Armageddon: The world flirted with financial Armageddon in March 2008 when one of the world’s largest investment banks Bear Sterns was tumbling into bankruptcy. At that point, the global financial system was already weakened by the worst US financial crisis since the Great Depression in the 1930s. A “financial nuclear winter” would have hit the US economy if Bear, reportedly a counter-party to some $10 trillion of over-the-counter financial derivative transactions, was not rescued on March 16 and allowed to fail. The consequences to the US and the world would have been unimaginable considering that the total credit-default swaps generated by the financial community amounted to a ridiculous $41 trillion.The disastrous 1997 Asian financial crisis, which caused economic dislocation and massive wealth destruction in the region, including the Philippines, would have seemed like a picnic in comparison.
Inflection point: By April 25, 2008, or barely over a month back from the precipice and amid the pervading doom and gloom, there are signs, albeit early and possibly tenuous, of optimism. When taken together, these indicators (listed below) show a compelling picture that risk aversion and flight to quality have abated. The market appears to be at an inflection point. In a classic disconnect, the financial market is reviving and starting to decouple from the still wobbling real economy in the United States, which is the epicenter of the crisis. Among the most telling indicators of improved sentiment is the recent dramatic decline of government bond prices, particularly of US Treasury bills and notes, and Japanese bonds. Inversely, yields have soared. The price of these debt instruments were previously driven up sharply by a mass flight by jittery investors to this safe haven investment. This recent Japanese bond action may be a bonus, as it points to the end of the stubborn decade-long deflationary trend in Japan. This may spur more consumer spending in Japan that will help lift the global economy, further bolstering bullish market sentiment.
Global contamination. The crisis ensued when the giant US housing bubble started to burst in 2005. Rising delinquencies and foreclosures of home mortgages became evident by March 2007. A few months later the market for subprime home mortgage-backed securities and their financial derivatives collapsed. The credit market in the US and Europe became dysfunctional. The cost of credit, if it was available, soared. As the crisis worsened, there was mistrust among banks. Cash was hoarded and lending curtailed. The infection spread to a gamut of credit instruments. Banks were stuck with leveraged buyout loans. Auction rate municipal bonds failed. Business transactions and investments, including mammoth urban redevelopment projects throughout the US, were postponed or scrapped. The US caught a most virulent strain of financial flu with the virus spreading globally to Europe and Asia.
Fallout on Philippine market: Investors fled the Philippine stock market, which became among the biggest losers in the emerging market. Prices of dollar-denominated government bonds fell and, as a consequence, the yield expectation of lenders rose. Credit-default swaps (CDS), the cost to buy a form of insurance against default, rose sharply. Only when conditions improve in the locus of the crisis, the US, will the situation improve in the Philippines. Will the country reap the full benefits of a global recovery? Read below.
Fed measures. Market sentiment had significantly improved after the Bear Sterns rescue on March 16 and emergency measures undertaken by chairman Ben Bernanke of the US Federal Reserve Board. Massive liquidity was injected and cost of funds was drastically slashed. The measures included an emergency three-quarter of a percentage point discount rate cut on Jan. 22 that was the largest one-time drop in 24 years and allowing brokers and dealers direct access to its discount window, a policy unused since the 1930s. The market is comforted that Sheriff Bernanke is vigilant and ready for action when needed. Discounting mechanism. The market, being a forward looking discounting mechanism, appears to be pricing-in the end of the credit crisis and the prospect of improving US economic conditions in the second half of the year. The end of the US interest rate cutting cycle is also being discounted. At the forthcoming April 30 policy meeting, the US Fed is expected to shift its focus from growth concerns and financial system stability to inflation watch. Bonds, stocks and currencies are being repriced.
Indicators.
