A new beginning

 I have decided to restart my blog after a long gap. I will henceforth pen down my thoughts on how the machine of world economy runs and what I make of it .

'Too big to fail' just got 'Bigger'!

Having burned its fingers by allowing a collapse of Lehman Brothers, the US Federal Reserve, and thereon other major Central banks were quick to pledge unlimited support so as to keep afloat beleaguered financial institutions. It was widely accepted then that it was the only way to prevent another great depression even if it mean leeching the taxpayer. A series of such helicopter drops thanks to exhaustive fiscal and monetary measures did extremely well in unclogging cash starved asset markets, mending tainted balance sheets and drastically reducing the systemic risk. Investors heaved a sigh of relief at this overtly generous gesture, pushing up the risk indices as they began to foresee no major event risk on the horizon. The lender of last resort had redefined its primary role by lending not just to depository institutions but also businesses groups, including auto majors and commercial real estate players. Concomitantly massive fiscal stimulus measures were announced aimed at pump priming the real economy which continued to face strong headwinds.

Having learned the lessons of excessive leveraging, financial institutions across the world embarked on a deleveraging drive, tightening their debt ratios while preferring to earn a low yet safe return on reserves rather than lend them to cash starved consumers. While such a hoarding behavior has done little to prop up real final sales across most major economies, the fallouts for the government have been even more worrisome. The concern of leverage has shifted from the financials to the government themselves as they continue to re-leverage themselves to seemingly unimaginable levels. Immense disparities between central bank credibility coupled with political and economic interlinkages amongst group nations means putting a lot at stake at the cost of another nation’s failure.

In this context, it was not surprising that members of the European Union, with the exception of Germany, pledged their support to a struggling Greece. Greece’s deficit has ballooned to around 12.7% of its GDP, way above the EU’s cap of 3%. With the nation facing more than 20 bn Euros in debt redemptions in April and May, it would likely struggle to fund its budget deficit sans support from other EU members. Amidst pressure from other EU members, Greece has pledged to reduce its budget deficit to 8.7 percent in 2010 by way of severe austerity measures, which would further cripple consumption demand in the struggling economy. Greece’s debt totaled 298.5 billion Euros ($407 billion) at the end of 2009. That’s more than five times what Russia owed when it defaulted in 1998 and Argentina when it missed payments in 2001. Amongst all nations, Japan has the largest debt, with official estimates of borrowings at 973 trillion yen (USD 10.7 trillion) by March 2011, more than the combined economic output of the U.K., France and Italy. Japan’s debt sustainability has been less of a concern so far since more than 90% of the country’s bonds are held domestically, thereby reducing the risk of capital flight. However, persistent decline in household savings rate coupled with a fall in JGB absorption capacity of the public institutions that hold about 40% of outstanding JGBs has raised concerns over the country’s debt sustainability going ahead.

From a nation’s taxpayer supporting domestic financial institutions to now supporting another sovereign is hardly an occasion to celebrate. Many may argue that no support would mean catastrophic implications for the Euro Zone and thereby for key global asset markets. However, while we take solace in the ‘it could have been worse’ notion, such measures do not leave the global consumer any better off either. The consumer in most developed nations still remains the missing link, capitulated by a fragile labor market, housing woes and tight lending standards. Underscoring this fact, the US Conference Board’s Consumer Confidence Index for February fell to its lowest level since July 2009. Meanwhile, bank lending in the fourth quarter of 2009 recorded a sharp 7.5% drop according to the Federal Depository Insurance Corporation (FDIC). Bank lending in 2009 fell at the fastest clip since 1942. Incessant small bank failures in the US are another major cause of worry, weighing further on consumer sentiment. 20 banks have already failed so far in 2010, bringing the total list of bank failures over the since January 2008 to 185.The FDIC’s list of ‘problem banks’ shot up during Q4-09 from 552 to 702, the highest number since 1993. FDIC expects total bank failures to cost USD 100 bn from 2008 to 2013.

The question of who will bailout the lender of last resort will continue to haunt market participants for some time to come. While most economies have already voiced their desire to deliver a credible pro growth fiscal adjustment program, such a process is expected to be extremely arduous, complex and long term. Last month, the US Federal Reserve Chairman, Bernanke acknowledged that the current US budget path was not sustainable although a downgrade of the country’s credit rating was unlikely. The US budget deficit (9.9% of GDP in 2009) is expected to stay high for many years to come as entitlement spending accelerates due to factors related to the aging of baby boomers (born between 1946 and 1964). A boost in interest payments due to massive accumulation of debt during the crisis years is another worrying factor over the longer term. Congressional Budget Office expects the overall deficit to begin rising again in 2015 in part because of a sharp rise in interest payments on the U.S. debt. In addition, there are massive budget issues in the largest US states. Amidst sluggish revenues and high spending demands, states are likely to face major difficulties in balancing their fiscal 2011 budgets. According to the Center on Budget and Policy Priorities, the combination of expected budget gaps next year and the current shortfalls leaves states facing a budget shortfall of USD 120 bn over this fiscal year and next.

