Botox Cures – Part 1

Botox (botulinum toxin), a highly toxic neurotoxic protein produced by Clostridium Botulinum, is commonly used in cosmetic procedures. Botox is sometimes injected to improve a person’s appearance by removing facial lines and other signs of ageing. The effect is temporary and can have significant side effects.

The global economy is currently taking the “botox” cure. A flood of money from central banks and governments – “financial botox” – has temporarily covered up unresolved and deep-seated problems.

Bad Risks…

In 2009 there was a ‘recovery’ in financial asset prices. The low or zero interest rate policy (“ZIRP”) of major central banks helped increase asset prices. Very low returns on cash or near cash assets forced investors to switch to riskier assets in search of return. Even Pimco’s Bill Gross discovered that his cash assets paid near zero returns.

The chase for yield drove rallies in debt and equity markets. Low interest rates acted like amphetamine as investors re-risked their investment portfolios.

High credit spreads for investment quality companies, driven by the panic of late 2008 and early 2009, subsided and rates returned to pre-Lehman levels.

Credit spreads for investment-grade borrowers fell to just over 100 basis points from their highs of 300 basis points in March 2009. Credit spreads for non-investment grade or junk borrowers market fell to over 500 basis points from the high of 1,300 basis points in the same period, driving returns of over 50 % pa. Extremely low rated bonds, such as CCC rated bonds (a mere one notch above default), generated even higher returns falling from rates of 30-40% pa to around 10% pa.

Debt markets were also underwritten by central bank purchases of structured securities. Central banks were the buyer of first and last resort for asset backed securities (“ABS”) and mortgage backed securities (“MBS”) driving large gains for holders.

Stocks rallied, in part, because of the dividends on offer. Another driver was fear of inflation, based on the loose monetary policies of central banks.

Re-risking was helped by the return of the “carry trade” as investors used near zero cost funds, especially in dollars, to finance holdings of risky assets. Any asset offering a reasonable return rose sharply in value. Morgan Stanley analyst Greg Peters outlined the outlook for 2010 in the Financial Times: “We like the junkiest of the junk…”

As the recovery became widespread spreading across most asset classes, naysayers were dismissed as perma-bears. As everyone knows: “A bubble is a rising market that one is not invested in; if one is invested, then it is a bull market.”

In contrast, the real economy, at best, stabilised during 2009. Most economies, with the exception of Australia and some emerging markets, most notably China and India, contracted during 2009. In Australia, which avoided a recession, GDP per capita actually fell (by around 1.5% pa.). Key real economy indicators, including employment, consumption, investment and trade, remained weak.

Massive government intervention helped arrest the rate of decline of late 2008/ early 2009. Without government support, it is highly probable that most economies would have been in serious recession. Elements of the package resembled Soviet Gosplans. Just as China practised capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.

Investor sentiment ignored delays in the implementation of government initiatives. The Public Private Investment Partnership (“PSIP”) was deferred and then reduced in size. The much touted loan modification program was also delayed with only around 24% of eligible loans being modified. There was also evidence that even after modification a high percentage of these loans became delinquent.

Despite speculation on the “shape” of the recovery – “V”, “U” or “W”, key issues are unresolved. Major risks in the financial and real economy remain and may disrupt the hoped for resumption of business as usual.

Bad Banks…

Capital injections, central bank purchases of “toxic” assets and explicit government support for deposits and debt issues helped stabilise the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.

In their September 2009 Financial Stability Report, the International Monetary Fund (“IMF”) forecast total losses from the Global Financial Crisis (“GFC”) of $3.4 trillion of which $2.8 trillion would be borne by banks. Approximately $1.5 trillion of those losses, around half of which was attributed to European and U.K. banks, had not been recorded and were expected between Quarter 2 2009 and Quarter 4 2010.

In December 2009, the European Central Bank (“ECB”), who are more optimistic than the IMF, forecast that Euro-zone bank write-downs between 2007 to 2010 could potentially reach €553 billion ($774 billion) of which some €187 billion ($262 billion) (34%) have not been recognised to date. The ECB feared a second wave of losses reflecting weak economic conditions.

Despite capital injections from governments and/or share issues taking advantage of the recovery in stock prices, bank capital positions remain under pressure from the risk of further losses. For example, the four largest U.S. banks have bad debt reserves of $130 billion (4.3% of loans) and capital of $400 billion against total assets of $7,400 billion. Difficult to value Level 3 Assets (known as “mark-to-make believe” assets) are estimated at around $346 billion, slightly less than the capital available. The current market fair value of loans for these banks is estimated to be $76 billion below the carrying value.

