July 27, 2007 | posted by Michael Baxter in IABN | comments (0) |

In some ways it was old news that did it. The last few years have seen the growing popularity of collateralised debt obligations (CDOs.) It’s a clever idea, when a bank agrees to lend a consumer or a business money, it then sells the loan on. It shares the proceeds with a host of other financiers, but also reduces its risk. If the debtor defaults, then the lender does not take too big a hit.

It’s a clever idea, but there is a snag with it. Maybe, by reducing the exposure to the loans it makes, a bank may become slightly less risk averse, and start lending to companies it would not have lent to otherwise. This in turn increases the chances of multiple loan defaults.

If there is a problem with just one loan, then it’s not too bad an issue. But supposing these loan defaults become endemic. Then all of a sudden, the creditors find themselves taking just as big a hit as if they hadn’t syndicated the loan in the first place. This is the snag with CDOs, they are fine for reducing risk associated with one-off failure, but don’t work if failure becomes a trend.

And this week we have seen markets gradually wake up to the dangers of syndicated loans. As we said yesterday, business failure on a micro scale may not matter so much when debt has been syndicated. But, on a macro scale, debt syndication may merely syndicate over-confidence.

The fears really hit the headlines on Tuesday. That day, bond guru Bill Gross said he thought that markets were due for a correction of between 5 and 10 per cent. JP Morgan warned that in June $50.6 billion worth of CDOs were sold, but by the 20 July sales had reached a mere $19.9 billion.

Then there was talk that Cerberus Capital Management was struggling to raise the money for the buyout of Chrysler, even fears that the banks backing the offer would not be able to syndicate the loan at all, and would have to cough up the money themselves.

In Blighty, fears grew that the buyout of Alliance Boots, the biggest buyout in UK corporate history, had hit a fund raising hurdle.

And betwixt the UK and US, the sale of the US fizzy drinks arm of Cadbury Schweppes could be put on hold. The reason: private equity firms trying to buy the drinks unit are having problems raising the necessaries.

In part then, it was just a case of the penny dropping. Markets slowly began to appreciate the full ramifications of these problems.

But then the mood was made worse by Moodys. The leading credit ratings agency in the US released a report yesterday which carried a tale of woe. Mark Zandi, Moody’s Chief Economist, warned that the US housing market crisis could be a lot worse than expected, and he predicted that by the end of next year average house prices in the US will be down 10 per cent from their 2005 peak.

Perhaps even more worryingly, he predicted US growth slowing to just 0.7 per cent this year, in sharp contrast to the official prediction of nearer 3 per cent.

Fed chairman Ben Bernanke has received some flak. He is too preoccupied with inflation say his critics, and doesn’t realise that the current rises in the rate of interest dictated by the markets are as much about a change in the amount of risk markets are prepared to tolerate.

Put all that together, alongside news that another Australian hedge fund has hit problems, and news from the US that new home sales fell 6.6 per cent last month, and in the UK throw in all that rain, which make us all feel a little down, and the markets just couldn’t take it.

Cut through it all though and it seems the problem is this. All that borrowing consumers and business, and indeed government, have undertaken in recent years has led to demand outpacing supply, hence inflation worries. This has led to increases in the rate of interest, and all of a sudden markets are fearing that some businesses and individuals won’t be able to keep up their payments. As a result, risk has been re-evaluated, and the market rate of interest has risen.

In other words, base rate is higher thanks to inflation fears. And the gap between base rate at the level markets are prepared to lend at has risen too, because of the need to reduce risk.

That’s why markets are panicking.
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 27, 2007 | posted by Michael Baxter in IABN | comments (0) |

Yesterday may prove to have been one one of the most eventful days of the year. The FTSE 100 saw its biggest one day loss in more than four years, the Dow suffered its second worst day of the year, a leading credit ratings agency threw a very unpleasant spanner in the works of all those economics reports predicting economic growth for the US, and in the UK signs emerged that the housing market may be about to change gear into reverse.