With investors becoming more discerning than ever before, they are already demanding much higher premiums for the best of credits relative to levels prior to the Dubai and Greece crisis. CDS for sovereigns has seen a stark increase, led by Greece, which stands at a record 350 to 400 bps cost of protection. CDS spreads for Japan, UK and the US have also seen a notable increased off late but remain much below worrying levels. What is also alarming is that the appetite for Treasuries has declined by the largest amount in December with China and Japan reducing their allocation by USD 34.2 bn and USD 11.5 bn each to USD 755.4 bn and USD 768.8 bn respectively.

The ongoing global economic recovery has been a lot de-synchronized given varying economic and financial conditions across nations at the start of the recession. In the Non Japan Asia space, growth in most countries is expected to be robust and close to trend. Domestic demand is expected to be the key driver of growth in China, India and Indonesia while greater linkages with China would also prove beneficial for Korea and Taiwan.Restoration of global trade flows is also expected to be a potent source of support for global economic recovery. We have already begun to see the positive implications of a revival in trade with the emerging market economies largely benefitting from a strong bounce in exports. Commodity producers such as Australia and Canada have been relatively unharmed during the crisis period. However, for the major developed economies, namely the US, UK, Euro Zone and Japan, beyond the cyclical rebound seen so far, structural realities paint a dismal picture. The absolute levels of unemployment, consumption demand, housing market conditions and credit flow have a lot to improve before self sustainable growth can be assured. Whether measured by the output gap, the unemployment rate, or the manufacturing capacity utilization rate these economies are running well below their potential. In the US, although the labor market is showing incipient signs of recovery, a sustained improvement would depend a lot on broader economic growth, which is expected to be sluggish in 2010. The US economy has shed 8.7 million jobs since December 2007, the largest percentage points drop in payrolls since World War II. Output Gap, which measures the difference between the actual level of GDP and the level where GDP would be if the economy were operating at full employment, currently stands at a worrisome level of around negative 6%. Meanwhile, key issues facing Japan include a protracted deflation, an aging population and concerns over sustainability of government debt.

Against this backdrop, an orderly handoff from ephemeral sources of growth to sustainable sources of private final demand is imperative for a steady recovery across major developed economies. Thereby, the focus should be on achieving the two keys to a self sustaining recovery, namely, a pickup in household demand along with steady improvement in capex.

Global Financial Conditions Monitor, Week ending March 21st 2008

Global equities seesawed across last week as investors grew jittery after the buyout of the troubled Bear Stearns at a fire-sale price by J.P.Morgan but garnered some confidence on the back of a string of positive moves by major Central Banks. The financial sector led most of the rallies throughout the week as investors hailed the Fed’s 75 bps cut in its key interest rate along with a host of broad based liquidity injection measures as a potential building block in the long term solution to the credit crisis. Stronger than expected first quarter results of investment banking giants Goldman, Lehman and Morgan Stanley also helped shore up global equities. The Dow gained 3.25% across the week while the FTSE gained 1.49%.

Citing a weakening economic outlook as well as an elevated inflation, the US Federal Reserve delivered another shot in the arm to the slowing economy as it cut the Federal funds rate as well as the discount rate by 75 bps each, thereby bringing them down to 2.25% and 2.5% respectively. Earlier in the week, Bear Stearns's sudden meltdown had forced the Fed to take the extraordinary measure of allowing securities firms to borrow from the central bank under terms normally reserved for regulated banks.

In an effort to bolster the ailing housing market, the OFHEO reduced the capital surplus that GSEs Fannie Mae and Freddie Mac must hold to 20% from 30% previously. The move is expected to provide a much-needed respite to the two hobbled GSEs as it provides up to USD 200 bn in immediate liquidity to the troubled MBS market. The Fed’s latest measures to unfreeze the credit markets appears to be working in the MBS market where yields have come off their recent highs. The difference on the yield on 30-year MBS compared with U.S. Treasurys fell to 2.74 percentage points, from a high of 3.7 on March 6th. However, upward risks remain abound as another collapse may trigger massive develeraging as investors, banks and others try to reduce their own exposure to risky markets. In what has become one of the most pervasive credit crisis, the issue no longer remains whether it will yield a recession, which seems certain, but whether the Fed’s novel efforts would help to cut the tail risk of a deeper and prolonged recession scenario.