Proposed regulatory changes increase the capital required to be held by banks against risky assets, restrict the types of instruments qualifying as bank capital and place absolute limits of leverage. This may require banks to raise capital to meet the new requirements although implementation of the rules has been deferred.

In 2009, strong earnings of major global banks helped re-build their capital. Credit losses and declines in investment banking revenues (down around 50% reflecting equivalent declines in deal volumes) were offset by an increase in trading revenues. Higher trading revenues reflected increased volatility, higher bid-offer spread and reduced competition. Trading revenues reflect increased risk taking and require capital. Higher trading earnings may not be sustainable reducing their contribution to restoring the banks’ capital base.

Banks are likely to remain capital constrained in the near future reducing availability of credit. The capital shortage is estimated at around $1-2 trillion implying a potential contraction of 20-30% from pre-crisis levels. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage.

High volumes of bond issues indicate a slowdown in and switch from bank lending rather than a return to normalcy in debt markets. Small to mid sized companies without access to public debt market, in particular, are likely to face difficulties in obtaining credit.

Despite its merits, recent initiatives – the “Volcker” rule – limiting banks’ proprietary trading or investing in hedge funds and private equity may further restrict the availability of credit. Firstly, it will reduce earnings limiting internal generation of capital. Secondly, it will further restrict the “shadow banking” system which helped the rapid build-up in credit in recent years.

Constraints on availability of credit and its higher costs are a risk to economic recovery.

Bad Loans…

Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one-in-ten householders are at least one payment behind (Quarter 3 2009) up from one-in-14 (Quarter 3 2008). If foreclosures (now at 4.47 % up from 2.97% one year ago) are included, then one-in-seven mortgages are in some form of housing distress.

Recent stability in U.S. house prices may be misleading reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed’s MBS purchases.

The value of 20-30 % of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures. Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve.

Rising vacancy rates, falling rentals and declining values of commercial real estate (“CRE”), primarily office and retail properties, are apparent globally.

In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames – the 12-storey Watermark Place – for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times:”… I’m unlikely to see [the terms] again in my career.”

Global commercial property lending is around $3,400 billion, 25% of which has been repackaged into commercial mortgage backed securities (“CMBS”). Current values of many properties are substantially below the loan amounts outstanding. Many CRE loans are in breach of covenants. Lenders have waived breaches of loan conditions and extended maturities.

Lack of liquidity, low sales volumes and difficulties in financing purchases have discouraged owner or lenders from seeking to sell properties. Sales at low values would also necessitate lenders recognising losses on other CRE loans not been written down to current distressed values. CMBS Delinquencies are currently around 3.5%, expected to peak at an estimated 10-12%.

Leveraged or private equity loans also face difficulties. Terra Firma’s £4 billion purchase of EMI, financed in part by a £2.6 billion loan from CitiGroup, is an example of the problems. In the recession, EMI’s revenues fell by around 20% and losses tripled as cost savings were offset by higher interest charges. Analyst’s estimate that EMI’s value is around £1.4 billion, below the level of its debt.

In 2009, Terra Firma wrote off half its investment in EMI and offered to inject £1 billion in equity but only if CitiGroup would write off a similar amount of debt. The bank refused. Subsequently, Terra Firma commenced legal proceedings against CitiGroup claiming unspecified punitive damages on top of the £1.5 billion plus write down of its investment.

Many recent private equity loans were cov lite (covenant light); that is, they lacked usual protective covenants requiring borrowers to meet financial tests, typically minimum amount of shareholders funds, loan to equity ratios and minimum coverage of debt and interest payment by the borrower’s earnings or cash flow. Some loans, known as ‘toggle’ loans, included a pay-in-kind (“PIK”) feature where borrowers have the option to pay interest by issuing an IOU. This means that the lender cannot declare in absence of a failure to make scheduled cash payments default deferring recognition of problems. In the absence of a significant recovery in economic conditions, further losses may occur.

Borrowers face significant refinancing risks. Over the next 5 years over $4,200 billion of debt will need re-financing, including $2,700 billion of CRE loan (peaking in 2011) and $1,500 billion of leveraged loans (peaking in 2014).

Securitisation (CMBS and CLO (“Collateralised Loan Obligation”)) markets, which were crucial in funding CRE and private equity transactions, remain troubled. According to one estimate, if the CLO market remains closed and half 2012-14 leveraged loan maturities were re-financed in the high-yield bond markets, then issuance volume would need to be double 2006 peak in high-yield bond issuance to accommodate this requirement. Similarly, the equity injection needed to re-finance commercial real estate debt maturing by 2014 is estimated at between $200-750 billion.

