Fears of Mortgage Rate Re-Sets May Fuel LIBOR Manipulation and Mask Deeper Banking System Problems
Will US’s Bailout leads to another Asian’s Currency Crisis?
The recent credit crunch and the US’s release of its $700 billion of bailout plan had failed to stabilize the stock market in recent week. The Dow Jones had fallen by 16.9% this week, followed by Moscow (24%), Bangkok (23.4%), Hong Kong (16.3%), Sydney (15.7%) and Singapore (15.2%). Nevertheless, against the financial turmoil in US, dollars had risen against major currencies due to concerns of risky market conditions (Europe’s banking conditions) and risk-aversion investors had cashed in for US dollars to place their safe bet in long term US treasury bonds. (Llya, 2008) It would argue that once the rush into treasuries was subsided, the dollar would resume its decline.
However, with recent events occurring and the Asia countries proclaiming that they were less affected by the US Subprime Crisis, we had seem a weakening of Asia currencies against dollars over the months. More interestingly, the US government planned to borrow the money from world financial markets through issuing an additional $700 billion worth of treasury securities, which one might expect a weakening dollar. Nevertheless, the Asia countries were facing dilemmas in their currency policy due their exposure to currency risks :
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- A fallen dollars would mean hurt Asia countries whom relying heavily on the export market
- Much of the foreign reserve in Asia countries (especially China and Japan) are still denominated in US dollars. Depreciation in dollars means a decline in their foreign reserve. Worst of all, if the US government defaulting, these would mean zero value to their US foreign reserve that lead to problems in funding their own economy growth. (see Table 1)
- Many Asian countries’ currency policy still pegged with dollar. At the end of 2000 to Sep 2004, the accumulated foreign exchange reserves of the Asian economies had risen from $543 billion to $917 billion as compared to Japan’s $811 billion and China’s $515 billion. (The International Economy, 2005) A fallen dollar might force these countries to abandon their dollar peg, allowing it to float which in turn lead to further drop in US dollars, hurt their export, and prone to speculative attacks since their currency performance would be tied to their export.
- On the other, if these countries continue to support their dollar peg policy, these would mean a further buying in of more US treasury securities/dollars using their local currencies/foreign reserves, which lead to further drop in their own currencies/foreign reserves, inflation rises, and might trigger another Asia Financial Crisis 1997-1998. The question was how much can the Asian countries to continue to absorb the debt in order to stabilize the dollar without sacrifice their short-term debt obligations. (see Chart 7)
In addition, it was suspected that the recent depletion in Asia’s currency rate might due to withdrawal of their financial assets by foreign investors whom were facing a credit crunch in their own market, and in need of cash to fund their operations at home. Again, these would hurt the Asia countries’ currency since it would deplete their foreign reserve, investors selling off their currencies in exchange for dollars, and triggering a further decline in Asia currency rate. Lastly, to protect their own currencies, a massive sell-off of dollar/T-bills to absorb their own currencies by these Asia Central Banks was most undesirable to be seen in the global financial market.
With an unstable political situations facing by Asian countries, the vulnerability came in U.S. dollar and their exposure to external markets; it was most likely they would fall to the prey of unethical investors whom looking for another speculative currency attacks in these countries. It was crucial for these countries to setup a well-planned policy and strategies to face of the potential risks that might arise within the short term in the money market.
BIBLIOGRAPHY
1. Kelvin Tan (2008). To Catch a Falling Dollar. http://www.asia-inc.com/index.php /investing/101-may-june-2008/166-to-catch-a-falling-dollar, 1 May 2008
2. The International Economy (2004). The new U.S. Asian dollar bloc: and Why Europe would end up the loser, http://goliath.ecnext.com/coms2/gi_0199-1531/The-new-U-S-Asian.html, 22 Mar 2004
3. The International Economy (2005). Has Dollar Pegging Paid Off For Asia? (Economic Conditions in Asia), http://goliath.ecnext.com/coms2/gi_0199-4926132/Has-dollar-pegging-paid-off.html, 1 Jan 2005.