But how serious is it? Some say we are going through a necessary correction. This is just a hiccup - after all, stock market chaos is not unusual during the summer months. They dismiss fears over a potential end to the abundant supply of credit, and point at China and at the rich oil exporting countries. Enough money is coming from those sources to keep the credit coffers topped up, or so they say.

And then there’s Europe. Economists are becoming more bullish with their projections on Europe. Maybe our trading partners, for so long the laggards of the OECD, will be able to pull us through by buying our goods and services, while consumers take a breather.

Others see it all from a much less pleasant perspective. They say the global economy is being hit by two nasties; rising inflation, at a time when we have taken on too much debt.

Maybe it all boils down to the rate of interest. Maybe at the level currently seen in the UK, things are sustainable - just. Maybe, even if rates increase another quarter of a per cent, or even another half a per cent, the UK will still be able to tick over. But supposing they rise even higher than this. After all, as Capital economics pointed out yesterday, the RPIX rate of inflation averaged 2.8 per cent throughout much of 1997. And yet at one point in that year, the rate of interest hit 7.25 per cent. (In June of this year the RPIX stood at 3.3 per cent.)

Perhaps the prize for the most telling comments should go to the National Institute of Economic and Social Research (NIESR) which said, “Two years ago the market was forecasting a rate of around 4 per cent per annum for July 2007. Nor were the probabilities the market gave to an interest rate of 5.75 per cent per annum very high. Twelve months ago the market in financial options implied that the chance of the rate exceeding 5.66 per cent per annum was only 15 per cent. Even in January of this year the chance of it reaching its current level or higher was put at less than 25 per cent.”

In other words, rates may well rise a lot further. If they do, it’s difficult to see how the housing market can avoid some kind of crash, and it’s difficult to see how the mergers and acquisitions mania, we have seen in recent months, can avoid coming to a sudden and dramatic end.

On the other hand, maybe the Bank of England has done enough. Maybe everything is now in place to stop inflation in its tracks, maybe all we need is the calm gradual brake-pressing we have seen over the last 12 months and the economy will gently ease through the over-enthusiasm into a more realistic and sustainable mindset.

That’s why the housing market, the market for mergers and acquisitions, and the economy at large sit on a knife edge. Which way it goes depends…
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 27, 2007 | posted by Michael Baxter in IABN | comments (0) |

And yet it isn’t all bad news.

For one thing, the market would appear to have a self-correcting mechanism.

Too much credit fuelled too much risk-taking and too much inflation. Now, the market is reacting to that by upping the rate of interest.

Sure, higher rates will spell a slowdown in the economy, but that should eventually stop inflation and enable rates to fall again. The fear is twofold. First, inflation will prove harder to crack this time, and second, the fallout from higher interest rates could be very serious.

And yet there are still plenty of bulls out there.

This morning the FT quoted Jonathan Morton of Credit Suisse who said that SP 1500 non-financial companies have free cash flow yields higher than their cost of capital. In other words, these companies are ripe for a buyout. More to the point, Mr Morton added, it would take a 5 per cent rise in the rate of interest before the number of companies with free cash flow greater than the cost of capital fell to below 10 per cent.

Not even the most pessimistic commentator thinks a 5 per cent rise in rates is conceivable, and so we should be pretty safe.

Then there’s China. Sure, credit is drying up, but as long as China has its 1.2 trillion dollars worth of foreign reserves, it seems likely that there will be plenty of money out there. After all, China is ploughing a big slug of money into the Blackstone float, not to mention Barclays Bank.

Then, this morning, the latest forecast from the National Institute of Economics and Social Research (NIESR) hit the streets. And while all around there was panic, NIESR gave us good news.

The World Economy expanded last year by 5.4 per cent, the fastest since 1973. This year, growth will slow only a little to 5.2 per cent, decelerating a bit further in 2008 to 4.9 per cent, it said. Against this background, it said, a pick-up in OECD inflation in 2008 will be moderate.

The US economy will grow by only 2.1 per cent this year, recovering to 2.6 per cent in 2008.
The Euro Area will grow by 2.8 per cent this year, much faster than it did in 2001-5, underpinned by the continuing vitality of the German economy, and Japan will grow by 2.3 per cent this year and by 2.2 per cent in 2008.

