don't keep track of what the IMF officially says (I do not have a high opinion of their economic forecasts if you really want to know) but the April 2007 issue (it is published twice a year) of the "Global Financial Stability Report: Market Developments and Issues" is definitely a must-read given the treasure-trove of information that the publication contains. According to the IMF, the report (GFSR) "assesses global financial market developments with the view to identifying potential systemic weaknesses. By calling attention to potential fault lines in the global financial system, the report seeks to play a role in preventing crises, thereby contributing to global financial stability and to sustained economic growth of the IMF's member countries."
Without going into forecasting, I believe the report does a very good job in communicating the possible risks to the world's various economies and asset classes - and especially letting the readers make up their own minds. Moreover, the Global Financial Stability Report is also a very comprehensive document. In the latest issue, the report seeks to cover everything from subprime mortgage risk to global imbalances (such as the US current account deficit and the Yen carry trade) to risks in the hedge fund industry, and the latest bottom in leveraged buyouts.
It will literally take four or five separate commentaries to cover all the issues mentioned in the latest issue of the Global Financial Stability Report. Over the next few weeks, I will attempt to pick out a few selected issues that are dear to our readers' hearts, or that have not been covered in the mainstream media, such as the latest investment trend in Sub-Saharan Africa and a case study of Zambia. For now, I want to give our readers a brief overview of what the IMF is currently watching and what their assessments are in terms of the type of different risks.
For those that do not have the time to read the 130-page report (I am assuming that 99% of you don't), I would encourage you do at least check out the two-page Executive Summary. This summary discusses quickly the organization of the document, with Chapter I focusing on “principal near-term risks,” while “chapters II and III examine the financial stability implications of two longer-term trends: the changing investor base from which global capital flows are sourced, and the globalization of financial institutions, particularly
Banks.” For the purpose of this commentary, I will be giving you a quick overview of the near-term principal risks covered in Chapter I, since this is what most investors and traders are concerned about for the most part.
Chapter I starts off with a discussion on the continued deterioration of the subprime mortgage market, as has already been discussed in a prior commentary. However, I would like to show you two more charts that speak further to this issue. The first figure is Figure 1.4 from the report, showing 60-day delinquencies in subprime mortgages by vintage year. Indeed, subprime delinquencies have historically peaked 18 to 27 months after origination, and based on the steep trajectory of the 2006 vintage mortgages, along with the fact that it has been only three months after the end of 2006, there is a very good chance that subprime delinquencies will continue to rise at least throughout the summer and possibly into the end of this year.
Of course, all the above will be a moot point if the 2006 vintage of subprime mortgages did not make up a significant portion of the mortgage industry. Unfortunately for the bulls, this is not the case, as shown by the following Figure 1.5 from the report:
As of January 2007, subprime mortgages made up 14% of the $5.8 trillion mortgage universe, with the Alt-A market (where we have started to see some troubles as well) making up 12%. That being said, the IMF concludes that “the weakness has been contained to certain portions of the subprime market (and, to a lesser extent, the Alt-A market), and is not likely to pose a serious systemic threat. Stress tests conducted by investment banks show that, even under scenarios of nationwide house price declines that are historically unprecedented, most investors with exposure to subprime mortgages through securitized structures will not face losses. These stress tests simulate how slowing house price appreciation would produce losses for asset-backed securities (ABS) collateralized by subprime mortgages. The stress test illustrated in Table 1.1 shows that tranches rated A and higher would not face losses unless house prices fell 4 percent per year for five years.”
There is no reason to doubt the above views of the IMF – at least not yet. To the extent that this latest episode does not dampen liquidity in the mortgage markets going forward, then the latest “washout” in the subprime and alt-a mortgage market is bullish for the stock market and the world's financial markets in the long-run. However, there are always repercussions when a large sector of the economy becomes irrational and starts to speculate – and we may now be witnessing these repercussions in spades, as legislation is now being drafted to effectively shut out subprime borrowers from owning their own homes going forward. This will place a significant restraint on not only the US mortgage market, but on global financial market liquidity as well. For those that have been sitting on the sidelines waiting to get back into the housing market again, however, the latest washout is a God-send and will most likely result in flat housing prices for years to come. If it is still more economical to rent versus to buy in your area, then I would suggest renting for now. There is no rush to get back in now and probably not for the rest of this decade.