4. Llya Spivak (2008). US Dollar Rises as Jobs Fall, Markets Call for Fed Rate Cuts – Why?(Euro Open). http://www.dailyfx.com/story/topheadline/US_Dollar_Rises_as_ Jobs_1223273562748.html, 6 Oct 2008.
5. Mark Landler (2008). In a Weak Climate, U.S. dollar has muscle, http://www.iht.com/articles/2008/10/06/business/dollar.php, 6 Oct 2008.
6. Leika Kihara (2008), Return of Asia Currency Crisis Unlikely: ADB, http://www.chinapost. com.tw/business/asia/asian%20market/2008/07/05/164040/Return-of.htm, 5 July 2008
7. Tyler Cown (2007), The Dollar is Falling, and That’s Good news, http://www.nytimes.com/2007/12/02/business/02view.html?_r=2&ex=1354338000&en=388b47b38dc5bf57&ei=5088&partner=rssnyt&emc=rss&oref=slogin&oref=slogin, 2 Dec 2007.
8. Jack Ewing (2008). The Power of Falling Dollar, http://www.businessweek.com /globalbiz/content/mar2008/gb20080310_608242.htm, 3 Mar 2008.
9. FxStreet.com (2008). UPDATE: Asian Shares, Currencies Drop; US Econ Concerns Rise. http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=2fab6dbf-96e9-4862-a5f4 -1f4accde0e2a, 6 Oct 2008.
10. Henry C K Liu (2007). The Interest Rate Condundrum, Part 2: How Currency Devaluation Destroys Wealth. http://www.atimes.com/atimes/Global_Economy/ IF14Dj01.html, 14 Jul 2007
11. Daniel Kruger (2008). Yen Gains Most in Decade as Investors Abandon Risk, Carry Trade. http://www.bloomberg.com/apps/news?pid=20601101&sid=alu1s9F0w0bM&re fer=japan, 11 Oct 2008.
Inside the Credit Crisis: How the Fed’s Efforts to Lower the Fed Funds Rate May Leave it Powerless to Stop the Financial Meltdown
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Where will be the Bottom for Dow Jones?
I had stumbled upon an article “In the Long Run, the Dow’s 40% Nosedive May Actually Turn Into a Safe Landing” by Martin Hutchinson. This article argued that for those whom believe in fundamental stock-market valuation, the Dow Jones would be trading at 7.829 as of today which in line with the nominal GDP since Feb 1995. The author attributed the many economic difficulties were due to a change in U.S. Federal Reserve Policy which took place in spring 1995, where Federal Reserve had adopted a broad money supply which contradicted to its policy of monetarism from 1979 to 1995. Nevertheless, the shift in policy in 1995 had not caused much inflation as it coincided with the arrival of Internet and cheap cell-phone technology that enabled manufacturing to outsource globally, suppressing price increases and inflationary pressures. After 2000, other countries followed Fed’s lead to loosen monetary policy and caused asset prices to soar worldwide with the exception in Japan.
The article arouses my interest to find out any truth in the author’s words. Based on the data gathered and as shown from the chart, there was a good correlation between the Dow Jones and U.S. GDP growth from 1980 to 1995 attributing to the monetarism policy adopted by Fed Reserve. After Alan Greenspan had turned to a more-expansionary policy, the stock market had rose 225% vs GDP (Unadjusted) growth of 93.89% (1995 -2008). If indeed we were trading based on the fundamental of U.S. economy, the article reflected the stock market as of now, the market were trading at roughly 10% overvalued, according to Dow Jones closed at 8,579.19 (10 Oct 2008).
Nevertheless, in a bear market, it is possible for the Dow to trade at below 7,829. As such, coming to this, where would be the bottom will be? Thus, if we put our basis when the year of monetarism policy started (1979) and estimated based on the year-to-year GDP growth rate, the Dow Jones would find a roughly good supporting ground at 4,281 as shown in the chart.
