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Which is the worse news for the financial markets: William Poole’s assurance that the USA will not go into recession or Warren Buffett’s offer to take over municipal bond insurance? |
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The first is easier to deal with. This is the same member of the Fed who gave us his assurance back in July that the impact of the sub-prime problem was limited to the housing market. Take his pronouncements for what they are worth! |
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The second is more subtle, but we still judge it to be rather disquieting, for it raises the possibility that what we saw as unimaginable actually come about, viz., that the monoline insurers be allowed to be downgraded. Let us just review the Buffett proposal again. He uses his wealth and influence to create a new municipal bond insurer with the backing of the authorities of New York State. He then proposes to take over the insurance of municipal bonds currently insured by the monolines. He declines any corporate or asset-backed bonds. Just how does that help monolines avoid being downgraded? Good question! Actually, it does not help at all, and rather increases the likelihood of downgrading as they will be left with only Credit-Risk Asset-backed Paper, more commonly known by its acronym! |
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The US authorities must be holding many secret conferences. At them they decide who will say what to provide reassurance (we find their choices of President Bush and Poole a little questionable), while what they are really doing is seeking damage limitation. For the latter they have brought in the country’s second richest man and are pretending that monolines are just a minor problem that can be handled by State authorities. There has to be connivance of the US authorities over this Buffett deal. If the deal increases the possibility of monoline downgrading, it suggests that downgrading will come what may, which is why we guess that damage limitation rather than disaster avoidance is the new policy. Better to save the municipal bond market and let the rest go hang, than have everything go down together. Readers will forgive our scepticism, but can people like Bernanke really not see that the economic situation is so dire? |
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The nightmare Poole assured us was not going to happen thus unfolds a step further via the monolines, but does not stop there. While CDO losses continue to increase (S&P downgraded more than 8,000 bonds and CDOs on January 30th, and noted financial institutions losses tied to them could more than double to $ 265bn), they are being joined by default in other debt: consumer debt (credit cards, auto loans and student debt) and leveraged loans. The “pipeline” of leveraged buy-outs is totally blocked up as investors are no longer interested to take the associated loans off banks’ hands ($148 bn according to The Economist, with another further $64 bn in High Yield bonds). |
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In addition, estimates of sub-prime losses continue to mount. In recent weeks losses of about $120bn have been revealed, and the German Finance Minister said that the G7 thought losses could be $400bn. However, perhaps more worrying for banks were the comments by, Mr Draghi, Governor of the Bank of Italy and Chair of the Financial Stability Forum (a committee of international supervisors and central bankers), who said regulators were ready to force banks to reveal their losses and replenish their equity ratios. He did not rule out the possibility that governments might eventually need to inject capital into banks, although he stressed that market solutions should take precedence (what a surprise!). Whilst such a cure may be needed, the medicine may be too much for the markets to take, hence the reason why most banks are not revealing losses until they can also announce capital injections from their new friends, the sovereign wealth funds. Whilst we believe that transparency is vital to the proper functioning of the financial markets, we can also see that this could lead to the biggest period of turmoil the markets have ever experienced. |
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The knock-on effects of the housing price decline arise in the most extraordinary places, and we are not just thinking about non-US banks. It appears that owners of houses in the USA with negative equity and reset mortgages are not just walking away, but leaving their pets behind and, sometimes, committing acts of arson. |
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In this period of renewed credit market fall, our recommendations in favour of safety through quality have to be still more conservative. Even high-quality corporate bonds, which we praised last week, have tightened so much that that their spreads over governments mean that new purchases can scarcely be justified (although it is nice if you already own some). While we do not withdraw our recommendation about sovereign EM bonds in local currencies, great care is needed in choice of country. Admire the bravery of Zambia which has now issued its first international bond in Kwachas. |
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Focus |
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(!) USA: Indy-Mac, a mortgage issuer focusing on “Alt-A” has lost USD 500 mln, ceased dividend payment and will now issue only prime mortgages |
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(?) Europe: signs of inflation in UK and Denmark. Germany reasserting itself as a massive exporter with the 2007 trade balance very nearly EUR 200 billion. Unemployment in euro zone reaches new low |
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(!) China: pork price inflation at 50% over the last year threatens to bring about higher interest rates and a concerted effort to slow growth |
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(–) Emerging market currencies: the ZAR under pressure apparently due to capital flight linked to the electrical power fiasco. The Thai baht is also weakening. |
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(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question |
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