Credit markets: On April 25, Japanese bonds suffered the biggest one-day selloff in five years that saw prices fall and, notably, yields of 10-year bonds rising to 1.65 percent. In turn, this prompted a wider same-day selloff in the global bond markets. Credit indices, particularly in the US and Europe, declined from their elevated levels. The exceedingly stiff US yield curve is now starting to flatten. The sharpest moves were made in the short 13-week and two-year US T-bills. The abnormally low yields at the short and intermediate ends are now rising and in the process, narrowing the previously very wide 400 basis point gap with the longer-dated Treasury notes and bonds. By April 25, the yield of 13-week T-bills had risen by more than 100 percent, or by 79 basis points, to 1.29 percent. A month ago on March 20, following the Bear Sterns fire sale, the yield of this same T-bill was driven down to 0.50 percent by the great demand from panicky investors. Another indicator is the narrowing yield spreads between benchmark US Treasuries and higher risk corporate bonds. The yields are converging with that of US Treasuries rising while those of higher risk corporate bonds falling nearly 150 basis points since the Bear Sterns crisis. Even the London interbank offered rate (LIBOR), the benchmark from which commercial lending rates are set, has started to fall. Credit default swaps have likewise declined.
US stock market. All the stock volatility indices have significantly improved. Vix, the broader US stock market “fear gauge”, has gone down to the calmer 19.6 reading from the panic-high 37.5 in Jan. 22, 2008 when stocks were at their 52-week low. Adherents of the Dow Theory believe that the market is in a bull trend when the Dow Transportation Index rises in concert with the Dow Industrial Index, as it did recently. At the close of trading on April 25, US stocks reached a four month high. Significantly, when the Bear Sterns high tension drama was playing out in March stocks did not drop back to the January low, likely the trough for the year.
Foreign exchange. The unloved US dollar, previously battered down by sharply declining interest rates and the large US twin deficits, strengthened against most currencies. The yen fell from its 12-year high against the dollar that was reached at the height of the crisis on March 17. From only ¥95.76 needed to buy a dollar, it was ¥104.4 on April 25. The previously mighty Euro weakened from its high perch at 1.60 down to 1.55. Even the Chinese RMB moved back to seven to the dollar.
Similar pattern. This latest financial development shows a similar pattern that was manifest as early as Aug. 27, 2007 during the first leg of this crisis. Barely over a week after the Aug. 17 panic in global markets that prompted the US Fed to intervene, the market exhibited signs of returning investor confidence and declining risk aversion. From that point, the stock markets in the Philippines, US, HK and China, among others, staged a strong recovery and made new or multi-year highs in October. At that point, emerging market stocks achieved gains of about 40 percent from the August panic lows. Thereafter, the second leg of the crisis took hold. In November, investors fled from two French hedge funds as it suffered severe losses in its holdings of subprime related securities. The market realized that the balance sheets of many banks throughout the world were loaded with these now loathed assets that were fast losing their value. Investors reacted predictably by pulling out their funds from risk assets. The market for subprime related securities disappeared and their value was difficult to fix. Stocks dove to their 52-week low in January 2008.
Early call. The first sign of spring from the financial winter, which did not attain nuclear intensity, came appropriately in early April at the onset of spring in the northern hemisphere where the financial turmoil started. Standard and Poor’s (S&P), a credit rating agency, declared on March 13, 2008 that the end may be in sight for subprime mortgage writedowns and that the total may reach $285 billion. This is a marked difference from the $400 billion estimated by other analysts. Bernanke gave an estimate of $100 billion in testimonies given last year at a congressional hearing. Understandably, the S&P view was met with scepticism as it was followed by declarations of four global financial giants of a further $50 billion in write-downs in addition to the aggregate $150 billion previously reported by the banking sector. But to the apparent relief of the market, subsequent writedowns show amounts tapering down. Total writedowns is now getting close to the estimate of S&P and, if accurate, is indeed near its end.
Bubbles and changed role. In the year 2000, the Internet bubble burst and coupled with the 9-11 attacks the US went into a recession in 2001. Fed Chairman Alan Greenspan responded by cutting interest rates to a 40-year low. That boosted housing and helped keep the recession shallow and short. But a housing bubble followed which caused the current downturn. Now it is chairman Ben Bernanke’s turn and he brought down interest rates at a faster clip than his predecessor. This accommodation plus booming foreign sales to the emerging markets led by China and India are filling the gap left from the slumping domestic side of the US economy and putting a floor to its current downturn. Hopefully Bernanke’s cure will not unnecessarily extend as Greenspan’s did and create the next bubble — commodities.
