Guest Post by James A. Kaplan, Chairman and CEO, Audit Integrity
Getting older has its comforts. One of them is that you get to experience a number of historic events and can gain perspective on consequences that result from those events.
It’s been well over a decade since the Japanese economy imploded. That implosion was based on a speculative frenzy that drove values to the extreme, where it was discovered the effects of gravity could not be overcome.
The Japanese government’s response to this dramatic situation was to slash interest rates and rapidly increase government spending. (Note: they did not substantially increase their money supply.) The government claimed to be making substantial efforts to correct the impact of the shrinking private economic sector. The private economic sector, while paying lip service to growth opportunities, continued to stagnate as the banking/industrial complex refused to take risks. The national economy floundered between underwater loans and lack of demand. To this day, over a decade after the implosion, Japan is still struggling with lackluster economic growth.
That sounds a lot like déjà vu, doesn’t it? Of course, in the “good old U.S. of A.,” we are different – or so we say. As best I can tell, our response to date looks much like Japan’s response of a decade ago. The Fed has lowered the cost of short-term borrowing to nearly Zero (a rate that discourages long-term savings) and increased government spending to the point where the credit of the United States is in jeopardy. Financial institutions continue to stagger under the weight of non-performing loans. Industry is reluctant to invest without evidence of a pick-up in demand, while consumers’ wealth and savings have dropped so precipitously they are reluctant — or unable — to spend.
One can only hope that the rapid increase in money supply, both domestically and globally, will result in a different outcome than that suffered by the Japanese. I would not like to see the U.S. endure a protracted economic struggle. However, if we look specifically at the actions of our commercial banking system, we find little comfort.
Commercial banks hold over $1.7 trillion of commercial real estate, and are reluctant to write down their holdings. In fact, FASB has changed its interpretation of FAS 115-2 and FAS 124-2, making it extremely easy to avoid recognizing loss in value.
According to the Congressional Oversight Panel, over 2,988 commercial banks are classified as having a high commercial real estate concentration. The FDIC currently has 702 publicly-held banks on its watch list.
Much like Japan, we have turned a blind eye to a major potential implosion, and in fact, are working hard to cover it up. Of course the banks are taking FASB’s lead and not writing down assets. Remember, unwillingness to fairly reflect values was a criticism placed on Japanese banks one decade ago. .
Bank charge-offs of the 4th Quarter of 2009 totaled $59 billion, an increase of 47.7% year over year. The bulk of these charge-offs related to single-family home loans – not to distressed commercial real estate. I believe the real charge-off rate should be three to four times higher than the banks are willing to admit.
A charge-off rate that more accurately reflects commercial real estate values would drive banks into a substantial negative earnings position. That’s a position no one likes to be in, but denying it does not change the fact that a bank in that kind of financial distress represents a substantial risk to stakeholders, taxpayers, and the economy overall. We’ve seen the impact “Extend and Pretend” has had historically, and the results are not pretty.
Below is a select list of mid-sized commercial banks that I believe are representative, to a greater or lesser degree, of the problems the industry faces. They are all talking a good game. I certainly endorse the power of positive thinking – but not when it is used to distract investors from the truth.
Technorati Tags: commercial-real-estate, regional-banks, U.S. banks
Big banks, except those in emerging markets, will probably destroy value over the next four years (McKinsey)
MGI: New sectors such as cleantech are too small to make a difference to economy-wide job growth.
Excellent microcosm in 7 minutes of how American homeowners got overleveraged (podcast by NPR’s Tamara Keith)
Audit Integrity Updates Investor Watchlist for Western Europe
Credit Suisse scorecard of OECD countries most likely to face government debt funding problems (via @FTAlphaville)
Social spending is up to 24% of GDP in OECD countries, driven by healthcare and elderly costs (OECD)
Technorati Tags: big banks, home-equity-loans, social spending, sovereign-debt, unemployment, western europe
The use of foreign exchange (FX) swaps as a source of funding and as a hedging tool may increase the risk of financial and economic instability during periods of turmoil, according to a new Working Paper published by the International Monetary Fund (not official IMF policy).
Selected Excerpts from FX Swaps: Implications for Financial and Economic Stability (free pdf) Prepared by Bergljot B. Barkbu and Li Lian Ong1
The spillover of the liquidity crunch in international money markets into the FX swap market during the recent financial crisis has placed a spotlight on the latter’s potential impact on macro-financial stability. The increasing reliance on FX swaps for FX funding by some market participants and the sharp increase in cross-border transactions in this instrument gave rise to significant concerns when the market faltered during this tumultuous period. Specifically, the role of banks as key dealers and users of FX instruments—and their central importance for financial stability and economic activity—raised worrying questions in some countries about the possible impact of FX swaps on the health of the banking system and real economy.