Source: Data based on U.S. Department of Commerce: Bureau of Economic Analysis
BIBLIOGRAPHY
1. Martin Hutchinson (2008). In the Long Run, the Dow’s 40% Nosedive May Actually Turn Into a Safe Landing. http://www.moneymorning.com/2008/10/10/high-dividend-yields/, 11 Oct 2008
Review of Subprime Crisis (Part 3) – Resemblance of Japan’s Debt Crisis.
The problem associated with US subprime loans resembled a lot similarities of those faced by Japan’ debt crisis during the 1990s. The two meltdown had started in the same way – with busted stock and real-estate bubbles. Both the US and Japan’s market were ignited by a loosely credit policies, smoldered under a lack of oversight from government regulators, market analysts or such private-sector sentinels as credit-rating agencies which fanned into a frenzied financial conflagration by the promise of easy profits.
Financial Turmoil in Japan
When Japan’s real estate bubble burst in 1991, it was predicted the prices would bottom out around 1995. (Kobayashi, 2008) Nevertheless, they continue to decline steadlily for 12 more years until 2007. By early 2004, houses in Japan were selling at 1/10th of their peak value and commercial real estate was selling for less than 1/100th of its peak-market value. It was estimated that $20 trillion in stock market and real-estate had been vaporized.
At the beginning of 1990s, Japan policy-makers and banks believed the problem was self-contained and that the banks holding huge unrealized capital gains could easily overcome losses from disposals of bad loans, just like the US counterparts believe so in the early of the crisis. It may recall that in 1989, all of the world top 10 banks were Japanese. But the deteriorating in Japan’s land prices had fallen for 17 years and this was beyond anyone’s anticipation. This scenario had told us that the US policy-makers should prepare for a worst-case scenario in the event of the vicious circle continues.
Economy Vicious Circle
The nature of the current financial crisis faced by US should be understood not as a liquidity crisis but as an “insolvency crisis”. As such, once this fear emerged in the US market, ordinary macroeconomic policies e.g. fiscal and monetary policies might not work as these policies are designed for liquidity crisis.
Taking in the worst-case scenario in which US housing prices continue to fall for many years. In this scenario, the concerns about bank insolvencies might materialize. Continuing fall in housing prices would increase the bad loans in which banks had to dispose of bad loans in excess of the collateral value. If the collateralized houses lose their value over the years, bank’s capital might dry up. Anxiety over this worst-case scenario materializing might worsen the prevailing mood in the market and among consumers, leading to lesser consumption and lower housing prices.
Self-help by financial institutions might not be able to stop the vicious circle as losses could swell beyond control. Firstly, the three downward spirals facing by US financial institutions of today are:
Confidence: Banks and insurance companies rely on widespread perception they are financially sound. However, even the soundest firms could not pay its obligations on short notice when there is a bank rush and consumers withdrawing their money resulting from the rumors and news of bank failure. Moreover, Federal deposit insurance runs on commercial banks but not other financial institutions such as AIG, Bear Stearns, Lehman Brothers etc.
Deleveraging: The paradox of today is that the financial firms were doing the right thing by reducing the debts. However, to reduce debt, they were all trying to sell their financial assets which drove the prices down, reducing the value of assets. This forced them to sell more assets and drove the prices down further.
Housing: Since housing is the root of the problem, the situation would get better only with the market hit the bottom. However, till date, they were no sight that the market would hit bottom in the coming years.
Macroeconomic policies were powerless
With the fear of future bank insolvencies at the core of this crisis, ordinary monetary policy would be powerless. Japan’s experiences with monetary policy had clearly proved this. In 1990s, Bank of Japan (BOJ) conducted aggressive monetary policy by cutting interest rate repetitively until the nominal interest rate hit zero. But, the financial system still stayed in crisis throughout the late 1990s to early 2000s.
If the problem was due to banks run shortage of money, a massive liquidity provision or aggressive interest rate cut would stabilize the payment system and financial institutions would become solvent again by the payment system. However, in the situation where now the market was concerned with insolvencies, monetary policy might not able to restore confidence.
Fiscal policies to save mortgage borrows and boost aggregate demand would not work either. The fiscal policies to restore confidence would be effective depending on the expectations on the future path of the economy. Nevertheless, fiscal policies, such as tax cuts, public works etc were too indirect a policy to eliminate the fear of insolvencies.
