First, let’s take a look at the performance of the Shanghai Index compared to the US indexes over the past 6 months.
Despite earlier thoughts that the Chinese market had topped and shortly would implode; the Shanghai Index appears to be driving towards new heights. The robust growth in China’s economy and inflow of cash from new investors is driving the internal stock market. The situation appears to still be a “bubble”; the question being how much more can it inflate.
One interesting note is that the Chinese stock market from a correlation perspective is the least correlated with world-wide markets. On days the Chinese markets go up, the world markets are down… and visa-versa. The lack of correlation to the outside markets makes the Chinese market a potential safe haven as a component in a diversified portfolio. Straight-forward math in Modern Portfolio Theory (MPT) would indicate that people should have some component of their stock portfolio be Chinese indexes from a safety perspective.
The economic policies of the Chinese government isolate their stock markets from much of the outside risk. The implementation of yuan currency range setting, limiting monetary inflows/outflows, and limitations on external investment shield the Chinese stock market from some of the external excesses that are now becoming apparent in the credit liquidity crisis.
This is an interesting situation. The concept that a foreign stock market that many believe is in a bubble could potentially be a safe haven… may rewrite the concept of how risk should be evaluated in the financial markets.
Thursday, August 16, 2007
First, let’s take a look at the performance of the Shanghai Index compared to the US indexes over the past 6 months.
Wednesday, August 15, 2007
Many corporations carry a line item listed as “Cash Equivalents” on the balance sheet. By traditional definition, cash equivalents include U.S. government Treasury bills, bank certificates of deposit, bankers' acceptances, corporate commercial paper and other money market instruments.
As of 2006, corporate America has been sitting on record cash hoards.
Corporate America sitting on record cash stockpiles
Some large corporations such as Microsoft have over $20 billion in cash equivalents, placing them in a category where they are bigger then many fixed rate hedge funds. Cash equivalents of this size require an entire financial group for oversight and administration.
Earlier this year, the FASB proposed striking the term “Cash Equivalents” from corporate balance sheets in an attempt to improve reporting. Many companies have placed all sorts of assets into this column, some which may not be appropriate. The FASB wants to sort out items that should properly be defined as short term investments from true cash items.
FASB Moves to Nix "Cash Equivalents"
Corporations are regularly driven to seek the best yield on their “cash” stockpile. Many investment banks offered derivative products backed by mortgages that exceed the rate offered US Treasuries by a small percentage. Many of these products were hawked as being fundamentally safe from a risk perspective, and sold to pension funds, corporations, and other institutions.
The reality is that many of these bundled derivative products should have never been included under cash equivalents in balance sheets. Corporations do not fully disclose the cash equivalents that are held, so it is difficult for stock investors to get a sense of the quality of the holdings.
The recent liquidity crisis is bringing this situation to a head. There are probably a good number of corporate finance departments cringing as they re-evaluate their exposure to the CDO meltdown. Suddenly investments pushed by their investment banking partners have an entire new dimension of risk associated with them and are no longer “safe”.
This leads to the question – If the liquidity crisis continues will corporations have to re-state the value of their cash equivalents if any of the instruments held incur losses? What is the level of impact to the bottom line when these items are marked-to-market? How toxic are the cash equivalents on the books of America’s corporations?
Saturday, August 11, 2007
The Fed stepped into the market this week to inject an unprecedented amount of liquidity into the markets. On Friday, the Fed pushed $38 billion in temporary reserves into the system on top of the $24 billion added on Thursday. This is greater then the amount injected after 9/11. Similarly, the European Central Bank injected over $130 billion into their financial system.
Reserve acts to stem credit turmoil
The primary purpose of these injections was to prevent panic that would totally constrain credit and place the entire financial system under stress.
The other interesting note about the Fed’s operation is that they purchased mortgage-backed debt for cash. This type of temporary open market operation is rarely performed for mortgage debt, it usually involves the repossession of treasury or agency notes for cash.
