Transcript ACCA CPD Event - Dec 2008.pps

Wall Street to Main Street
ACCA CPD Event
2 December 2008
Hamid Hamirani
[email protected]
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Recap Extracts from Nov 2007
Presentation
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So What is Causing All This – What are the Consequences ??
Collection of Thoughts 2 - Toxic – Credit Problem - 22 August 2007
The problem facing the US economy is that toxic waste has infiltrated the
credit markets. Financial institutions are afraid both to lend and to buy
financial paper, for fear that the borrowing or issuing institution has
‘unknown' amounts of toxic credit in its portfolios and may default on a
loan or paper obligation.
So What Created this Toxic Waste – the Credit Crisis ??????
Yen Carry Trade: Up until last year Yen-bore was at Zero % - Hedge
Funds, seeing no end to the Asset Boom ( Brain Child of Alan Greenspan
), borrowed in Japan, converted into $ introduced new financial products :
derivatives , commercial paper and provided commercial banks and
mortgage lenders the opportunity to pass their risk to the hedge funds
and credit was given to many insecure and known credit-risk borrowers
thus: the Sub-prime crisis.
The liquidity was poured into investments in China ( Manufacturing ) and
India ( Soft Skill Outsourcing ) creating the demand which led to a
commodity price inflation and broke the conventional relationship
between a US $ rise and commodity price inflation.
Thus the US $ lost its natural hedging characteristics: this is critical for
the currencies which remain pegged to the US $ - and therefore we are
seeing a number of countries considering pegging to a basket of
currencies as Kuwait did and as China is currently contemplating,
resulting in further misery for the $
What are the Consequences of the Credit Crisis ??
Financial Institutes suffering leading to job losses & economy
slowdown
Citigroup Inc., the world's biggest bank, may have losses from assetbacked bonds of as much as $13.7 billion. The shares have fallen 17%
in a week, and reached a 4 year low. Bank of America Corp., the
second-biggest U.S. bank, is expected to announce losses of $5.4
billion, and JPMorgan Chase & Co., the third-biggest, is expected to
have lost $4.1 billion. Merrill Lynch & Co last month reported $8.4
billion write-down's in the third quarter
“Annual Audited Accounts may further open up the can of
worms”
What are the Consequences of the Credit Crisis ??
The losses are resulting in job losses and a reduction in wealth: this is
likely to further dampen the consumption leading to the economy
slowing down.
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Good Business Starved of Essential Finances:
With the Credit Squeeze and most leading financial institutions not
really knowing either their own potential risk or the others have
seriously curtailed their lending and they are lending at a risk premium
which is likely to effect good business.
Mortgages are not now easily available and the cost has gone
up
This is causing house prices to fall bringing more pressure on the
economy. The rise in cost is resulting in many foreclosures which is
leading to a slow down in consumption.
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The Root Cause…
Lending Disaster –
Short Term Profit Motives
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US Financial Crises – Enormous Changes in Lending Standards
Underlying EVERYTHING -- housing boom and bust, derivative
explosion, credit crisis -- is the enormous change in lending
standards.
After the Greenspan Fed took rates down to ultra-low levels, home
prices began to levitate. More and more mortgages were being
securitized -- purchased by Wall Street, and repackaged in forms of
bond-like paper. The low rates spurred demand for this higher
yielding, triple AAA rated, asset-backed paper.
In this ultra-low rate environment, where prices were appreciating,
and most mortgages were being securitized, all that mattered to the
mortgage originator was that a BORROWER NOT DEFAULT FOR 90
DAYS (some contracts were 6 Months).
US Financial Crises – Enormous Changes in Lending Standards
The contracts between the firms that originated mortgages and the
Wall Street firms that securitized them had explicit warranties. The
mortgage seller guaranteed to the mortgage bundle buyer
(underwriter) that payments were current, the mortgage holders were
valid, and that the loan would not default for 90 or 180 days.
So long as the mortgage holder did not default in that period of time,
it could not be "put back" to the originator. A salesman or mortgage
business would only lose their fee if the borrower defaulted within that
3 or 6 month contractually specified period. Indeed, a default gave
the buyer the right to return the mortgage and charge back the lender
the full purchase price.
US Financial Crises – Enormous Changes in Lending Standards
What did the rational, profit-maximizers do?
They put people in houses that would not default in 90 days -- and
the easiest way to do that were the 2/28 ARM mortgages. Cheap
teaser rates for 24 months, then the big reset. Once the reset
occurred 24 months later, it was long off the books of the mortgage
originators -- by then, it was Wall Street's problem.
This was a monumental change in lending standards.