A New Policy Scheme
Currently, it looks as if a massive federal intervention would stop these vicious circles – a policy scheme or government fund for unlimited capital injection into banks in case of insolvencies. Setting up such funds would not necessary be bad for the taxpayers but a good investment opportunity. During Japan’s 1999 banking crisis, the government set up 70 trillion yen for capital injection into quasi-insolvent banks. Around 12.4 trillion yen was invested in banks and 9 trillion yen was repaid by the banks with interest added. The remaining 3.5 trillion yen was schedule to be repaid safely. Secondly, there might no need for US federal to inject public funds if the scheme is established. With unlimited guarantee by government put in place, the fear of insolvencies would resolve. Thirdly, a provision against bank insolvencies would help to restore public confidence and stabilize the payment system.
Having to say it all, it is still necessary to aware the dangers of this policy and its critical problem – the responsibility of the CEOs and bankers of financial institutions. By imposing an unlimited guarantee from the government, this would encourage the moral hazard of the bankers whom recklessly lending out the money and do not need to bear the full consequences of its actions. The worst we could want to prevent is the shakeup of global confidence in US government and the defaulting risks of the country.
BIBLIOGRAPHY
1. Geoff Colvin (2008). The economy’s 3 vicious cycles. http://money.cnn.com/ 2008/09/29/magazines/fortune/colvin_economic_cycles.fortune/index.htm, 1 Oct 2008
2. William Patalon III. How the U.S. Financial Crisis Resembles Japan’s Lost Decade – And How to Play it. http://seekingalpha.com/article/85743-how-the-u-s-financial-crisis-resembles-japan-8217-s-lost-decade-and-how-to-play-it, 1 Oct 2008
3. Kobayashi Keiichiro (2008). Subprime Loan Crisis – Lessons from Japan’s Decade of Deception. US : Research Institute of Economy, Trade and Industry (RIETI).
4. Steve McGourty (2008). US National Debt – An Analysis of the Presidents Who Are Responsible for Borrowing. US
5. Paul B. Farrel (2008). A $75 trillion fright fest – Eight megahorror debts chilling America. http://www.marketwatch.com/news/story/75-trillion-fright-fest-8/story.aspx?guid=%7B1E95D857-7CB8-46AD-B26C-D3732D93FD06%7D, 1 Oct 2008
Review of Subprime Crisis (Part 2) – The Causes
The crisis could be attributed to a number of factors. Most of these reasons are complex and varied, mostly persuasive in the housing and credit markets. Some of these factors are:
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- Some news and media commentary blame the crisis on the complexity of the CDO and the failure of risk and recovery models used by credit rating agencies to value these products.
- Institutions lacked the competency to monitor credit performance or estimate expected cash flows.
- Some academics maintain that because the products are not priced by open market, thus the risks are not priced into its cost.
Nevertheless, whatever the reasons there are, it all stem from the fundamental change in the way housing mortgages are funded. In recent years, banks have financed their mortgage lending where they sell on the mortgages to the bond markets. This made it easier to fund additional borrowing, but also led to abuse as well.
Rise of Mortgage Bond Market
In the past five years, the private sector has dramatically increased its share in the mortgage bond market which previously dominated by government-sponsored agencies. They specialized in new types of mortgages such as sub-prime lending or jumbo mortgages for limit over $417,000. This model proved extremely profitable for the banks as they earned a fee for each mortgage sold. Thus, they urged brokers to sell more and more of these mortgages, which is now worth $6 trillion and is the single largest part of US bond market (bigger even than Treasury Bonds).
A combination of low interest rates and large capital inflows from outside the US had created a surplus of loadable funds and easy credit for many years which led to boom in housing market. Housing prices were high and it was extremely difficult to own a house without moving the very edge of the metropolitan area. Mortgage brokers instead focused their efforts to sell sub-prime mortgages to these people. But these mortgages tend to have a higher rate of repossession than conventional mortgages because they were adjustable rate mortgage (ARMs) or considered to be high risk loans. These payments were fixed for two years, and then became both higher and dependent on the level of Fed interest rates, which rose substantially after the US economic recovery and stead rise in inflation rate.
