FYI | Aug 20 2007
By Greg Peel
Dr Shane Oliver, chief economist at AMP, is an astute market analyst whose opinions are oft sought by the media. Dr Oliver has made the observation that there are a lot of similarities between the 1998 credit crunch and the 2007.
Leading into August 1998, the global economy was experiencing favourable conditions, despite the Asian currency crisis which had transpired the year before. The US economy was very solid, and there was a lot of interest in emerging markets in places such as Russia from a small but growing band of investors known as hedge funds.
The Fed had undergone a period of monetary policy tightening. Earlier easy monetary policy had allowed the credit spreads of risky assets to drift down. Leverage was rife, with one hedge fund – Long Term Capital Management – having used US$5 billion of capital to borrow US$124 billion from banks was invested in derivative positions with an exposure of US$1.25 trillion.
It is now the stuff of legend that faced with an economy in turmoil, Boris Yeltsin decided to default on his country’s sovereign debt – a move that might have been expected from tin-pot South American dictators, but not from the remains of the once powerful Soviet Union. This left-of-field action caused a sudden flight away from risk and back to quality assets. Corporate borrowing rates jumped by 100 basis points over government securities and high-yield spreads jumped by 300 basis points. LTCM collapsed, and the US banking system all but froze.
Sound familiar?
As central banks and investors alike feared a total financial meltdown, the Fed arranged a rescue package with the world’s largest investment banks to cover LTCM’s positions. All had been lenders to the world’s largest hedge fund. The US stock market fell 21% over a very volatile six-week period beginning in mid-July. The Australian stock market fell 16%.
For a period of three months, financial markets remained weak and volatile. Eventually the Fed decided it would have to cut the cash rate, and the market finally stabilised. The RBA cut its rate in December. The stock market had hit a low in October, but with the impetus of the rate cut only returned to true bullish mode in December. Then we entered the dotcom boom.
The similarities are too clear to be ignored. Dr Oliver notes every Fed tightening cycle in recent times has ended in a financial crisis. In 1998’s case, the tipping point came after a slow-burn affect following the Asian currency crisis the year before. In 2007’s case, it has been the slow-burn of last year’s US housing downturn that has brought us to this point. In both cases there was a fear of the entire financial system freezing up following the initial panic. Dr Oliver does, however, point out some differences.
Last time emerging market economies were vulnerable and the US strong. Now the US is weak, but stronger economies across the globe can dissipate the risk to a better extent. Corporate sector gearing is a lot lower this time around, and banks have a lesser ratio of net worth to assets. US stock PEs were at 22 times in 1998, compared to 15 times now. In Australia they were 17 times to 15.6.
(There is a lot of talk from the bulls that with recent stock market falls, forward PE ratios are so low as to render many stocks dirt cheap. But remember, it takes a very short time for the market to adjust the P, but months for analysts to adjust the forecast E).
Nevertheless, the potential weakening of the US economy is not particularly good news for the health of the global economy. But there is still a lot of faith placed in the resilience of the American consumer. Credit Suisse analysts, for one, note that consumption is far more affected by the job/wage scenario than it is by mortgage repayments, and US unemployment is at historical lows while wage growth remains positive.
However, one might care to take a glance at the following chart, as provided by Dennis Gartman. Many a bull has been at pains to point out that the actual defaults on US “subprime” mortgages amount to a storm in a tea cup. But as others point out quite stringently, subprime mortgages are nothing when compared to another class of low quality US mortgage which has also been popular this last year or two. Variously called “alt-A”, “reset” or “Adjustable Rate Mortgages” these loans start at a “teaser” or “honeymoon” low rate of interest and have already begun to step up to a much higher rate of interest (100, 200 or even 300 basis points higher). The chart indicates the value of those mortgages adjusting ahead. Most such mortgages would have been bought by Americans expecting house prices to just keep rising.
Whether or not retail consumption (which is some 70% of US GDP) is most affected by jobs and wages, this is a scary graph. It suggests there is more pain to come in US mortgages, and more pain for mortgage lenders, securitisers and hedge fund investors. We have only really seen the beginning of “subprime” mark-downs, given the underlying investment instruments such as CDOs can be marked to what financials institutions think they should be worth, and not what they are worth. This uncertainty is one ominous difference Dr Oliver points to this time around.
There will be many a hedge fund hoping that things return to normal soon so they don’t have to actually mark their investments to a non-existent market. And hoping that other, better quality investments don’t go the same way. They want to see the market settle down. How long can they hold out for?
As Dr Oliver notes:
“Once a credit crisis gets underway and starts to infect the confidence to lend and invest it can go on for a while. Panic liquidations are possible even of assets that are only tangentially connected to the real problem. Because of the uncertainty about the extent of the problems, it can lead to severe disruptions in financial markets.”
It took three months for markets to settle down in 1998.
History suggests it will take a Fed rate cut to finally encourage a “settling down”. The strong rally on Wall Street on Friday, and today’s subsequent rally in Australia, are as a result of the Fed cutting the discount rate – not the cash rate (See “Fed Invokes The Moral Hazard”; FYI; 18.08.07). Built into the Wall Street bounce is an expectation that the Fed will definitely cut rates eventually. It hasn’t yet.
Will it? Credit Suisse economists are not so sure:
“But the thrust of central bank open market operations over the last two weeks was not to change the current policy stance, but rather to defend the current policy stance. The Fed’s actions, as well as the actions of the ECB, and the tough talk of Bank of England Governor Mervyn King, reveal a common guiding principle among this new generation of central bankers – a strong reluctance to feed moral hazard into the financial markets and a desire to instil market discipline and a more thorough appreciation of credit risk. It is the central bank’s duty to keep the markets functioning, but it is not their duty to keep asset prices rising or to rescue bad judgments. With that in mind, we think the Fed will be extremely reluctant to ride to the market’s rescue barring a calamity in the financial system or clear indication that the real economy is in fact imperilled.”
So at what point will the US economy become “imperilled”? That is the big question.
Either way, Dr Oliver believes we are still in a long term bull market. He also believes, however, that there is likely more pain to come that won’t be alleviated, or confidence returned, until such time as the Fed makes its cut.
In the meantime, what have we got?
RAMS Home Loans has bounced today, but only after losing 80% of its value when it could not rollover $6 billion in mortgage financing. Today’s Sydney Morning Herald notes, on its front page, that Allco Finance Group’s low quality mortgage lender – Mobius Financial Services – has 10% of its loans now technically in default. A second German bank – Sachsen Landesbank – has had to be bailed out by the German central bank. Sachsen is owned by the state of Saxony. The Bank of England has taken the unusual step of withholding a speech by a key executive for fear it will cause further instability. The newly formed Chinese government offshore investment company has lost 22% on its stake in leading US private equity firm Blackstone. It is now almost impossible to find a proprietary market in Australian index futures options for any size, given the tumultuous volatility in the market. Index options are a means of hedging risk.
The fat lady has not sung. Nor has she warmed up, entered the building or even, possibly, risen from her bed.