Capital adequacy requirements under the Basel Accords hold implications for the application of capital charges when these instruments are held by banks, either for speculation purposes, to finance their FX needs and/or to hedge their open FX positions. FX swaps held by banks could also impact their liquidity positions, through margin calls by counterparties, even though they may be fully hedged for FX movements. Encouragingly, the accounting requirements under IFRS are aimed at improving the transparency of reporting by users of these instruments, by bringing them onto the balance sheets of the reporting entities.
During the recent crisis, central banks used FX swap facilities extensively to facilitate the rollover of FX swaps by the private sector during the crisis, in some cases, supported by swap lines with other central banks.
We conclude that the application of FX swaps is not infallible, despite their usefulness. That said, this paper is not intended as a critique of FX swaps, but rather, to examine the channels through which FX swaps could affect financial and economic stability, given their increasing popularity leading up to the crisis.
As recent events have shown, the use of this instrument could actually exacerbate risks to financial and economic stability during periods of turmoil. Thus, central banks, which typically use FX swaps as a monetary policy tool, and banks, which transact in this instrument for funding, hedging or speculative purposes, need to ensure that they have the necessary measures in place to address the stability problems that could arise from its use.
Technorati Tags: banking-system, central-banks, financial-regulation, FX swaps, money markets
Major developing countries will continue to outpace advanced economies’ performance in the second quarter, according to Oxford Analytica. We are pleased to offer a complimentary download of OxAn’s latest quarterly global economic outlook.
Selected Highlights.
The global recovery will continue, underpinned by the performance of major emerging markets. Exports to China in particular will contribute to growth in a number of developing and developed countries. Trade as a whole will continue to rebound, and energy prices are unlikely to change significantly. Nonetheless, US unemployment will persist, and European economies remain weak, amid concerns about sovereign debt.
- The United States will have a better quarter than most other developed countries, despite uncertainties about the sustainability of its recovery. As concerns about public debt and fiscal deficit mount, especially in Europe, governments are likely to phase out stimulus measures.
- Emerging markets remain the most dynamic part of the global economy
- The United States will perform better than most other developed economies.
- Pressure will mount on European governments to phase out stimulus measures.
- Inflation will remain subdued in advanced economies, where monetary policy will remain loose.
- Interest rates are likely to be increased in major developing countries.
- Trade will continue gradually to recover from its recession-induced slump.
Problems in OECD countries will weigh on the global picture, but not enough to compromise recovery. Inflation will remain subdued in advanced economies, and monetary policy unprecedentedly loose. In major developing countries, authorities probably will tighten monetary policy to avoid substantial price increases amid solid economic expansion.
Emerging markets will continue to be the most dynamic part of the world economy during the second quarter. However, the period will see divergence among developed countries, with:
- The United States growing, supported by government stimulus;
- Japan continuing to experience tepid recovery; and
- European performance faltering amid increasing concern over many countries’ fiscal and debt positions.
PROSPECTS 2010 Q2: Global economy has been made available free of charge to ResearchRecap users for 30 days by special arrangement with Oxford Analytica, an Alacra content partner. After 30 days, the report will revert to its regular AlacraStore price of $150.
Regional and country PROSPECTS 2010 Q2 reports are available here.
For additional free research reports from the Alacra Store click here
Technorati Tags: complimentary research, economic-forecast, emerging-markets, global-economy, interest-rates, japan, stimulus, US
Petroleum price subsidies are on the rise, adding to greenhouse gas emissions, according to a new “staff position note” from the International Monetary Fund (not official policy).
The paper notes that in 2003, global consumer subsidies for petroleum products totaled nearly $60 billion. They are projected to reach almost $250 billion in 2010. Tax-inclusive subsidies, reflecting suboptimal taxation, are estimated to be much larger—$740 billion in 2010, or 1 percent of global GDP. G-20 countries account for over 70 percent of tax-inclusive subsidies, with emerging G-20 countries accounting for a sizable share.
Halving tax-inclusive subsidies could reduce projected fiscal deficits by one-sixth in subsidizing countries and could reduce greenhouse emissions by around 15 percent over the long run.
The paper urges reform of subsidies, but recommends including measures to mitigate the impact of higher prices on the poorest groups.
Fore details, see Petroleum Product Subsidies: Costly, Inequitable, and Rising
Technorati Tags: emissions, energy-prices, greenhouse-gases, petroleum, subsidies
Moody’s takes a look at the residential mortgage market in Spain in a new report. While it too early to accurately determine final recovery rates, the initial findings are worrisome.