It’s a strong juxtaposition. On one hand you have the markets reacting as if all their worst nightmares have become reality at once. On the other hand, the NIESR tells a story of a global economy expanding at just below record pace. Even the US, which according to some is in dire straits, is expected to be okay.

And what about the UK? NIESR says GDP will continue to expand strongly but consumer spending growth will remain muted. House-price inflation is forecast to slow from 10.2 per cent this year to 3.3 per cent in 2008 and 2.3 per cent in 2009. One more quarter-point rise in the base rate, taking it to 6.0 per cent later this year, should ensure that inflation is around the target over the medium term. The current budget in the public finances will not return to surplus until 2010-11.

Its most positive comment it saved for last: “Demand has become more balanced with fixed investment contributing more than household spending to GDP growth in 2006, the first time this has happened since 1982.”
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 26, 2007 | posted by Michael Baxter in IABN | comments (0) |

Who said economics was a gloomy science?

The IMF has just released its latest forecast for the global economy, and it has upped its forecast for global growth. It now thinks the world’s economy will expand by 5.2 per cent this year and next, whereas it previously estimated growth of 4.9 per cent.

It now expects China to expand by 11.2 per cent this year, from 10 per cent originally estimated.

In fact, the IMF expects China to be the biggest single contributor to global growth, and China, India and Russia are expected to account for no less than half of all global growth this year.

And yet, in the US, politicians still clamber over each other to criticise China.

They say it subsidises industry, fails to offer adequate copyright protection and artificially keeps its currency too high in value. In fact they criticise China for adopting many of the policies that the US itself adopted when it was a developing economy in the 19th century.

The biggest threat to continued economic growth might well come from the land of the free, where paranoia over China threatens to hinder international trade and, via the potential appreciation of the yuan, create a massive increase in prices across the world.

Don’t forget there is a multiplier effect from growth. China’s expansion has helped other economies expand too. Without China the rate of interest would have been much higher, and global growth may not have been positive at all.

In seeking to pull the drawbridge up, and stop China from enjoying the kind of riches appreciated in the US, the US may condemn the world to an unnecessary economic slowdown.

July 26, 2007 | posted by Michael Baxter in IABN | comments (0) |

Yesterday we told of our fears that the sub-prime mortgage crisis in the US was spilling over to hit hedge funds and private equity. In the US traders hit the panic button over the news, as bond guru Bill Gross said markets were due for a correction of between 5 and 10 per cent, and JP Morgan said that the market for collateralized debt obligations (CDOs), that’s loans which are used by hedge funds and private equity, had seen sales fall dramatically between June and July.

Now news has broken to justify those fears.

In the US, Cerberus Capital Management, which is in the throes of buying US car maker Chrysler, is struggling to raise the money it needs. In all, the private equity firm is trying to raise $20 billion, with $12 billion coming from a bankers syndicated loan. But yesterday, news broke that bankers were struggling to rustle-up sufficient interest, and the issue of the loan has been postponed

No one is questioning whether Cerberus will eventually raise the necessaries, but the difficulty it is having shows how conditions have changed. Earlier this week, Bill Gross said that he had heard the private equity company is being forced to pay out debt equating to a 9 per cent interest rate, and even higher for parts of the debt, whereas, when the deal was first agreed, it was expecting to offer interest payments of around 7.5 per cent.

And then, on this side of the pond, the purchase of Alliance Boots by Kohlberg Kravis Roberts Co, the biggest buyout in UK corporate history, hit a hurdle.
The deal is being backed by a syndicate of banks made up of Deutsche Bank, JP Morgan and UniCredit (HVB) and Barclays Bank, Citigroup, Bank of America, Merrill Lynch and Royal Bank of Scotland. And yesterday this powerful coterie failed to raise the £5.1bn of senior debt they were after.
Now they are looking at raising the debt using different instruments offering a higher yield, or alternatively, may actually have to put the money where their mouths respectively sit, and fund the deal from their own coffers.