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US Financial Crises – Enormous Changes in Lending Standards
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It created millions of new potential home buyers. Why? Instead of
making sure that borrowers could pay back a loan, and not default
over the course of a 30 YEAR FIXED MORTGAGE, originators only
had to find people who could afford the teaser rate for a few months.
Greenspan believed the free market could self-regulate. (After all,
people are rational, right?). This would not have been possible
without the Greenspan ultra-low rates, which made the teaser
portion (the "2" of the 2/28) of these mortgages so attractive.
One of the many odd lessons of this era is that, under certain
circumstances, companies and salespeople will pursue short term profits
to the point where it literally destroys the firm and possibly the country;
Asset
/
Liabilities
Total US commercial mortgages $ 14 trillion
so would $ 700 billion be enough?
Total CDS US 55 trillion what happens if there
are corporate defaults?
Another Way of Understanding Wall Street Failure
Once upon a time in a village in India , a man announced to the villagers
that he would buy monkeys for $10.
The villagers seeing there were many monkeys around, went out to the
forest and started catching them.
The man bought thousands at $10, but, as the supply started to diminish,
the villagers stopped their efforts. The man further announced that he
would now buy at $20. This renewed the efforts of the villagers and they
started catching monkeys again.
Another Way of Understanding Wall Street Failure
Soon the supply diminished even further and people started going back
to their farms. The offer rate increased to $25 and the supply of monkeys
became so little that it was an effort to even see a monkey, let alone
catch it!
The man now announced that he would buy monkeys at $50! However,
since he had to go to the city on some business, his assistant would now
act as buyer, on his behalf.
In the absence of the man, the assistant told the villagers: ' Look at all
these monkeys in the big cage that the man has collected. I will sell them
to you at $35 and when he returns from the city, you can sell them back
to him for $50. '
The villagers squeezed together their savings and bought all the
monkeys.
Then they never saw the man or his assistant again, only monkeys
everywhere! Welcome to WALL STREET.
Why the Global Equity Market Shall Remain Under
Stress?
Recession - Are equities really cheap?
•75% of the World GDP ( Advance economies ) are already in
recession.
•A dozen emerging countries are in a stage of seeking IMF assistance.
IMF has only $ 100 billion.
•Even China’s and Brazil’s economies are in stress. China’s growth is
now 9%, considerably lower than what was expected; next year’s
growth will drop to between 8 & 9%.
Why the Global Equity Market Shall Remain Under
Stress?
Deleveraging – Have the equities really bottomed out ?
•Hedge Funds ( see separate slide )
•Recession creates risk for corporate failures which in turn risk CDS
write off - Sony sales are the worst in 13 years.
Fall in House Values – Reducing credit worthiness which is a lubricant
to economy
Securitization – Potential for more bad news – write offs
Securitization was supposed to mitigate risk but all it did was earn a
considerable amount of fees for all the intermediaries and only ended in
transferring the risk to the final victim.
Why Global Equity Market Shall Remain Under
Stress?
Seizure of Liquidity – starving good business of credit & ST
finances
• Increase in counter party risk, uncertainty on CDS write offs,
potential private equity LBO write off and hedge fund failures and
seized inter bank lending - this is effecting good business access to
credit and working capital finances, risking more economic down
turn.
•Unemployment
Growing unemployment - 6.1% in the US, expected to be 8% by the
middle of 2009
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Why Global Equity Market Shall Remain Under
Stress?
Regulation - Reducing potential returns as leverage is regulated.
Increase in regulation as shadow banking system cease to exist or
comes under more regulation with higher capital adequacy ratios
and increase in transparency in securitized instruments .
Bottom Line – Lost Consumers
US annual consumption $ 9.5 trillion. Chin-india
annual consumption $ 1.6 trillion
Hedge Fund Risk – More Worse Time to Come of Equities
Some 8,000 hedge funds with more than $1.7 trn (£1.1 trn) in assets are
“being caught in a vicious cycle” say Business Week’s Matthew
Goldstein.
Over the three months to September, another $179bn was wiped off the
value of hedge fund assets by falling asset prices, according to Hedge
Fund Research. Spooked by the market falls, and keen to have ready
cash at hand, investors have been pulling their money out at a rapid rate,
with almost $31bn being withdrawn over the quarter – which means
hedgies need to sell more assets to repay clients.
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Hedge Fund Risk – More Worse Time to Come of Equities
As the markets fall, lenders are also cutting credit lines to their hedge
fund customers or are making ‘margin calls’, i.e. demanding that those
funds come up with extra cash to back up their borrowings.