Federal Reserve Bank of New York
Temporary Open Market Operations
At this point, it is a race to determine if the central banks can calm the markets by injecting liquidity and taking other steps to alleviate the credit crunch. The IMF and other entities have made statements that the turmoil should be “manageable”.
What lies ahead next week?
The expectation is that the markets will continue to see more of the volatile roller coaster ride that has been seen over the past couple of weeks. The market will be driven to daily extremes by a news-focused cycle due to the uncertainty surrounding the credit liquidity situation.
More stock volatility next week as Fed battles credit woes
In the meanwhile, more bad news continues to leak out from many major financial firms. With the SEC directly probing the books of Wall Street firms, they will quickly have to come clean publicly about credit losses due to mortgage debt. Most are expected to lose $1 billion or more. The announcements by these institutions regarding the exact nature of their losses are likely to help calm the markets, as firm figures can be associated with the losses rather then just speculation.
Citigroup seen taking $700 million in credit losses
SEC Probes Books of Wall Street Firms
SEC Probes Books of Wall Street Firms to Determine Their Exposure to Mortgage Turmoil
The mortgage credit issues appear poised to spread to other areas of the market. There is an expectation that junk bonds will be hit next as outlined by rating agencies such as S&P.
Credit troubles could spur more junk bond defaults: S&P
What should the Individual Investor do?
This is **NOT** the time to panic and drastically alter your allocations or investments. The purpose of diversified portfolio is to ride out these types of storms over the long term; you may take a temporary hit but if you are properly diversified then you still do well in the long term.
Investors need to evaluate their exposure to credit contagion in their money market funds, REIT holdings, and junk bonds. They should take steps to move any investments with exposure to other similar (but safer) investments (for example moving a brokerage CDO-backed money market funds to a FDIC-insured bank money market).
Note that money-market funds are traditional thought of as “safe”. Unfortunately money markets funds may be the asset area where the individual investor most likely has potential exposure. Many money market funds at brokerage and mutual funds firms are backed by mortgage related CDOs. Investors need to read the prospectus to identify the underlying holdings in their non-FDIC protected money market funds. After this they need to investigate the holdings on the web, or call their brokerage firm or mutual fund directly to determine if the holdings are backed by mortgage-related CDO debt.
Is Your Money Market Fund Safe?
Despite the turmoil, investors should not greatly alter their overall diversified portfolio due to the liquidity issues seen in the credit market. In long-term investments such as 401K plans, investors should remain properly diversified without significant alteration of their allocations to each of the selected funds. Keep in mind the long term picture rather then the short-term fear generated in the financial press.
Friday, August 3, 2007
There are increasing signs that the mortgage crisis is traveling up the lending food chain. Recently, banks are drastically increasing rates, and refusing to underwrite Alt-A and other loans. Rates on jumbo loans from a number of institutions are over 8%.
Wells Fargo Raises Rates: Are Homeowners Out In The Cold?
Top Lender Sees Mortgage Woes for ‘Good’ Risks
The increasing institutional jitter in the mortgage market is spilling over into other debt instruments. Over the past few weeks the overall credit marketplace has become more risky. There is an inability to price and sell debt of any type, and a significant loss of liquidity. This situation is likely to have a significant impact on real estate, lending, and the stock market.
Many recent headlines reflect his concern. Comments from the Bear Stearns CFO regarding the bond market are being generally held responsible for driving the stock market into a selling frenzy late today.
Bond turmoil worse than Internet bubble: Bear CFO
Other recent articles also reflect the concerns regarding credit and liquidity risk.
Tighter credit could slow U.S. GDP growth
Five Signs That Subprime Infection Is Worsening
Stopping the Subprime Crisis
'The subprime crisis has not been averted. In fact, it is still largely ahead of us."
It is also startling how quickly some major mortgage companies implode. This problem is no longer constrained to sub-prime. American Home Mortgage specialized in medium-risk "Alt-A" mortgages, and didn't deal in subprime loans. Its recent demise was shockingly rapid, and underlines the expanding credit market mess.