Source: Trading Economics
Another contributing factor was the increased speculation in real estate market. It was estimated by end of 2005, nearly 40% were bought for this purpose. Eventually, overbuilding during boom period led to a surplus inventory of homes, causing the home prices to decline. Nevertheless, homeowners were unwilling to sell their houses, refinance becoming difficult and began to default on loans as their loans reset to higher interest rates and payment amounts. Thus, this led to further increase in housing inventory as shown below.
An estimated 8.8 million homeowners have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage, nearly 10.8% of total homeowners. (New York Times, 2008) As a result, these had a dramatic effect to the housing price with four million of unsold houses depressing the prices. In 2007, house prices are declining at an annual rate of 4.5% and it was expecting to fall by at least 10% by 2008 as shown below.
Bank Losses
As a result, the banking industry was facing huge losses. In 2007, the banks had announced $60bn worth of losses as many of the mortgage bonds backed by sub-prime mortgages had fallen in value. These losses could be much greater (as in 2007) as many banks might have concealed their
holdings in exotics, off-balance sheet instruments such as “structured investment vehicles” or SIVS. Although the banks did not own these SIVs and were not liable for their losses, but they were forced to cover any bad debts that they accrued. A good example would be Merrill Lynch in which the bank was addicted to the profit made from the “carry trade” – borrowing money at low rate and using it to buy CDO bonds paying higher rates.). Merrill Lynch might be optimistic that the credit market would be eased, thus leaving the bank to the large exposure of subprime paper remained unhedged, an estimated of $21 billion. (CNN, 2007)
Bond Market Collapse
These losses in terms had a dramatic impact to the bond market and bondholders, such as pension funds, which suffered huge losses. In the beginning of 2007, these bonds had fallen sharply in value and were worth between 20% and 40% of their original value.
Swap Market
With the troubles spilled out in the bond market, this had spread over to the Credit-Default Swaps – a private contracted that let firms trade bets on whether a borrower is going to default. The value of the swap rise and fall as market reassesses the risks that a company won’t be able to honor its obligations. Firms also use these instruments both as insurance – to hedge their exposures to risks and wager on the health of other companies. It was estimated there were more than $62 trillion in debt on credit-default swaps. (Wall Street Journal, 2008). One of the big new players in this game was AIG, the world’s largest insurer and a major seller of credit-default swaps to financial institutions and companies. Thus, with more firms defaulting, AIG’s strong credit ratings were affected and its balance sheet was thrown to turmoil by writing down on its derivative position. Its stock price was fallen dramatically and this had made it harder for the company to raise capital that it needed to maintain its credit rating. If its credit rating could not be maintained, this would mean a further drop in the value of its credit-default swap in which it was holding, thus having a great losses to its balance sheet and led to bankruptcy.
Hedge Fund
Hedge funds could be among the next problem areas as many had relied on borrowed money to amplify their returns. With banks under pressure and tightened their lending, many hedge funds’ returns would be pressurized. Furthermore, with the new rule and regulation planned to or passed from most central banks to stop taking short position, the funds would have to adjust their investment policy to limit tracking error in their portfolios.
Regulators’ Dilemmas
This crisis was also complicated by innovative financial instruments that Wall Street created and distributed. They were making it harder for officials and Wall Street executives to know where the next set of risks is hiding and contributing to the crisis’s spreading impact. The rules that the regulators devised in the past could not oversee the rapidly changing financial system. Investment banks were not as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators. With the runs happened in spheres, especially in the repurchase agreements or repo market, in which investment banks fund their day-to-day operations, regulators had no process to handle such failures and insurers like AIG which was not federally regulated.