As many as 30% of hedge funds will be shutting up shop “in a Darwinian
process”, says Emmanuel Roman at GLF Partners, and the US
authorities will force-feed regulation onto the rest: “there need to be
scapegoats, and they are going to go hunt people”. That will make
business even harder, and lead to even more forced selling. In London,
out of 450 hedge funds, more than 100 could be at risk, says Miles
Costello in The Times.
So how far can the S&P 500 possibly fall further ?
The consensus estimates peg 2009 aggregate operating earnings
for companies in the Standard & Poor's 500-stock index at about
$94 a share, according to Thomson Reuters. That figure assumes
earnings growth both this year and next.
If those estimates panned out, the S&P on Friday would have
traded at what looks like a bargain multiple of about 9.3 times
forward earnings. Shift earnings to the lower end of the
consensus range, about $75 a share, and the multiple rises to
11.7 times.
So how far further can the S&P 500 can possibly fall further ?
That still might seem cheap compared with multiples that often
exceeded 20 times during the 1990s. But it is well above trough
valuations of about eight times seen during the depths of the
1970s bear market, according to data from UBS. And the
economic outlook, along with the unwinding of the credit bubble,
means it is unlikely that earnings will increase this year or next. .
Bears are well below the consensus in their answer. Barry
Ritholtz, director of research at Fusion IQ, for example, says he
reckons that 2009 earnings could drop to about $50 a share. In
that case, even a multiple of 14 times would bring the S&P to
about 750 -- nearly 15% below current levels."
USA Macro Analysis Will the Stimulus Work
Consumption remains down Q3 to -3.7% from the original estimate of
-3.1
Home prices (S&P Case Chiller ) down 23% from its peak – negative
wealth effect can amount to a whopping $ 500bn. Consider adding
stock market losses to it??.
Retail Sales were down by 15% during July – October.
Commercial real estate can be the next shoe to drop the default can
be around $ 800bn CMBS usually follow the fate of residential
mortgages with a 2 years time lag.
Unemployment spooked in November with the 8 month continuous
rise in unemployment expected to rise to between 8% and 9%. This
would represent a drag in the economy.
USA Macro Analysis Will the Stimulus Work
Declining orders for durable and capital goods indicating industrial
production will decline significantly in 2009. This will result in a cut in
corporate expenditure representing a further drag on consumption.
Fall in energy prices will help to strengthen the dollar.
Lack of capital outflow to Asian & developing markets and global
demand destruction is likely to result in slow down of exports to
destinations like Japan, Europe, Asia and Latin America
•Can fiscal stimulus be implemented fast enough
in an increasing political environment.
•Cost of debt is rising at the same time of global
slow down
•How will it all be financed.
But All is not Gloom & Doom
Stock / Sector selection is likely to be key for wealth management
So What is Next ?
Much of the Rest of the World May Follow America & Europe’s Footsteps
Economists are lowering global growth estimates:
2009 E
2008E
2007A
Euroland
0.5%
1.1%
2.6%
United
Kingdom
0.4%
1.0%
3.0%
Japan
0.5%
0.7%
2.1%
China
8.7%
9.8%
11.9%
Brazil
3.3%
5.6%
5.4%
Key Factors Likely to suppress growths:
• Decreased global liquidity.
•Lower Capital Flows to emerging market
•Reduced G-7 demand for imports
•Lower demand for commodities
So What Lies Ahead for 2009 ?
•Global Slow Down – growth estimates shall be further revised.
Stagflation
•Reduction in interest rates however spread would remain higher
LIBOR loosing its benchmarking status
•Regulations more for the buy side rather then sales side.
•Fiscal stimulus and return of Keynesian Economy where Govt
spending rises.
•Rising Unemployment – More research and regulatory jobs – career
prospects
•Exchange Rate Volatility – Hedging demand is like to increase.
•Consolidation Mergers & Acquisition – Bargain Valuations
So What Lies Ahead for 2009 ?
•Change in Accounting Standards – Marked to Market Rules will be
challenged
•Social unrest– Geopolitical issues – Russia, Iran and Latin America –
War generates growth potential
•Commodity prices will act as a cushion
•US deficit how it will be financed additional pressure:
- Health care and ageing population
•No more vendor finance so what would be financing based on
geopolitical demand or higher interest rates
•Strong Emerging Market Countries and the GCC will play an important
role in stabilizing the world economy – China stimulus plan.
GCC Impact
How the GCC is likely to Fare…
•No Recession fears for the GCC: growth expected to be around
4.5% which is reasonable for the 33 million or so population. FIA may
return for good returns.
•3rd quarter results of Saudi & Omani Banks do not show any sign of
stress.
•The dollar liquidity squeeze will ensure projects are prioritized: it
should result in projects of extreme national importance being given
priority rather than investment hysteria into bricks and mortar Nakheel's decision to scale back work on Palm Deira
•Cash surplus combined with low commodity prices provides an
excellent opportunity for GCC to complete projects with relatively less
cost.