The second risk factor highlighted in Chapter I involves the latest boom in the private equity industry, with an emphasis on the latest boom in leveraged buyouts. In IMF's own words: “Second, low interest rates and healthy corporate balance sheets have spurred an increase in private equity buyouts. This has led to a substantial rise in leverage in the acquired firms, potentially making such firms more vulnerable to economic shocks. The increased use of leveraged loans as part of financing also poses risks to some intermediaries that provide bridge financing to leveraged-buyout transactions. The situation bears careful attention, especially if a large high-profile deal runs into difficulty, as this could trigger a wider reappraisal of the risks involved.”
One of the two significant worries that the IMF discusses is the sheer amount of private equity financing that has gone on over the last few years. Indeed, the private equity industry is expected to raise a whopping $500 billion in 2007, up from $430 billion last year. Of course, these are only estimates, and past estimates over the last few years have always been lower than what was eventually raised. This large influx of capital into private equity funds since this bull market began in October 2002 is illustrated in the following Figure 1.9 from the report:
Another significant factor is the steady rise in leverage among the world's corporations since the last bear market ended in October 2002, not only in the Us but in Europe as well. Since records have been kept in 1997, both the US and European LBO leverage ratio are now at all-time highs:
Of course, not all is bleak. Specifically, the current leverage in both US and European buyout deals are nowhere near as high as they were during the peak of the last buyout boom in the late 1980s. Moreover, the adoption of the leverage loan market as the main source of funding for buyout deals has greatly broadened the investor base for this type of loans – meaning that these risks are now spread more evenly among many more participants – thus reducing the chances of a systematic shock: As the IMF states:
The degree of leverage in the current wave of deals is rising, although it remains low relative to the 1980s cycle. The ratio of debt to earnings before interest, tax, depreciation, and amortization (EBITDA) among European LBOs reached almost 5.5 times by late 2006, up from around 4 times in 2002 (Figure 1.10). Leverage ratios have followed a similar trend in the United States, with debt/EBITDA rising from 3.5 times in 2000 to 5.1 times in late 2006.
In contrast to prior LBO waves, much of the financing is from leveraged loans—defined as loans that carry an interest rate more than 150 basis points above LIBOR—rather than from the high-yield bond market. Unlike bonds, leveraged loans are sold though a process of syndication to a highly professional investor base. Also unlike bonds, loan contracts help overcome the collective action problem by providing for circumstances under which creditors can intervene and impose management changes if management fails to deliver on an agreed plan for the firm. Importantly, the expansion of the collateralized loan obligation (CLO) market has greatly broadened the
investor base for these loans, with institutional lenders eclipsing banks
Finally, Chapter I closes with a discussion on the rising capital inflows/outflows risks to a selected number of emerging market countries, as well as another discussion on “global imbalances,” such as the US current account deficit and the Japanese Yen carry trade. While the recent inflows have most probably been due to improving economic fundamentals, another reason can be attributed to “the search for yield” as emerging markets typically offer securities (both stocks and bonds) at yields that are significantly higher than one can achieve either in the United States or Europe or other developed regions (including South Korea and Taiwan). I will discuss this in this weekend's commentary – as part of our discussion on the Gambia case study as well as the “new frontier” of global investing.
As far as the US current account deficit and the Yen carry trade is concerned, I have covered this many times in our commentaries, and so I will not rehash any of my views here. Suffice it to say, I still do not believe the US current account deficit poses a huge problem, as long as US households' income is continuing to rise and as long as we do not embrace any protectionist policies. More importantly, the US current account deficit is a dubious number to start with, and there is no way anyone can track the money spent on services of global citizens since they don't show up at the ports of Los Angeles, New York, or Houston. The “exporting” of U.S. educations (the cost of getting a two-year full-time MBA at a top 10 school, including room and board, is now approximately $150,000), the delivering of investment banking and money management services, and delivering software over the internet are prime examples. As for the Yen carry trade, there are definitely risks – although at this point, I don't believe the reversal of the Yen carry trade is imminent, despite the fact that the Yen remains hugely undervalued to the Euro, Australia Dollar, and New Zealand dollar on a purchasing power parity basis.
Henry To, CFA