Selected excerpts:
There is some uncertainty in Spain regarding how recoveries of non-performing mortgage loans are going to unfold as the adverse economic cycle progresses. This is exacerbated by the
lack of visibility of the market price of properties during the current recession and of the level and time at which prices will settle after the recession.
To better understand the drivers of loss severity and trends, Moody’s has obtained loan-by-loan recovery data from 59 Spanish Residential Mortgage-Backed Securities (RMBS) deals amounting to 26,626 cases of loans entering arrears 90 day between 1997 and August 2009.
Arrears 90 day severity has increased rapidly since 2006 from an historical low average of 5.8% severity with around nine months recovery lag during the benign cycle (1997 to 2005). For loans that entered arrears 90 day in Q1 2008 (the latest date analysed to give a minimum of 1.5 years of observation period for recoveries), the current average severity is 46.2% with a nine month recovery lag.
However, once the ongoing recovery processes are complete, the final severity could improve to a level around 11% with the recovery lag increasing to 21 months, based on a simplified assumption on future recoveries with 30% house price decline peak-to-through from Q1 2008 to Q3 2011 and net from interest accrued and foreclosure costs. The average severity and recovery lag for loans that do not cure or refinance will be higher than the levels shown above and are a better indication of severity on foreclosure. Based on the same assumption for future recoveries as above, the severity for non-cured and non-refinanced loans that entered arrears 90 day in Q1 2008 was calculated at 17.7% with an average recovery lag of 31 months.
We expect final recoveries for loans that entered arrears in 2008 and 2009 to show even more stressed results. At present, the observation period is too short to draw any conclusions on these vintages.
For details see: Recovery Trends In Spanish RMBS (Premium)
Technorati Tags: mortgage-backed-securities, RMBS, Spain, structured-finance
Intelligent home energy management systems should be able to reduce energy bills by up to 28%. (The Economist)
Kauffman Foundation launches Energy Innovation Network so entrepreneurs can accelerate the clean energy revolution
SWFs’ investments rose from $10bn in first half of 2009 to $50bn in second half, but still down 3% for year (IFSL)
It’s Time for Swaps to Lose Their Swagger (NY Times Gretchen Morgenson)
Very poor people in emerging economies surprisingly interested in mobile financial services (McKinsey)
Book Excerpt from ‘The Responsibility Revolution’ – Don’t Ignore the Transparency Imperative (via strategy+business)
Credit Suisse Annual Survey Finds Hedge Fund Managers Moderately Optimistic About Inflow Growth, Fees
Technorati Tags: credit-default-swaps, energy-efficiency, Hedge-Funds, mobile, Sovereign-Wealth-Funds, SWF, transparency, Twitter
Sustained flows of private investment will be crucial for economic recovery in South-east Asia as fiscal measures are phased out. Banks will remain cautious with lending until growth picks up, but FDI, portfolio investment and M&As are each set to rise.
Guest Post by Oxford Analytica
Fixed investment in South-east Asia dropped sharply last year, as the combined effects of weaker domestic demand and lower foreign orders hit output. Hardest hit were the export-dependent economies of Thailand, Malaysia and Singapore, which also experienced substantial capital outflows.
Signs of a recovery have been apparent since the end of September, as fiscal stimulus measures lifted consumption. Though weak US demand continues to restrain growth in some economies, notably Malaysia and Thailand, inventories are being rebuilt and capacity utilisation is rising across the region.
Recovering flows. Foreign reserves, a leading indicator of investment flows, have been growing since world financial markets began to stabilise in March 2009, strengthening the region’s currencies:
- The exception has been Vietnam, which faces inflationary pressures and a burgeoning trade deficit. The central bank was this month forced to devalue the dong by 3.4%, bringing it into line with black market rates.
- For the region’s other economies, stronger growth and a faster pace of monetary tightening than in other parts of the world has created expectations of currency appreciation. Indonesia’s rupiah has been the strongest performer, rising 17% against the dollar last year.
Supporting investment. Public investment is set to decline as governments progressively withdraw their fiscal stimulus policies. This will put the burden back on financial markets to sustain growth by funding private investment. The World Bank expects private investment to rise by 7-10% across the region in 2010, with impetus coming from several quarters:
Countries that adopted the most aggressive reforms during the downturn, particularly Vietnam and Indonesia, now look set to attract the bulk of medium-term inflows.
- Indonesia expects disbursed capital to grow by 15% to 13.8 billion dollars this year, after a 24% drop in foreign direct investment (FDI) in 2009. Vietnam has forecast a 10-12% rise on its 2009 inflow of 21 billion dollars, with 10 billion dollars being disbursed.