BIBLIOGRAPHY
1. The New York Times (2008). Rescue of Home Owners in Debt Weighted. http://www.nytimes.com/2008/02/22/business/22homes. html?_r=1&oref=slogin, 28 Sep 2008
2. CNN (2007). Wall Street’s money machine breaks down. http://money.cnn.com/magazines /fortune/fortune_archive/2007/11/26 /101232838/index.htm, 28 Sep 2008
3. Wall Street Journal (2008). Worst Crisis Since ’30, with No end yet in sight. http://online.wsj.com/ article/SB122169431617549947.html, 28 Sep 2008.
4. BBC News (2007). The Turndown in Facts and Figures. http://news.bbc.co.uk/2/hi/business /7073131.stm, 28 Sep 2008.
5. News In Focus (2008). X-Trackers Bank ETF Stops Taking Shorts in Europe. http://www.indexuniverse.com/sections/newsinfocus/10-news-in-focus/4585-x-trackers-bank-etf-stops-taking-shorts-in-europe.html, 28 Sep 2008.
6. Wikipedia (2008). Subprime Mortgage Crisis. http://en.wikipedia.org /wiki/Subprime_mortgage_crisis, 28 Sep 2008
Review of Subprime Crisis (Part 1) – CDOs
The financial crisis had begun 13 months ago. Till date, the situation has not been improved but is worsening and taken a new turn which shake the financial world. With the latest fallout from AIG, consumers were losing confidence and every distress banks was asking for “bail out” from the U.S. government. Central banks from all over the world were pouring hundreds and billions of dollars into the global market. In order to understand the problems, it was worthwhile to examine the products that led to this subprime crisis – Collateralized Debt Obligation (CDO).
Collateralized debt obligation
Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets and rated by the rating firms to assess their value. Since 1987 (Black Monday), CDOs have become an important funding vehicle for fixed-income assets.
Structures
Generally, CDO is a broad term refers to several different types of products in which their usage categorizing in several ways as follow:
1. Source of fund
a. Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO’s assets
b. Market value CDOs attempt to enhance returns by realizing the capital gains on the trading and profitable sale of collateral assets.
2. Motivation
a. Arbitrage transactions attempt to capture for equity investors the spread between the relatively high yielding assets and lower yielding liabilities represented by the rated bonds. The majority of CDOs (86%) are arbitrage-motivated (SIFMA, 2007).
b. Balance sheet transactions are used by issuing institutions to remove loans and other assets from their balance sheets to reduce their regulatory capital requirements and improve their return on risk capital.
3. Funding
a. Cash CDOs involve a portfolio of cash assets such as loans, corporate bonds, asset-backed securities or mortgage-backed securities.
b. Synthetic CDOs gain credit exposure for the above assets without owning those with credit default swaps.
c. Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs, therefore its portfolio includes both cash assets as well as swaps.
4. Single-tranche CDOs
a. Single-tranche CDOs are constructed from credit default swaps in which it is especially structured specifically for a single or small group of investors. The dealers hold the remaining tranches and their values are based on valuations from internal models.
Type of CDOs
A) Based on the underlying asset:
- Collateralized loan obligations (CLOs): CDOs backed primarily by leveraged bank loans.
- Collateralized bond obligations (CBOs): CDOs backed primarily by leveraged fixed income securities.
- Collateralized synthetic obligations (CSOs) : CDOs backed primarily by credit derivatives.
- Structured finance CDOs (SFCDOs) : CDOs backed primarily by structured products, e.g. asset-backed or mortgage-backed securities.
B) Other types of CDOs include:
- Commercial Real Estate CDOs (CRE CDOs) — backed primarily by commercial real estate assets
- Collateralized bond obligations (CBOs) — CDOs backed primarily by corporate bonds
- Collateralized Insurance Obligations (CIOs) — backed by insurance or, more usually, reinsurance contracts
- CDO-Squared — CDOs backed primarily by the tranches issued by other CDOs.
BIBLIOGRAPHY
1. Securities Industry and Financial Markets Association (2007). Global CDO Market Issuance Data: SIFMA : USA.
2. Wikipedia (2007). Collateralized Debt Obligations. http://en.wikipedia.org/wiki/Collateralized _debt_obligations, 21 Sep 2008.
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