The problem with these CDOs is that they may not spread risk quite as much as their backers think. In the event that the business venture being backed fails, or is unable to meet its loan obligations, then the creditors don’t take too big a hit, as they have managed to spread the risk over as many financial institutions as possible.
Is is possible, however, that because risk is spread, an element of complacency has been created. Maybe deals are being funded at a rate that would not be considered viable if the funding was provided by just a few lenders. This in turn has led to the danger of over-gearing in the corporate world - making private equity businesses more vulnerable to an economic slowdown.
If three people decide to lend you money, and you go bust, then each of those people will only take a third of the hit. But supposing those three people lend money to three people, and all three went bust. It’s a different matter then.
By spreading risk, and therefore offering more lax credit conditions, lenders have unwittingly increased the chances of wider business failure, and in the process merely spread their potential losses, so that they are harder to predict. Business failure on a micro scale may not matter so much when debt has been syndicated. But, on macro scale, debt syndication may merely syndicate over-confidence.

July 26, 2007 | posted by Michael Baxter in IABN | comments (0) |

It was just clever design. Nintendo looked like it was becoming the also-ran of the video games war. Increasingly it looked as if Sony and Microsoft were muscling the company out, and it seemed that its fate was to go the way of Sega, and drop hardware to focus on software. Then came one clever little gizmo, a motion-sensing controller that could be wielded like a sword, or smash an invisible ball over a virtual net, and all of a sudden, Nintendo is back. In the quarter just ended profits were four times up on a year ago, and although the firm’s turnover is dwarfed by that enjoyed by Sony, the two companies now enjoy a similar market capitalisation.

Meanwhile, that other great exponent of design in technology, Apple, announced another set of impressive results, with profits more than double the level seen a year ago.

At different times over the last few years analysts had written off the two companies as has-beens.

Back in 2003, Apple was still making a loss, while little Nintendo, with its turnover just a fraction of the level seen at Sony and Microsoft, appeared to have been completely outgunned.

But since then Sony has found itself being crushed on all fronts. Price competition in the world of consumer electronics is now so fierce that it is becoming harder to make a profit. We have speculated before that the consumer electronics industry is a bubble in the making, as hardware companies continuously try to get us to adopt new-generation technology, before we have had time to get used to the previous tech fashion.

Meanwhile, the video games market has see an arms race between Microsoft and Sony, as the two companies battle for ever more powerful machines that can handle better and faster graphics. It appeared Sony has pulled off a master-stroke with the PlayStation 3, combining the state of the art cell chip with its new generation Blu-ray DVD. But the components cost is high, the development time was longer than Sony had anticipated, and now the machine is out, sales are disappointing - recently the company was forced to slash $100 off the price of its flagship product.

Meanwhile, Nintendo has gone from strength to strength. Why, even Tony Blair was seen enjoying its charms recently, and last month the company hit the headlines when its market valuation briefly rose above Sony’s, despite the fact that Sony’s reported sales were eight times greater than Nintendo’s at the time.

For the latest quarter, sales at Nintendo came in at 131,449m yen (£530m) for the three months to the end of June, up from 32,670m yen in the previous year. Net sales more than doubled and, as for projections for the year to March 2008, the company has upped its projected profits 41 per cent from its previous forecast.

In all, the last quarter saw 3.41 million Nintendo Wiis sold.

Mind you, that’s nothing compared to the iPod. Apple enjoyed sales of 9.8 million iPods in the last quarter. Actually, that wasn’t that much of an improvement over a year ago, when sales came in at 8.5 million, but then again, considering the company was busy preparing for the launch of the most hyped mobile phone the industry has yet witnessed, that was still an impressive achievement.

But this time, perhaps the sales figures for the Mac were slightly more interesting. The company sold 1.7 million Macs, compared with 1.1 million in the same quarter last year, and just 807,000 in the second quarter of 2004.

With the iPhone proving a hit with the reviewers, with the usually cynical hacks still apparently caught up in the pro Apple hysteria, it seems inevitable that this company is set for more impressive profits announcements in the future.

July 25, 2007 | posted by Michael Baxter in IABN | comments (0) |

Of late it has been tempting to say that the economic cycle is dead. 60 months of economic growth and still going strong#33; Maybe, here in Blighty, we have licked the economic cycle altogether.