American Home Mortgage to shut down
Multiple hedge funds have recently revealed to be worthless after losses; including the complete wipeout of two Bear Stearns’ funds and the termination of redemptions on another.
Bear Stearns Halts Redemptions on Third Hedge Fund
There is increasing speculation among some market pundits that Bear Stearns may go completely under; imploding in an unprecedented chain of credit derivative failures. If this type of failure occurs, what does it imply for other leading firms involved in the mortgage credit derivative market such as Lehman? Or firms such as JPM with huge general derivative exposures?
Many times when determining risk relative to the market; it is usually best to outline various scenarios and assign probability to each. Define the required investment actions needed to reduce exposure relative to a particular scenario, and then arrive at an overall plan to ease your portfolio risk.
What are the Best, Middle, and Worst cases for the impending Credit Crunch?
The information below outlines some thoughts on the best, middle, and worst case scenarios. Until recently, most analysts believed that we were solidly in the best case scenario. There appears to be increasing risk that the economy is sliding towards the middle case as the credit liquidity problems intensify.
The best case scenario is that most real estate markets in the U.S. correct between 3-7% (we are there now) and recover somewhere late in 2008. In this scenario, Wall Street will be very volatile this summer as more bad debt news comes out and there are signs of economic weakening due to mortgage-linked consumer spending problems. Over the short term, the market bounces up and down in a news-driven cycle embedded in an environment reflective of fear and uncertainty. VIX and VXN reach new local highs reflecting the volatility. Risk premium is priced back into the debt market forcing down the prices of lower-grade debt. The stock market shakes off the credit news in the fall timeframe (Sept- Nov) and continues the upward trend. Earnings from corporations remain solid, and mainstream corporate debt reflects solid pricing withstanding any credit concerns. The economy avoids any recession in 2008.
The middle case outlines a situation in which most local real estate markets correct between 7 to 20% and do not recover well into 2009. The U.S. stock market starts to slide deeply over the next few weeks as the bad debt news spreads to prime mortgages, junk corporate debt, and PE/LBO debt. Mortgage rates increase greatly on non-standard fixed rate loans, and lenders refuse to underwrite several types of mortgages. The debt market yields increase and bond values across the board dive. Moody's, S&P, and other rating agencies will be down-grading bonds like mad with pressure from regulators and Wall Street to get ahead of the curve of defaults. Consumer spending weakens and unemployment increases causing the stock market to enter a recessive slide for several months with limited recovery near the end of 2008. After most of the damage is done, the government statisticians come out stating that a recession occurred for a period of time.
Recent articles outlined the increasing expectation of no real estate recovery till 2009, and the contagion of credit concerns to other types of debt. Consumer confidence has been decreasing in recent surveys, and the recent unemployment report showed an increase to 4.6%. Much of the information associated with the “middle case” scenario is more readily apparent in recent news.
The worst case scenario shows 30%+ adjustment in many local real estate markets, and Wall Street panic as the leveraged debt market completely falls apart akin to a feeble house of cards and requires government & banking bail-out. The evils of CDOs is constantly in the news as the "toxic waste" that destroyed the economy. Many major lenders go under. Several hedge funds implode each day taking down pension plans and other institutional entities in droves. The words "death spiral" is readily apparent in articles about consumer spending while politicians debate a solution for the unemployment crisis. The world stock markets re-entrench considerably before the end of this year. The impact would be world-wide as trade and other key economic engines are hit. World debt conditions would remain jittery, reducing the amount of available credit to major corporations and countries, many who start defaulting on loans.
Until a couple weeks ago, most pundits thought the best case scenario was the most probable. The deteriorating credit conditions over the past two weeks enhance the risk that a scenario resembling the middle case will occur.
What are the key things that an investor should do to ride out a potential storm? First, keep your long-term portfolio properly diversified. In the short term, rotate out of junk bonds, mortgage-focused R.E.I.T.s and other investments that are likely to take significant credit based hits.