- Political instability and policy inertia will undermine flows into Thailand, Malaysia and the Philippines, the other main FDI recipients.
Capital markets. Equity markets lost about half of their turnover in 2008 but recovered in the second half of 2009 as investors sought safe havens from volatility on Wall Street. Spurred by low inflation and higher earnings, trading in Indonesia, Singapore and Thailand has more than doubled since the deepest trough in late 2008, according to World Bank data.
Bond issues have rebounded as interest rate spreads narrowed, while listings have surged. Malaysia and Indonesia saw 65% increases in initial public offerings in the year to October 31, though returns were mixed. Liquidity is generally ample, but borrowing costs are still high due to debt concerns in Europe and tighter bank scrutiny of loans.
Mergers and acquisitions. South-east Asian companies have become prime targets for equity alliances and takeovers as they struggle to secure funding. Cash-rich investors in India and China are leading the way, with South Korean, Japanese and Western European buyers also active.
Last year saw some 290 mergers and acquisitions (M&As) worth 1.1 billion dollars in Vietnam, a 71% increase on 2008, mostly in banking, construction and manufacturing. In the first two months of 2010, Indonesia had a 10.7% share of global buyouts, largely due to a 770-million-dollar deal by Europe-based CVC Capital Partners for an 80% stake in retailer Matahari Putra Prima.
Brand-name retail and manufacturing firms, construction groups and real estate holdings will be highly sought after elsewhere in the region, as the removal of tariff barriers through recently implemented free trade agreements encourages cross-border expansion.
Technorati Tags: FDI, Indonesia, M&A, Malaysia, Philippines, Singapore, South-east Asia, Thailand, Vietnam
Standard & Poor’s believes Spain’s weak economic growth prospects could undermine the government’s fiscal consolidation program.
In a bulletin released today S&P said that in its view “Spain’s general government deficit is likely to remain above 5% of GDP through to 2013 versus the official forecast of 3% of GDP by 2013. As a result, we expect the general government debt burden to rise above 80% of GDP by 2012. We also expect much weaker economic performance than current budgetary assumptions. There is, moreover, significant implementation risk with regard to the government’s fiscal consolidation plans, which are not yet fully specified.”
The negative outlook on the sovereign ratings, which we assigned on Dec. 9, 2009, remains in place in the absence of more aggressive and tangible actions by the authorities to tackle Spain’s economic and fiscal imbalances. Any deterioration over and above our current expectations could put further downward pressure on the ratings.
For details, see Bulletin: Economic Growth Prospects Could Undermine Spain’s Fiscal Consolidation Program (Premium)
See also Spain: Country Economic Forecast from Oxford Economics, available for complimentary download via the Alacra Store.
Technorati Tags: sovereign-debt, Spain
NERA Economic Consulting argues in a new white paper that limiting the size of financial institutions may actually result in more risk-taking, not less.
Selected excerpts:
Legislative proposals that rely on a size-based identification process would erroneously identify a number of financial firms as systemically risky, when in fact they are not. Other firms that do in fact pose significant systemic risk would fail to be identified. Such a process, if enacted, would create a cross-subsidy of significant magnitude from firms that do not pose systemic risk to those firms whose activities are systemically risky.
The resulting moral hazard would encourage increased risk-taking and, as such, could ultimately defeat the legislation’s intent of reducing the economy’s exposure to systemic risk.
Further, if a size-based process for identification of systemically risky financial firms were accompanied by heightened regulatory requirements and new systemic risk charges, the following economic results would be expected:
- Increased financial system risk as a result of new sources of moral hazard;
- Distortions in the competitive environment, impacting economic efficiency and creating
potential barriers to entry;
- Increased costs to consumers for basic, often required, financial services, as a result of the pass-through of assessment cost, and costs associated with increased regulation; and
- U.S. job losses, including those predicted to result from reductions in capital and labor expenditures and economic dislocation, as a result of efforts by firms to structure to avoid size thresholds.
On balance, the costs of the proposal, considering the moral hazard and economic impacts, are economically significant, easily exceeding the benefit of the actual systemic risk fund itself. Though reducing systemic risk and related taxpayer costs is critically important, to achieve these goals and avoid negative economic distortions, underlying sources of firm systemic risk must be properly identified. Elements not directly linked to size, including interconnectedness, cyclicality, leverage, liquidity, and transparency are important considerations in the identification and quantification of systemic risk. While incorporating such elements into the official identification and assessment of systemically risky financial institutions may increase the complexity of the process, a size-based process could result in more economic harm than good.
The full paper, prepared for the Property Casualty Insurers Association of America, is available here.
Technorati Tags: big banks, financial institutions, financial-regulation