Funding pressures unlikely to abate soon:

The Fed’s new direct lending program aimed at primary dealers coupled with a substantial 75 bps cut in its key interest rate eased funding pressures in the short term money markets over the last week. The size of the total borrowing from the Fed’s primary credit lending facility suggested broader interest amongst the securities dealers. The program drew an average of USD 13.4 bn in daily borrowing in the week ending March 19th ’08 with firms having USD 28.8 bn in loans outstanding.

The 3M USD LIBOR edged up 2.7 bps across the week to 2.606% while the 6M USD LIBOR rose 17 bps to close 2.53%. The ABCP market deteriorated for the third consecutive week with its outstanding value having dropped by USD 4.3 bn last week compared to a USD 5.7 bn dip previously.

A few spoonfuls of potent medicine by the Federal Reserve

In its bid to overcome growing recession and liquidity fears, the Fed had earlier announced that it would add further liquidity to money markets by raising the size of the Term Auction Facility (TAF) auctions to be held on March 10th and 24th to USD 50 bn each, an increase of USD 20 bn from the amounts that were announced on Feb 29. Fed officials also announced that it would initiate a series of 28-day term repurchase transactions that are expected "to cumulate to USD 100 bn" and increase the auction sizes further in future if conditions warrant. Yesterday, the Fed in coordination with four other Central Banks (BoE, SNB, BoC and ECB) stepped up its efforts to assuage the growing strains in global credit markets by significantly extending dollar loans to banks in their respective nations. The Fed supplemented its previous TAF and repo initiative with the Term Security Lending Facility (TSLF) thereby expanding its low securities lending program to enable bond dealers to borrow up to USD 200 bn of Treasury securities, collateralized by other securities, including Fannie and Freddie Mac backed bonds, Fannie and Freddie Mac backed MBS and other AAA rated MBS. Furthermore, the Fed also raised the size of its "swap" agreements with the European Central Bank (ECB) to USD 30 bn from USD 10 bn previously, and with the Swiss National Bank (SNB) to USD 6 bn from USD 2 bn previously. With many banks in the EU facing huge dollar loan obligations while being exposed to risk of US mortgage loans, the swap agreements would enable the respective Central Banks to borrow dollars from the Fed and lend the same to their own banks, thereby alleviating the funding pressures in these markets.

March 10th TAF Auction suggests increased demand for funds:

The result of the March 10th TAF auction suggests that funding pressures continue to exist amongst US banks despite substantial liquidity injection by the Fed through previous TAF auctions in addition to the discount window borrowing as well as open market operations. Until January, it seemed that the Fed had done considerably well in managing market liquidity and eased liquidity concerns in the short term money markets. This is evident from the table above, which depicts a significant drop in bid/cover ratio ( 1.25 in Jan 28th from 3.08 in December 17th) as well as total propositions submitted (USD 37.45 bn from USD 61.553 bn in December 17). However, credit conditions deteriorated markedly over the past two months as the contagion spread beyond the realms of subprime mortgage onto much safer Alt A and even prime mortgages to some extent, thereby hitting major banks, bond insurers, mortgage insurers, hedge funds among others. The latest TAF auction reflected heightened demand for funds with the number of bidders increasing to 82 from 72 previously while total propositions rose to USD 92.595 bn from USD 50 bn previously.

How is TAF different from TSLF?

The Fed has established the Term Auction Facility (TAF) program in order to auctions funds to depository institutions of approximately one-month maturity. The TAF is essentially a collateralized credit facility that allows all those depository institutions that are eligible under the Discount Window Facility, to bid for an advance from its local Federal Reserve Bank at a rate that is Auction determined. The collateral that is eligible to be pledged remains the same as under the Discount Window facility, which includes U.S. Treasury securities, State and local government securities, Collateralized mortgage obligations (AAA rated), and Investment-grade certificates of deposit.Under the Term Securities Lending Facility (TSLF) the Fed auctions U.S. Treasury securities, which includes Treasury bills, note and inflation indexed securities against AAA/Aaa-rated Residential Mortgage backed securities not on review for downgrade along with bonds and MBS which are backed by Fannie and Freddie Mac. The TSLF essentially extends the Fed's low-profile Securities Open Market Account (SOMA) lending program enabling banks to pledge a wider range of collaterals for a longer period of up to 28 days at a time rather than overnight, as was the case with SOMA.

Would TSLF serve its purpose?

