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Foreign Liquidity Looks Encouraging

(May 7, 2009)

Dear Subscribers and Readers,

First things first.  According to the US Treasury, the final results of the “stress test” of the 19 largest bank holding companies will be released later today, at 5pm EST.  The assumptions of the stress test take into account the Treasury's “more adverse” scenario – with a target Tier 1 ratio of 6% and a common equity risk-based ratio of 4%.  The Treasury emphasized that this is intended to be a “what-if” scenario, as opposed to a projection of the banks' future losses.

The disclosure of only the results under the “more adverse” scenario is designed to boost confidence in both the US financial system and the US economy.  Preliminary results suggest that the 19 bank holding companies would need a total of $66.5 to $67.5 billion in common equity capital.  On an individual level, any additional capital could be raised as part of a secondary equity offering, a conversion of preferred stock to common stock, or sales of operating units (e.g. Citigroup just sold its Japanese brokerage unit, which freed up $2.5 billion of common equity).  Not surprisingly, Bank of America is expected to require the most capital ($34 billion), followed by Wells Fargo ($15.0 billion), GMAC ($11.5 billion), and Citigroup ($5.0 billion).  More importantly (and interestingly), the shares enjoyed a significant rally yesterday, despite the threat of further dilution of equity shareholders.  Most likely, investors are (finally) regaining confidence in our banking system – suggesting that investors view the stress test as credible and conclusive.  Note that the higher these stocks rally, the less dilution there will be when the common equity is raised.  For example, Bank of America's market cap rose from $69 billion at the close on Tuesday to $81 billion yesterday.  With a market cap increase of $12 billion, a $34 billion equity offering (or conversion) would result in a 30% dilution of equity shareholders, as opposed to a 33% dilution if the offering was done on Tuesday.  With a close to $70 billion boost in common equity, the lending power of the 19 banks (assuming a 10-to-1 leverage ratio) would increase by $700 billion.  This is equivalent to a 10% increase in the amount of loans and leases under bank credit, per the latest Federal Reserve data.  In other words, a $700 billion increase in lending power is not insignificant – and is probably sufficient to pull the US out of its recession, assuming the lending power is fully utilized.

Thankfully, the US has not been alone in finding ways to reflate its own and the global economy.  The Bank of England, for example, voted at its March policy meeting to adopt a “quantitative easing” policy to purchase £75 billion in assets financed from central bank reserves (i.e. by “creating money out of thin air”).  From March 12th to March 26th, the Bank of England purchased a cumulative £982 million in commercial paper, £13.0 billion in UK gilts, and £128 million in corporate bonds, as shown in the following table (courtesy of the Bank of England's 2009 Q1 Asset Purchase Facility Report):

Asset purchases by type

Since March 26th, the Bank of England has purchased an additional £535 million in commercial paper, £31.5 billion in UK gilts, and £420 million in corporate bonds.  In other words, since the beginning of its asset purchases on March 12th, the Bank of England has printed more than £46 billion to purchase commercial paper, UK gilts, and corporate bonds!  In proportion to the size of its domestic economy, this is one of the most aggressive easing policies in modern times.  While interest rate spreads have narrowed slightly, critics claim that the Bank of England is still not doing enough by purchasing more commercial paper or corporate bonds.  Still others assert that the Bank of England should announce that it stands ready to utilize the full £150 billion maximum as set by the Chancellor of the Exchequer.  We should have a better understanding of what the Bank of England seeks to do sometime today, once the Bank of England announces the results of its two-day monetary policy meeting.

Over in Japan, the Bank of Japan has also gotten more aggressive in recent months, as indicated by the following monthly chart showing the year-over-year growth in the Japanese monetary base, the change in the year-over-year rate of growth (the second derivative), and the year-over-year change in the Nikkei 225 Index from January 1991 to April 2009:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly)(January 1991 to April 2009) - With the y-o-y growth in the monetary base rise to 8.2% (its highest level since March 2004), liquidity conditions in Japan are starting to be bullish for its equity market - especially given the extreme divergence between them...

As shown in the above chart, the year-over-year growth in the Japanese monetary base just reached another five-year high of 8.2%.  More importantly, the divergence between the growth in the monetary base and the change in the Nikki Index has now reached an extreme.  Assuming the Bank of Japan continues to ramp up its monetary base, this implies a much higher Japanese stock market over the next several months.  The resurgence of the Japanese stock market is also supported by strong liquidity in Asia in general – as exemplified by the aggressive expansionary policies in China, as well as the creation of the US$120 billion “crisis fund” by the 10-country ASEAN under the “Chiang Mai” initiative.

We will have more to say about liquidity conditions in the Euro Zone and Central and Eastern Europe this weekend, after the European Central Bank announces its latest monetary policy decision (and whether it will take additional steps to combat the financial crisis in Europe).  For now, Europe remains the most vulnerable region – although as we have mentioned before, the ongoing (and the promise of) IMF aid should provide enough support for Central and Eastern Europe to get through this summer at the very least.  With the year-over-year growth of M-3 slowing down to just 5.9% in February (see below table, courtesy of the ECB), both the ECB and fiscal policy makers have their work cut out for them.

Summary table of monetary variables

Signing off,

Henry To, CFA

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