FYI | Aug 13 2007
By Greg Peel
Steak n Shake is an Indianapolis-based fast food chain. It has found that its third quarter same-store sales have fallen by 4.3%. The company issued a statement on Thursday suggesting “Some segments of Steak n Shake consumers continue to be sensitive to high gasoline prices and mortgage interest rates”.
MetroPCS Communications is a Dallas-based mobile phone company. It said last week that it is feeling the pinch from customers facing foreclosure.
These two statements (reported by Bloomberg) may not seem of significant consequence, given the world’s current focus on a global banking industry rapidly freezing and subsequent multi-billion dollar liquidity injections. But don’t be fooled. These two statements are a testament to the future state of the US economy.
Bloomberg also reported on the case of Peter Herbert’s client. Herbert is a Houston-based mortgage broker who last week attempted to find a mortgage for one self-employed client whose credit rating put him just above what’s considered subprime. On his third attempt, Herbert was offered 10.5% with attached penalty provisions. Last year he would have been offered 7.99% with no provisions. Herbert attempted to lock in the rate nevertheless, but at the last minute the lender changed its mind and pulled out.
Herbert’s experience is a microcosmic representation of what is now a macrocosmic problem. The problem started in February, when problems in the US subprime mortgage market came to light. At the time there was popular analogy going around, which suggested there was one house on fire on one street. Firemen were working to contain the fire, but there was a risk it would spread to houses either side. No one expected such, but there were further concerns that if the fire spread, the whole street could go up.
What has actually transpired, despite early reassurances, is that the entire city is ablaze in an inferno reminiscent of London in 1666. Just as the London fire had the positive effect of wiping out plague-ridden houses, so too did authorities see the benefit of a subprime-inspired credit crunch ridding the market of underpriced debt and excessive leverage. But the authorities underestimated the fire’s ferocity. Last week they had to call in Elvis the water-bombing helicopter.
Local US mortgage lenders are now too scared to issue mortgages. Banks are reluctant to finance lenders. Last week global investment banks Goldman Sachs, Lehman Bros and Merrill Lynch insisted that hedge funds to whom they had lent money – and global investment banks are the source of hedge fund credit – must pay back a greater proportion of their debts by day’s end than they had previously been required to do under a margin call. Other banks were said to have followed suit.
At the same time all banks and financial institutions across the globe became suspicious of lending money to each other overnight. In Europe the focus was on Germany’s corporate lender IKB which had to be rescued by the Bundesbank, and on BNP Paribas’ hedge funds that had to be frozen. In the US the focus was on Goldman Sachs’ US$400m Alpha Fund which, despite being considered “market-neutral” with respect to its debt security investments, closed its doors. Bank’s were not willing to risk their overnight funds in a market where more bad news was being issued every day. Hence, they stopped being willing and accommodating lenders and suddenly the liquidity in the global banking system was disappearing.
With little capacity to borrow money, hedge funds had but one option – they had to sell assets. The only problem is that the whole crisis was triggered by debt assets, so there are no buyers. That meant the only course of action was to sell any other assets that still attracted a price. The most obvious choice was equities. That is why equity markets tumbled across the globe on Thursday and Friday.
Suddenly the world’s central banks – those institutions which had spent five months sooling the world with definitive statements that the subprime crisis would be contained, and that there would be little contagion – were forced to do what central banks are there to do. They had to dump water on an out-of-control fire, and they did so in the form of massive liquidity injections. Despite the ECB’s biggest ever injection on Thursday, it had to follow up with another significant injection on Friday. It has told European banks it will provide whatever liquidity it has to. The US Fed injected twice its average daily amount on Thursday, only to find that cash was still trading at 6.00% and not the targeted 5.25% on Friday. An even larger injection was needed.
It is now clear that talk of containment, and talk of it being merely a healthy development that underpriced risk be returned to more relevant measurement, was misplaced. It is not just the over-leveraged hedge funds that have suffered. Some of the hardest hit funds have been the quantitative funds. These operate on statistically-driven models of balanced debt and equity investment. While normally the funds would adjust when the value of debt securities fell by selling those securities and replacing them with equities. But last week quant funds couldn’t sell any debt, so they actually had to sell equities instead.
Everyone is caught in the fire.
But although the moves by global central banks were clearly necessary, will they prove to be moves that settle the market long enough for fear to dissipate and stability to return?
Michael Kosares of Centennial Precious Metals in Denver has suggested to USAGold.com that the central banks have set a dangerous precedent.
“One of the points made repeatedly in the financial press today is that no one in the banking industry or the central banks knows the extent of the [mortgage security] losses. Take it a step further and you have to assume that no one knows the extent of the ongoing bailout either.