Philippine benefit. The Philippine market dances to the music of the major markets and will benefit from a global market revival. But whether it will reap the full benefit is an open question. The country, along with some others, is in the midst of a serious food crisis arising from the shortage and high prices of rice in the international market. Crude oil is at a record high. Inflation is fast rising and becoming a serious economic and political concern. The government is throwing money at the problem and the negative effect of this on the fiscal position will not be lost on investors. Abandoning the fiscal balance target will continue to weaken the peso, which has already started to weaken from its recent high. A weaker peso will exacerbate inflation as cost of imported rice and inputs will cost more. Policy makers are in a quandary. Tightening monetary policy may help squelch inflation and put some floor on the peso slide but will raise cost of funds to business. All these come at a time when perception surveys show the popularity of the government at a very low level. This may constrain difficult policy options. Policy makers are now between a rock and a hard place. The fate of Philippine financials hinges on how the government handles the crisis.
A great contrast to Japan. The quick resolution of this global financial crisis, if indeed it takes hold as such this early, will be in sharp contrast to the more than decade-long malaise experienced by Japan after its own asset bubble burst in late 1989. This amazing and admirable development may be attributed to a large extent to the decisive measures taken by the US Fed and EU monetary authorities. New accounting rules that required the value of debt instruments to be “marked to market” instead of at cost also played an important role. This rule previously covered only listed equities. Many analysts blame this new rule for highlighting the damage wrought by the crisis and raising the fear level. But actually, the writedowns had positive effects. The disclosure of value writedowns of impaired securities brought the losses out into the open. In turn this enabled the public to assess the health of financial institutions and helped rebuild confidence in the financial system. The quick recapitalization to bolster balance sheets, albeit achieved with significant dilution of share value, and top level management changes undertaken by the battered financial institutions were strong medicine. In contrast, Japanese institutions were less transparent and did not clean their balance sheets quickly enough. Mistrust and suspicion lingered to the detriment of their financial system. Other important lessons may be learned from this crisis but that is another topic that will require another article.
US headwinds. Some analysts scoff at this new found strength of the market as a “head fake”, a false spring in the nature of a rally within a bear market. This view is understandable given that the US, which is the global economic and stock market leader, is still facing strong economic headwinds. US house prices, off 20 percent so far, are in free fall, sales of new homes are down 40 percent and unsold new homes rose to the equivalent of 11 months supply, which is a three decade high. Loan defaults and foreclosures continue to rise. Many homes have negative equity and buyers may walk out of the mortgages. Job losses, especially in the large financial sector, continue and the unemployment rate is under pressure. The most recent reports show credit card debt delinquency on the rise and this plus auto loans are possibly the next shoes to drop. Consumer confidence, as surveyed recently by the University of Michigan, had fallen to a 26-year low. Optimists, on the other hand, believe that the market had already priced in all of this.
Spanner. A real or false spring? During the crisis, US financial stocks made multiple upswings of five percent or more yet is still deeply in the negative from its pre-crisis high. Pundits say this rally will fizzle out like the others. There is no question market environment will remain challenging and volatility will continue. But to bring the market back on its knees to the January 2008 low will require an event-driven shock to the markets such as if the price of crude oil shoots up farther beyond the already record high. This will likely occur if the word war with Iran over its troublemaking in Iraq turns into a shooting war. Or, if the US or Israel decides that the Iranian nuclear program has gone far enough and takes military action. Or, a major oil supply disruption occurs in other trouble spots. Or, if US consumers, groaning under a heavy debt load, record high gas prices and job insecurity, closes their wallets despite the tax-rebate checks. Or, if a large hedge fund blows out. All these are in the realm of possibilities. There will always be a wall of worry to climb. But that is when opportunities abound.
(The author, a certified public accountant, is a property developer and former chairman and president of the Subdivision and Housing Developers Association (SHDA). He presented an analysis of the 1997 Asian Financial Crisis at a forum by the Human Development Network on Nov. 4, 1998; published “A Tax-less Economic Growth” on Oct. 22, 2004, an analysis of the principal cause of the drastic decline in fiscal revenues that was cited by the Asian Development Bank in its 2004 Philippine Yearend Economic Review and “Is the Economy Overtaxed” on Dec. 1, 2004; featured in “Financial Analyst Proposes Novel Fiscal Measures” on Sept. 30, 2005,”The 1997 Asian Financial Crisis and 10th Anniversary Market Crashes, April 2007, “The Panic of 2007”, Sept. 3, 2007, in The Philippine STAR.)
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