Well, impressive as 60 months of growth may seem, these days the UK is like a soft flower floating on the high winds. We have done well to achieve stability while all around recession follows boom like night follows day, but there are underlying forces at work here, and not even the UK is immune.

Of late, much has been made of inflation. There’s good reason too. The last few years have seen an inexorable rise in credit. Of late the money supply both in the UK and US has been rising fast too.

In any other era, inflation would been ignited by now. But today, it’s different. The massive surplus capacity brought to the world economy by a growing India and China, coupled with the Internet bringing almost perfect price knowledge to customers, has acted as a big constraint to price rises.

Even so, over the last few months the inevitable has started to occur and price pressure has been building. It takes time before the cause and effect equation is complete. And now we know that despite India, China and the Internet, the inflation genie is far from dead, although it’s unlikely to be quite as frisky as it used to be.

In a way, it is quite ironic. Central banks have reacted to soaring rise in credit, giving rise to inflation fears, just as markets start fearing lending has been a tad irresponsible. It seems that just as we start to get our heads around the idea of higher interest rates, then signs are afoot that the force of economic gravity is just beginning to come down on those very forces that created the inflation fears.

If, as the article above suggests, the credit bubble is coming to a close, then it will take some time before this translates into lower inflation. In the meantime, the Bank of England and other central banks will be wrestling with the after-effects of the boom.

Yesterday saw two pieces of news break. First of all, one of the Bank of England’s two deputy governors became even more hawkish than normal.

The Bank’s two deputies occupy different ends of the hawk/dove spectrum. Rachel Lomax is considered something of a dove, cynical about the relationship between the rising money supply and inflation. The other, Sir John Gieve, is an ornithologist’s dream, a very rare bird indeed, an arch hawk, or so it would appear.
Yesterday he appeared to call for the Bank of England to stop pussy-footing around with quarter of a per cent rises, and go for the jugular. He said, “If we get behind the curve, gradualism in monetary policy could compound problems.”
Most economists now seem to think that rates will rise to 6 per cent, but only a minority expect further rises. But if we take Sir John literally, it would appear he is advocating at the very minimum one hike very soon, and perhaps he is even suggesting the bank should up rates by half a per cent.
And yet, yesterday, we saw just a hint that maybe inflation is beginning to ebb.
You may recall, the CBI was one of the first to warn of dangers bubbling. Its Industrial Trends Survey has been improving. Every month it asks its members whether orders are up or down on a year ago. The balance forms its index. Last month it reported on a score of plus 8 for the sector, the joint highest score in 12 years.
It’s good that manufacturing appears to be staging something of a comeback, but alas, price pressures are building too.
The CBI also publishes an index for showing what prices manufacturers expect to charge over the following four months. And throughout this year this index has been making the headlines for the wrong reasons.
It hit plus 21 in March, but since then it has been falling. For July the index is down to 11, the lowest level this year.
It will take some time before the kind of trend which has been illustrated by the CBI shows up in the general inflation figures. Even so, there are signs that at last inflation pressures are being brought to heel.
Unfortunately though, the Bank of England has to set its sights on the here and now, which is why the rate of interest is likely to rise, despite the changes in underlying trends.
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 25, 2007 | posted by Michael Baxter in IABN | comments (0) |

Japan illustrates quite how back to front the world really is.

The economy of the rising sun has suffered years of modest inflation, or even deflation, its trade deficit has been soaring, and yet its currency keeps falling.

The yen is now at its lowest ever level against the euro and 6 per cent down against the dollar.

And while the currency falls, the trade surplus grows. In June the surplus was 53 per cent up on a year ago, hitting 1.23 trillion yen or $10.2 billion, in the month. To put this in perspective, the US trade deficit is around the $60 billion mark, and the UK deficit around £10 billion a month.

It just goes to show that a massive trade surplus does not automatically mean a fall in the value of the currency, not any more.

Even so, a falling yen brings with it inflation worries, and it seems that the chances have increased that the Bank of Japan will soon up rates to 0.75 per cent.