Global financial markets have hauled the Central Bank's coordinated actions with the Dow climbing 3.5% yesterday while the S&P 500 gaining 3.71% yesterday. Conditions in the short term money markets eased considerably following Fed's initiatives to address hightenened liquidity pressures coupled with an assurance " to conduct TAF auctions for at least the next six months unless evolving market conditions clearly indicate that such auctions are no longer necessary," The 3M USD LIBOR dipped further below the current fed funds target rate to 2.8675% from 2.938 bps last week while the 6M USD LIBOR touched a low of 2.74% from 2.86% last week. The TSLF provides an important outlet for stained MBS, thereby comforting dealers who were stuck with the soured paper after being dumped by investors facing margin calls. The move would also help partially mitigate the investor nervousness over financial condition of GSEs Fannie Mae and Freddie Mac, who had posted huge fourth quarter losses amidst rising delinquencies. However, there is a high risk that TSLF may prove to be a short term analgesic as the securities lending facility is a temporary transaction with the MBS returning to bank balance sheets after maturity. Also, with the ball now in the Fed's court, the Fed's own balance sheet looks much riskier thanks to the increased share of the risky MBS instead of the safe treasuries. The Fed, which would need to cushion these risky securities with extra collateral and guarantees, seems confident that the TSLF would play an important role in promoting liquidity in the financial markets for treasury and other collateral and thus foster the functioning of financial markets more generally.

Rising foreclosures + plummeting home equity = worsening housing crisis

Credit rating agencies have put ratings of various insurers on watch for downgrades because of continued weakness in the U.S. mortgage markets, especially foreclosures on mortgages backed by subprime and limited-documentation borrowers. Bond as well as mortgage insurers are under tremendous pressure to raise billions of dollars in capital to forestall possible downgrades in their credit ratings as worries about the value of the securities they've insured persist. Failure to make higher payments on ARMs by property owners has lead to a surge in bank seizures of US homes. With property owners failing to make higher payments on adjustable rate mortgages, U.S. home foreclosures have jumped 90% YoY to 45,327 in January. Total foreclosure filings, which include default and auction notices as well as bank seizures, have increased 57% YoY in January, its highest level since August last year. According to Realty Trac, more than 1% of U.S. households were in some stage of foreclosure during 2007. The situation is expected to worsen in the months to come with an estimated USD 460 bn of adjustable mortgages scheduled to reset in 2008. Delinquency rates have already touched their highest levels since 1985 having increased by 87 bps since December 2006 to 5.82% in the last quarter. As long as house prices continue to plummet rising foreclosures would compel banks to resell the foreclosed properties (estimated to be 1 mn in 2008), adding further to the glut of inventory and forcing prices down even further. The vicious circle is expected to persist unless house prices recover. However, a housing bottom looks nowhere in sight with Mr. Bernanke expecting housing to weigh on the economy "in current quarters". The sharp fall in house prices has also created negative equity for home owners as they find it difficult to secure funds on housing stock whose net worth is depleting sharply. Share of homeowners' equity, the market value of a home minus the size of its mortgage, has plunged to 47.9% in the fourth quarter of 2007 from a high of more than 80% in 1945, a reflection of surging delinquencies and housing foreclosures. Value of housing related assets (including mortgaged assets) have fallen by USD 170 bn to USD 20.2 tn last quarter.

Over the recent past, policy markers in coordination with various financial institutions have announced multiple measures aimed at comforting homeowners squeezed by the housing mess. The U.S. Department of the Treasury and the Department of Housing and Urban Development in collaboration with the country's largest mortgage servicers convened the "Hope Now Alliance" whose objective is to try and halt the flood of foreclosures either by freezing mortgage rates, extending payment periods, counseling and postponing or eliminating scheduled rate reset increases. Further more, six major mortgage lenders, namely, Washington Mutual, Bank of America, Wells Fargo, JPMorgan, Citigroup and Countrywide Financial in coordination with the Bush administration have worked out a plan titled "Project Lifeline", wherein the lenders promise to seek contact with homeowners who are 90 or more days overdue on their mortgages. In some cases, homeowners will be given the chance to "pause" their foreclosure for 30 days while lenders try to work out a way to make the loans affordable. The New York State Insurance Department met with banks to persuade them to inject capital into the monolines - reportedly in the region of USD 5 bn in immediate capital and ultimately to commit up to USD 15 bn as concern mounted that further guarantor downgrades could force a fresh round of write-downs. In a move to boost the housing market in expensive areas, the government has raised the cap on the size of mortgages that can be bought by government-sponsored mortgage giants Fannie Mae and Freddie Mac or insured by the Federal Housing Administration (FHA). Furthermore, Fed Chairman Ben Bernanke has urged lenders to reduce the principal amount of troubled mortgages and proposed that the FHA's authority be expanded so that it can then insure the written-down loans.

