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A Timely Liquidity Update

(April 23, 2009)

Dear Subscribers and Readers,

As we discussed in our February 8, 2009 commentary (“Evaluating Industries and Competitive Advantage”), one of the industries that is still deleveraging and that we have been monitoring is the casual dining industry.  Similar to our thesis on the retailing and specialty retailing industries, the ongoing leveraging in this industry – forced by the decline in consumer discretionary spending – will eventually be beneficial to the survivors, as the survivors will be able to enjoy higher pricing power and as operators will be less aggressive in expanding and opening new casual dining concepts for years to come.

As we have covered earlier, the casual dining industry as a whole is still (amazingly) adding capacity.  In fact P.F. Chang's (PFCB) – the second most successful casual dining chain on a sales per store basis – announced their intentions to expand their capital expenditure spending for the rest of 2009 on Wednesday evening.  Specifically, Morningstar believes that P.F. Chang's management plans to develop as many as 14 new stores this year, versus previous guidance of 6 to 10.  Digging deeper into the headlines, there is no doubt that the casual dining industry is undergoing a significant transformation.  While the industry as a whole will continue to shrink for the next couple of years, there will inevitably be some concepts that will outperform – specifically concepts that have been able to differentiate themselves (such as Cheesecake Factory) and to cater to the national change in tastes.  In other words, the traditional “steakhouse” such as Outback Steakhouse or the traditional “Italian restaurant” such as Olive Garden should continue to experience a structural decline in market share going forward.  Valuations aside, there is no way this author would ever buy restaurant stocks such as Brinker's (EAT) or Ruby Tuesday (RT).

Deleveraging within the casual dining industry aside, both the US Treasury and the Federal Reserve have continued to commit to “reflating” the US economy.  With the stock market up more than 20% and with credit spreads narrowing since early March, it looks like the Feds are starting to win the battle.  For the latest week (from April 15 to April 22), total reserve bank credit (i.e. the size of the Federal Reserve's balance sheet) increased by approximately $70 billion, with $26.2 billion of that increase coming from the outright purchase of GSE debt (including GNMA) and MBS, as seen in the following table courtesy of the NY Fed (which shows gross purchases only):

Gross purchases from April 16 through April 22: $41,450 million. Net purchases from April 16 through April 22: $26,200 million.

The size of the Fed's balance sheet is now a whopping $2.17 billion.  Since its most recent bottom in early February (when the size of the Fed's balance sheet declined to $1.83 billion, from a high of $2.22 billion in late December), the size of the Fed's balance sheet has increased by a whopping $340 billion (interestingly, the stock market embarked on another round of liquidation after the Fed started shedding assets in late December).  Given its current trend, total reserve bank credit will most likely surpass its old highs of $2.22 billion in the next couple of weeks.  Following is a weekly chart showing total reserve bank credit over the last ten years:

Reserve Bank Credit (WRESCRT)

In its latest March 18, 2009 meeting, the FOMC indicated that the Federal Reserve would purchase an additional $1.15 trillion in long-term Treasuries, agency debt, and agency mortgage-backed securities in order to provide further liquidity to the housing and mortgage markets.  If the Federal Reserve decides to make good on its entire promise – and assuming that the Fed does not wind down their other liquidity/credit lines (such as swap lines with other central banks), total reserve bank credit should surpass $3 trillion in the next 4 to 6 months.  In our opinion, this should be sufficient in bringing down mortgage costs and general borrowing costs, and increasing the availability of mortgage loans.

What the Federal Reserve cannot do is to directly reliquify the system by “fixing” the balance sheets of the 19 major national and regional banks.  The restoration of these banks – on both a solvency and a confidence basis – will fall on the shoulders of the US Treasury and to a lesser extent, the FDIC.  On a most immediate basis, the “stress test” for the 19 major banks is clearly the major focus.  The detailed methodology for evaluating the banks will be released later today, while the actual results will be released on May 4.  At this point, we believe the results would look “credible” to investors – as the Fed's “adverse” stress test scenario looks reasonable stretching out to the end of 2010 (8.9% unemployment rate by the end of this year, and 10.3% by the end of 2010, with a 3.3% real GDP decline this year and a real GDP growth of 0.5% in 2010).

Looking further out, the Feds will force the banks that fail the stress test to either engage in a recapitalization (through private capital or a conversion of TARP funds into common equity) or asset sales (potentially through the PPIP) to rebuild their balance sheets.  Affected banks are expected to commit to a recapitalization program by May 25.  Sometime in June, the FDIC will start conducting test asset sales under the PPIP – with the program expected to start operating later in the same month.  The deadline to raise private capital will be sometime in October.

I will offer my thoughts and analysis on the IMF's latest Financial Stability report this weekend.  For now, it looks like the Obama administration should succeed in reliquifying the mortgage markets and recapitalizing the US banking system.  With respect to the latter, we believe that there are sufficient funds in the remaining portion of the TARP (about $100 billion) to recapitalize the 19 banks undergoing the stress test – in addition to the initial amount that could be converted from Tier 1 capital to common equity if needed (note that the Feds are clearly focused on the common equity ratio).  The danger, of course, is in the implementation of such a plan, as there are many political/executive issues that still need to be hashed out.  Assuming that we maintain some stability in the global banking system, any stimulus or new liquidity facilities implemented by the Fed should provide tremendous benefits to both the US and global economy (and of course, the stock market).  In the meantime, we will continue to monitor the actions of the European Central Bank – as it is clearly behind the curve in its easing policy (which we have discussed since last summer, when it raised rates by 25 basis points in the middle of a global financial crisis!).  Various German economic think tanks are now calling for the ECB to adopt a “quantitative easing” policy.  We couldn't agree more – as this is the only way that the region (including Central and Eastern Europe) could avoid a full-scale bust.

Again, I will put together more thoughts this weekend.

Signing off,

Henry To, CFA

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