Of course, this will mean the cost of borrowing in Japan is tiny, but as the yen falls, and rates rise, the idea of taking money out of Japan and investing it into the US and UK is looking less attractive. This could mean a collapse in the carry trade, another reason why the global supply of credit could, all of a sudden, dry up.
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 25, 2007 | posted by Michael Baxter in IABN | comments (0) |

Three separate pieces of news, and three letters did it. The end result, markets in the US fell 226 points, London saw a rout, and fears grew that markets may have peaked.
First there was Countrywide, the largest US mortgage lender, saying it won’t be until 2009 before the US housing market starts seeing growth again. The giant lender had announced a 33 per cent drop in Q2 profits, and it seemed like the company was trying to get all the bad news out of the way in one go. Its boss compared the US housing market to a warship and said, “It just takes a long time to turn a battleship around.” He added that his gut feel told him it would take “the balance of this year to get this thing to look like it’s slowing down (and) 2009 to head into the other direction.”
Then there was JP Morgan and those three letters. CDOs, or collateralized debt obligations, have been a key financial instrument of the last few years. They are a little like those complete meals you can pick up in Tesco. Just like the Tesco product they re-package different products and combine them into one. But whereas Tesco might combine potatoes, beef and a couple of vegetables, CDOs will combine different types of debt, investment grade debt, for example, or perhaps high yielding bonds.
It’s a market that has enjoyed outstanding growth. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totalled USD $157 billion in 2004, USD $249 billion in 2005, and USD $489 billion in 2006.
But yesterday came news from JP Morgan that CDOs seem to be coming out of fashion fast. In June $50.6 billion worth of CDOs were sold, but apparently so far this month sales have reached a mere $19.9 billion.
Now analysts are panicking that the banks will find themselves with debt on their hands that they don’t want. Instead of selling the debt on, reducing their exposure, they are suddenly finding that they have got to take responsibility for their own lending, and suffer the full consequences if some of their loans go bad. They won’t like that, and it’s feared lending could plummet as a result.
Finally, there’s Bill Gross. Mr Gross is one the great gurus of US investing. He is the manager of the $103.1 billion PIMCO Total Return Bond Fund. Earlier this year he called the top of the bond market, and it was his words that initially sparked off the fall in the price of bonds.
Yesterday his wise words had the market running for cover.
This is what he told CBS: “There’s no doubt this recent upward movement in yields justifies a 5-10 per cent correction in stock markets.”
Mr Gross cited the private equity buy-out of Chrysler from the Daimler Chrysler Group. It’s being bought by Cerberus Capital Management. Mr Gross says that he has heard the private equity company is being forced to pay out debt equating to a 9 per cent interest rate, and even higher for parts of the debt whereas, when the deal was first agreed, it was expecting to offer interest payments of around 7.5 per cent.

Mr Gross said “So times have changed in a period of two months. At the same time, investors have focused on sub-prime markets. But they haven’t really seemed to notice the dramatic move in high-yield markets#133;.Investors have basically been the willing servants of private equity and hedge-fund managers who are willing to take advantage of them#133; but investors no longer trust the rating services to adequately and fairly rate the bonds they’re buying#133;. basically, bond buyers have become frozen in place.”

So, what does all this mean? It would appear that the rise in yields witnessed over the last few months, initially caused perhaps by the US sub-prime crisis which saw the collapse of mortgage lender New Century and the near collapse of two Bears Stearns’ funds, is spilling over.

The last few years’ cheap credit hasn’t just propped up house prices, it has funded the mergers and acquisitions boom. And now, it would appear, the show is close to ending.

But, it may be worth putting this into perspective. Considering Mr Gross’s comments, even a 10 per cent fall on the Dow would merely see the index return to the level seen at the end of March. A five per cent fall, and the index would fall to the level seen at the end of April.

And while the FTSE also fell sharply yesterday, no one is yet calling the peak in the London markets.
Copyright #169; 1996-2007 Find.co.uk Limited. All rights reserved

July 25, 2007 | posted by Michael Baxter in IABN | comments (0) |

The GBP continues to firm versus the USD but the yield spreads are
not supportive…click here for more - Thought for the dayRed Tower Research