Although the steps taken by the Bush administration towards rescuing homeowners on the brink of foreclosure are definitely in the right direction, the measures undertaken might prove to be just a short term palliative rather than providing a permanent solution. While lenders need to move more aggressively to reduce loan balances to current home values and make monthly payments affordable, these lenders face the risk of lawsuits from troubled investors that own the loans if they believe that borrowers have been given overly generous terms. One also wonders how many of the bigger loans Fannie Mae and Freddie Mac will be able to finance when they themselves are heavily cash strapped having recorded massive fourth quarter losses of USD 3.56 bn and USD 2.45 bn each. While Bernanke's rescue proposals have recieved a positive response from policy makers and are expected to effectively address the housing crisis if implemented succesfully. It is, though, a huge, 'if'.

Recession jitters balloon in the US as labor market sheds 63K jobs in February

Recession jitters ballooned in the US economy after its labor market shed 63K jobs in February, its fastest rate since March 2003. The February NFP numbers belied market expectations of a 25K increase. Job losses suffered in January were worse than first reported, revised to -22K from -17K previously. Two successive months of negative jobs growth does not augur well for an economy slated to be on the brink of a recession. The payroll declines hit almost every sector of the US economy, except for government jobs. However, the gains in government jobs (+38K) did little to offset the massive fall in private employment (-101K). While the goods producing sector extended its downfall, cutting an additional 89K jobs in February (-54K previously), dwindling support from the services sector (+26K from +32K previously) is a major concern for the embattled U.S economy. Substantial job losses in retail trade (-34K) and financial services (-12K) have been primarily responsible for the slowdown in services employment. Within financial activities, employment in credit intermediation (which includes mortgage lending and related activities) has fallen by an additional 5K last month. The manufacturing sector, which has been slashing jobs continually for the past 20 months now, axed 52K more jobs in February (-31K previously) while the construction sector followed suit as employment slumped by 39K from -25K previously. The construction sector has been on a downtrend since the sub prime fiasco unfolded as declining home sales and tightening mortgage lending standards have together dented builders' sentiment. The industry has lost a total of 321K jobs since its peak in September 2006. Meanwhile, the February unemployment rate edged down to 4.8% from 4.9%. This is primarily because some job seekers dropped out of the labor force. The size of the US labor force declined by an estimated 450,000 in February, thereby driving down the unemployment rate. Average hourly earnings increased 0.3%, up 3.7% on a YoY basis. The bleak job report has reinforced the widening view that the US economy is falling into a recession. Amidst the ongoing turmoil in the housing and financial markets, the report has heightened fears of a 'negative feedback loop" in which financial market strain lead to a weaker economy, which in turn leads to more financial market turbulence. The February data supports the Fed's recent aggressive response to signs of economic weakness and suggests further easing at its next FOMC meeting.

US Manufacturing slumps to a five year low as ISM slides to 48.3 in February

Manufacturing activity across the US weakened to a five year low as the US ISM manufacturing breached the 50 threshold in February falling to 48.3 from 50.7 in the previous month. The February reading, which came in slightly below consensus expectations of 49, further aggravates recessionary concerns in the US economy. A reading below 50 signals contraction, while any reading above 50 signals expansion. Digging deeper into the data, the major components new orders and production have also registered a decline with the new orders index continuing to remain in the contraction territory, dropping further to 49.1 from 49.5 in January while the production component of the index edged down, although still above the expansion threshold. (50.7 from 55.2 previously). This underlined the ongoing weakness in capital spending, previously reflected in the January durable goods orders release, which depicted a 5.3% MoM decline in new orders. Inventory liquidation continued for the 22nd consecutive month as anufacturer’s inventories contracted again in February with the Inventories index falling to 45.4 as compared to 49.1 in the previous month. Labor market conditions in the manufacturing sector continued to remain iffy as reflected by the manufacturing employment index, which fell to 46 from 47.1 in January. Meanwhile, inflation concerns remained anchored with the prices paid index still at elevated levels, despite edging down to 75.5 from 76 previously. Historically, ISM has been a reliable predictor of US recessions and the current slump in US manufacturing
has added onto concerns about an impending US hard landing. A slowdown in manufacturing may also end up decelerating trade improvement, a significant factor to support growth during such distressed times. Recent speeches by top Fed officials coupled with the dismal nature of economic and financial news over the past fortnight strongly suggests that the Fed officials are prepared to ease interest rates further in order to stave off a possible recession in the U.S.