Default and re-financing risk remain high. The problems of Dubai World, in substantial part, relate to commercial property and refinancing risk.

Real Bad…

The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. As Wells Fargo CEO John Stumpf told the Wall Street Journal on 19 September 2009: “If it’s not a government program, it’s basically not getting done.” Private demand remains somnolent. The problem remains as government incentives encourage current consumption and investment but ultimately “steal” from future demand.

Employment, a key indicator given the importance of consumption in developed economies, continues to decline albeit at a slower pace. In the U.S., unemployment reached 10%. Despite attempts to put positive spin on the numbers, the rise in U.S. unemployment was the highest recorded since World War II.

In many countries enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.

Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long term and youth employment also remains high.

European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new “export” as guest workers are shipped back to their country of origin or remittances home fell sharply.

U.S. economic activity is not generating the 200,000 to 250,000 jobs per month that would allow unemployment levels to fall. In addition, newly created jobs are part-time, casual or at lower income levels.

Economic uncertainty has increased saving levels further crimping consumption.

In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure. In the U.S. dividend cuts have resulted in investors losing approximately $58 billion in income in 2009. It is unlikely that dividends will recover to 2007 or 2008 levels until 2012 to 2013. The ability to borrow against rising asset prices to fund consumption is no longer readily available.

In 2009, global trade stablised after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009 world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. The OECD reported that G7 exports stabilised in Quarter 2 2009 levelling off at a year-on-year decline of 23.3%. There is concern that trade flows in late 2009 were stagnant or declined as the effects on government stimulus, inventory restocking and Chinese commodity purchases slowed.

Trade protectionism threatens recovery in global trade. Despite repeated statements reaffirming a commitment to free trade, most countries have implemented implicit and explicit trade barriers. Traditional techniques (tariffs, embargoes, subsidies) have been supplemented by “buy local” programs, selective industry support schemes and directed lending to domestic borrowers. Emerging markets have been aggressive in introducing protectionist policies. Trade disputes may increase, particularly if economic recovery stalls and unemployment remains high.

Stock prices assume a rapid recovery in corporate earnings. Beating much reduced expectations and a return to previous earnings levels are easily confused.

The “E” in the PE ratio remains difficult to forecast. Equity pricing assumes a return to 2006 levels when U.S. corporate earnings represented a record share of profits in GDP.

In 2009 full year earning per share for the S&P 500 are around $60, down from US$65 in 2008 and 30% below peak earnings of US$85 recorded in 2006. In 2009, company results reflected the effects of aggressive cost cutting and the benefits of government support. To return to pre-crisis levels and rates of growth, improvements in revenue and underlying demand are necessary.

Stocks are also not cheap. Jeremy Grantham, founder of Boston-based fund manager GMO, recently noted ruefully that after 20 years of more or less permanent overpricing of the S&P 500 the market saw just five months of underpricing after the March 2009 trough.

Growth in emerging markets reflects the effect of aggressive government policies to stimulate the economy both at home and in developed countries. Emerging markets, led by China, India and Brazil, implemented anti-cyclical spending programs, that in percentage terms were larger than those in developed markets. Emerging markets preserved or introduced social spending programs to protect more vulnerable parts of the population. They also benefited from the government spending in developed economies, which flowed into emerging market exports.

The spending has fuelled speculative booms in emerging markets and also in commodity suppliers who now function as proxies for direct exposure to China and India.

The boom was exacerbated by the rapid flow of funds into emerging markets. In 2009, inflows into emerging market equity funds increased to $80.3 billion, well above the $29.5 billion previous record in 2007 and the highest since 1997 when data was first recorded. The inflow compared to outflows of US $86 billion from developed world equity funds in 2009 as investors sought exposure to faster growth and better prospects in emerging markets, especially the BRIC economies.

The small size of emerging markets accentuated the effect of these inflows. In 2009, the FTSE All-World Emerging Markets Index rose 75% compared to a 28% rise in the FTSE All-World Developed Index. By late 2009, emerging markets were trading at about 20 times their trailing 12-month earnings, compared to about 8 times at the March 2009.

Potential disappointments in the rate of improvement in developed economies or a reassessment of the prospects of emerging markets remain potential risks during 2010.


Originally published at Eurointelligence and reproduced here with the author’s permission.

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