“What the press has failed to point out in its treatment of the financial crisis is that the actions of the Fed, the European Central Bank, and the Bank of Japan last week amount to printing money.”
When one country prints massive amounts of money, it devalues that country’s currency against all others. But here we have a case of money being printed in all major currencies, and hence there are no major relative currency moves. What must happen, however, is that all currencies will devalue against global goods and services. This means that if the bailouts needs to continue, there is a chance the cost of living is about to erupt to levels much higher than expected. On this basis central bank fears of inflation remain very well placed.
Now Mr Kosares is a gold dealer, and the first good or service that is likely to jump in price under his scenario is gold. But his comments are not worth dismissing for that simple reason. There is a growing divide amongst traders and economists who believe that central banks will be forced to ease interest rates lest the banking liquidity crisis becomes a solvency crisis, and those who believe they simply won’t do it.
Former Fed chairman Alan Greenspan was quick to lower the US cash rate after the LTCM collapse and after 9/11. But Lombard Street research economist Gabriel Stein told the London Daily Telegraph:
“Greenspan was a serial bubble blower who never saw a rate cut he didn’t like, but Bernanke wants to curb inflation and wring the excesses out of the system. We’re looking at a very different kind of Fed.”
Danske Bank economists believe a liquidity crisis has to be met with liquidity, as is the case, and not with monetary policy easing.
“While it cannot be ruled out that the turmoil could eventually force the Fed to cut rates, we view this as a low-probability outcome. The Fed will not cut rates unless systemic problems accelerate markedly or become long-lasting and/or signs of a significant negative impact on growth show up or become overly likely. We do not change our forecast of the Fed keeping interest rates unchanged at 5.25 % in the coming quarters.”
Similarly Danske believes the ECB will still deliver a rate rise to 4.25% in September, although it may be forced to adopt a wait and see approach. The Bank of Japan was expected to raise its rate on August 23, and Danske continues to believe it will go ahead, although it may be affected by carry trade unwinding pushing up the value of the yen.
We have only this month had an interest rate rise in Australia, and by all indications from the latest RBA statement of monetary policy, there is more to come.
If inflationary pressures continue to make rate hikes inevitable, or at least preclude any thoughts of easing, then where does this leave Steak n Shake? It will only suffer further sales declines as the American consumer begins to shut up shop. And when the American consumer shuts up shop, the ramifications spread across the globe.
There are two elements to this “subprime crisis” that are definitely not over. The first is the US housing slump which started the ball rolling. The second is the extent of known losses within financial institutions due to loans made to mortgage lenders and hedge funds.
In the case of the former, Bloomberg notes the inventory of unsold US homes in May was the largest since records have been taken. Defaults and foreclosures are only likely to increase due to the US$1 trillion in adjustable-rate mortgages that are scheduled to reset this year, peaking in October. The average US house price will fall year-on-year in 2007 – the first time this has happened since the Great Depression. Housing and related industries generate almost a quarter of US gross domestic product.
There is little doubt the US economy will slow, the only point of contention is by how much.
In the case of the latter, regulatory agencies in both the US and UK have been forced to move into Wall Street brokerage firms and check to make sure they aren’t hiding losses. The problem with mortgage-backed CDOs and other securities is that they cannot be marked to market when no market exists. Revaluations are dependent on marking to an assumed price, and it is undeniably likely that some firms are yet reluctant to admit just how low that price may be. A lot of people will be hanging on to see whether the dust can settle, and as such a market can return for the securities. For to announce serious losses now could well be extremely damaging, particularly to share prices.
The fact that authorities have seen it necessary to take such steps indicates their suspicions that the whole story is far from known. That the ECB is prepared to turn on its liquidity tap for as long as it takes also has traders very worried that the central bank is not letting on something it knows about the crisis.
There are plenty of analysts around the world who are screaming out that equity market collapses are offering a golden opportunity to invest in now undervalued stocks, particularly financial stocks. They point out further that the markets are still only down about 6% from the highs – hardly a major bout of panic. But there are few that disagree that this crisis still has to work itself out, and that this will take time.
In the meantime, CNNMoney reports that “big-money” institutional investors have turned more risk averse than at any time since August last year, taking positions they typically do not reverse quickly, State Street data showed on Friday. State Street said its clients, who keep some US$13.04 trillion with it as a custodian, have moved into what it called a “safety first” regime. This is characterized by moving from emerging to developed market equities, embracing bonds and unwinding currency “carry” trades. The firm said that since September last year investors had been taking positions reflective either of abundant liquidity or leverage opportunities.
Such a change in attitude is a good indication of how global pension funds are now likely to react. High risk, high-yielding assets will be replaced by low risk, quality assets across the debt and equity spectrum. When the “event shocks” are over, when all the bad news eventually has come out, this should prove a strategy to respect. But again, it will take time.