How the GCC is likely to Fare…
•Inflation will be checked, slow down will provide opportunities to align
structural imbalances.
•Loss of revenue in oil is to a larger extent compensated by a
reduction in construction cost, deflationary pressures on wages and
the strengthening of the $ and consequent increase in buying power
• The oil price fall is likely to arrest or certainly delay capacity
extension and alternative energy projects which were a real threat to
the long term stability of oil prices.
•The reduction in oil consumption will ensure that the life of the vital
and finite asset will be extended for the future generation.
So Why Are The GCC Markets Are Falling?
In general the GCC suffered from the triple whammy:
1. Liquidity dried up due to changes in reserve requirement for
inflationary fears in Oman around US $ 500 million went out of the
system.
2. FII withdrawals due to redemptions in their own backyards and due
to unrealized expectations on currency revaluation.
3. Freezing of Inter-bank lending which prompted local banks to offer
high fixed deposit rate to local depositor thus generating a switch in
asset class from equities to deposits.
So Why Are The GCC Markets Are Falling?
More recently due to the fear of local financial institutions exposed to
toxic assets, global slow down and fall oil prices.
More Specifically:
1. the real estate debacle in Dubai; corruption and fall in prices causing
local banks to tighten the credit and increase in spread in Dubai
around 700 basis points and lenders raising mortgage lending
criteria's which puts further pressure on the real estate demand.
2. Oil prices fall in global slow down affecting the petrochemical
industry basis of Saudi.
So far the GCC has addressed the financial
risk, but fiscal measures are required to
address the economical risk. The market
needs visibility of earning projections.
So Can China Make the Difference?
Massive stimulus packaged of around $ 600 billion. Main spending
includes public works, social welfare and tax reforms.
•Public work spending areas are: public housing for poor
households, infrastructure projects such as railways, roads, airports,
power grid and earthquake repairs.
•Tax reforms includes VAT reforms with estimated savings of 120
billion yuan. This will encourage capital spending by corporate
businesses.
•Social reforms include setting up minimum grain prices, increase in
subsidies for farmers, social security benefits for low income groups,
and increase spending on health and education. This should
increase consumer spending as the above measures are likely to
result in an increase in consumer disposal income.
So Can China Make the Difference?
Factory closures are oversold. Most closures have been in the shoe and
toy sectors which represent only 5% of China’s total exports. Factory
closures are also due to relocation to inner china where cost are
relatively still low. Export of machinery and transport equipment
representing almost half of the total exports are up by 20% in volume in
annual terms.
The China housing bust is not as bad as the US. Total household debts
are only 13% of GDP compared to the US 100%. Chinese buyers have
had to put down a minimum deposit of 30%.
Over the past year real income have risen to 10% in urban areas and
14% in the countryside.
Retail sales rose by 17% in real terms in the year to October.
Public sector debts represents only 20% of the GDP, surplus stands at 12% of GDP.
Final Words…
No doubt we can be certain on the global slow down and financial
crisis ( Wall Street ) turning into economic crises ( Main Street ).
The US focus will shift from toxic assets to addressing the housing
and lending crises which are the main drivers for all the gloom and
doom. This is an “ Independence Day “ scenario where the whole
world stands together from Mumbai to Shanghai ready with massive
fiscal and monetary measures.
The greatest fear is do we have enough time for all the measures to
work before the social unrest further deteriorates and manifest into
change in political uncertainties.
Final Words…
Exchange rates and interest rates are likely to remain volatile. We can
begin to see pressure building on dollar as the US bailout plan is
financed and the interest rate option is not available at least in short to
medium term.
Commodity prices and energy prices should provide some cushion and
inflationary pressure are likely to reside.
Average growth of developing countries is likely to revert to
the 1980 – 2002 pace of 3.5 to 4%. For the GCC IMF
forecasts 4.5% growth for 2009. This is not too bad at a time
when the US and much of the developed world faces an
extended period of sub-par growth. This should increase the
relative appeal of investing in the GCC and emerging
markets in contrast to the 1980s and 90s when the US was
growing at 3% and looked much less risky.
Final Words
The views expressed in this presentation are purely
of the presenter and does not represent the views of
either the ACCA or Vision Investment Services.
Disclaimer : This is an informative Seminar and needs to be used
as such. The topic is dynamic and the Presenter shall not be held
liable for any business decision taken based on this session. Each
Business & individual makes their decision on specific
circumstances and the business environment at the time of
decision making.
Mr. Hamid Hamirani, FCCA
+968 99359852
[email protected]