The 2008 Global Financial Stability Report
(April 10, 2008)
Dear Subscribers and Readers,
Here is a random thought to start off our mid-week commentary:
If “subprime” and “monolines” were the two least favorite words in the financial markets in 2007, then the third least favorite word has to be “run-off.” As discussed in a Barron's article back in January, value investors such as Third Avenue's Marty Whitman, Davis Selected Advisors, and private equity firm Warburg Pincus bought in MBIA late last year, its “run-off” value – as opposed to potential value after taking into account mark-to-market losses was estimated to be in the $30 to $40 range. Even should the “consensus view” of a further 10% decline in housing prices take hold, many analysts assert that this estimate will most likely not change – as bond insurers such as MBIA and Ambac only guarantee the timely payment of interest and principal over the life of its underlying obligations. Therefore, from a cash flow standpoint, higher defaults in mortgages would not result in an immediate hit to its balance sheet, although based on GAAP accounting, the bond insurers would need to take significant write-offs. Since the Barron's article, however, the stock is still languishing, trading within the $10 to $15 range over the last ten weeks. Another stock that has recently took a hit – despite its estimated run-off value of around $7.50 a share – is First Marblehead (FMD). The company, one of the largest securitizers of student loans in the country, took a hit (declining from $7.70 to $4.63 a share) over the last couple of days in light of a bankruptcy filing by its guarantor, the Education Resources Institute.
Given the (still) playing out of the liquidity and credit crunch over the last six months, such risk aversion isn't totally surprising. Aside from the usual sentiment indicators that we track, such as the AAII and Investors Intelligence surveys, the ISE Sentiment Index, the equity put/call ratio, the dramatic surge in money market assets, and the unprecedented “blow out” in credit spreads over the last six months, other major indicators have also indicated that investor risk aversion has increased tremendously over the last few months. Following is an excerpt from the April 2008 IMF “Global Financial Stability Report” showing four of these indicators, including the Merrill Lynch Fund Manager Survey, the State Street Investor Confidence Index, total inflows into emerging market bond and equity funds, and the Goldman Sachs Risk Aversion Index:
Two of these indicators (the Merrill Lynch Fund Manager Survey and the Goldman Sachs Risk Aversion Index) are now showing risk aversion levels not seen since late 2002/early 2003. Meanwhile, the State Street Confidence Index is now indicating risk aversion – on the part of institutional investors – that is historically unprecedented. Undeniably, unless or until the G-7 and the Financial Stability Forum agree on a plan for coordinated policy action (hopefully to come as early as this weekend), it is definitely still too early to expect investors to deploy their capital into riskier assets. On the other hand, fund inflows into emerging market securities – while slightly negative – have not totally fallen off a cliff – signaling that the “decoupling thesis” still holds water, for now. More importantly, it is a sign that risk aversion is, for the most part, domestic in nature – suggesting that when the reversal ultimately comes, most of the strength will be focused in domestic risky assets.
Speaking of the IMF Financial Stability Report, the latest April 2008 issue (it is published twice a year) was just released earlier this week. While I do not have a high opinion of their economics forecasts (after all, they stated in their April 2007 report that “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 securitization will not face losses…”), the report is definitely a must-read given the treasure-trove of information that the publication contains. To their credit, the IMF has also gone to great lengths to disclose their assumptions as well as the most up-to-date and relevant market data and their interpretations. According to the IMF, the Global Financial Stability 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." Again, 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 the current liquidity and credit crisis (tackling issues such as the rise in mortgage delinquencies, the rise in hedge fund margin requirements, rating agencies, and central bank interventions) to the rise and the role of Sovereign Wealth funds, as well as the latest macro and financial indicators of selected emerging market countries.
It is beyond the scope of this mid-week commentary to discuss all of these issues, as it will literally take three or four separate commentaries to tackle all the issues mentioned in the GFSR. In this commentary, I will attempt to tackle one of the most contentious issues raised in the GSFR (I will cover other interesting issues raised by the IMF in this weekend's commentary) – i.e. the IMF's $945 billion in estimated loans and securities losses stemming from this credit crunch, up from its estimate of “only” $240 billion in the October 2007 issue of the Global Financial Stability Report. The following table shows the IMF's latest loss estimates based on mark-to-market accounting relative to its estimates back in October 2007:
Again, note that these are all mark-to-market estimates – which are inherently unreliable in a liquidity-constrained market such as what we are currently experiencing (in such an environment, such losses can feed on themselves as investors further bid down risky assets because of these write-downs, which lead to further write-downs, losses, and so forth). Interestingly, the estimates losses in the CMBS alone make up $210 billion. Just six months ago, the IMF did not even bother to model losses in this category. To the IMF's credit, the report does acknowledge the fact that a significant portion of the recent blowout in CMBS spreads were due to technical and liquidity factors, as well as the transition of hedging activity from the structured finance ABX indices to the CMBX indices. Indeed, as we have discussed earlier, at its most recent peak, CMBS spreads were implying a default rate in the commercial real estate market of as high as 80%, when historically, the worst period in this market saw lifetime defaults on these bonds reach just over 30% (this would be the 1986 vintage). In addition, the IMF further acknowledges that while the commercial real estate market is now showing signs of strain, there are significant differences between this and the residential mortgage sector that should prevent losses in this sector intensifying to the extent we have seen in the residential sector. Quoting the IMF:
First, only about one-quarter of the commercial real estate sector is securitized, substantially lower than the 80 to 90 percent securitization rates observed in the subprime residential market at its peak, and there is less repackaging into structured products. This should increase the “skin in the game” for the sector as a whole. Second, commercial mortgage borrowers are less likely to face payment shocks associated with resetting mortgage rates, since most commercial mortgages are standard, 7- to 10-year fixed-rate loans. Third, borrowers in the commercial sector typically have audited financial statements, which should help keep the incidence of fraud well below that observed in the residential subprime sector.
Aside from the fact that commercial real estate investors represent “smarter money” than your average subprime borrower (although we should recognize the fact that they are not immune from exhibiting “irrational exuberance”), we should recognize that lending standards in general have remained sound in this sector, despite the fact that cap rates are still generally near all-time lows. Specifically, there were practically no cases of “soft fraud” such as what we witnessed in the residential sector, including loans that were based on falsified income levels, or even to folks with no income, no savings, and dismal credit scores. We will continue to keep track of the CMBS market, but for now, we find it highly unlikely – short of a Great Depression scenario – that losses in this sector would come near $210 billion once the credit crunch is over.
Note that cash indices were used to estimate consumer ABS and high-grade corporate debt securities. Since these cash indices did not have the same technical and liquidity problems that plagued the structured finance indices, no losses were estimated for consumer ABS and high-grade corporate debt securities, as the corresponding cash indices have been positive over the past year. Indeed, the major flaw in the IMF's analysis is now highly obvious – that is, how could any analyst estimate an aggregated loss of $450 billion in the ABS and ABS CDO market while at the same time providing a “no losses” estimate for the consumer ABS sector? Stranger things have happened – especially in the financial markets – but my sense is that once most of the smoke clears, it would be apparent that ultimate losses would come nowhere near IMF's estimate of $945 billion. Even should this “worst-case Armageddon-like” scenario come to pass, subscribers should note that as a percentage of U.S. GDP (which is in itself a very conservative measurement since these losses are spread out across the globe), the losses incurred from this crisis would still rank below that of the Japanese banking crisis and the Asian crisis, as shown in the following figure courtesy of the IMF:
Henry To, CFA