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Monday, November 17, 2008
Wednesday, October 15, 2008
Financial History In The Making
FINANCIAL HISTORY IN THE MAKING
So much has happened this month, it's hard to know where to begin. It’s been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts I know stayed up all night, several times, as developments and markets spiraled out of control in what’s being called a "financial tsunami".
What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds.
We do know that this is clearly the end of an era and the beginning of a new one, and we’ll all be affected in one way or another.
LENDER OF LAST RESORT
For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here’s why…
As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.
Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S. , totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget...
Then things really intensified.
A HOUSE OF CARDS
Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world’s largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.
The government then took over AIG, to avoid the worst collapse in history of the U.S. ’s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.
Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.
PANIC SET IN
But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.
Seeing the market’s reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won’t be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.
REALITY HITS MAIN STREET
Meanwhile, folks on Main Street were generally against the package. They simply didn’t trust it or the politicians. Once they saw the stock market’s reaction to the no vote, however, many people changed their minds as it became more obvious that this wasn’t simply a plan to bailout the mistakes made by greedy Wall Street big shots.
People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.
The economy is the number one concern for most people and they’re irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it’ll be interesting to see how the election unfolds too.
DELICATE GLOBAL FINANCIAL SYSTEM
There’s no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Last week's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They’re literally pulling out all the stops to revive lending and the world economy. In Canada, there is another half-point drop in the Bank of Canada rate expected.
Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?
HYPER-INFLATION OR DEFLATION?
The Fed is spending money at an astronomical rate. It’s creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it’s extremely inflationary.
Normally, there is a lag of about a year or so between money creation and inflation but eventually, what’s recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but not necessarily.
The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they’re being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.
In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don’t do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don’t, the outcome could be much different than what most analysts feel is a done deal.
WHAT TO DO
At this point, it’s best to be prepared for either outcome.
That means gold and commodities (despite their recent collapse) for inflation and cash for deflation, at least until we see how things unfold.
For now, important changes are taking place but that also means challenges and opportunities.
This may all end up differently than what we initially thought, but we’ll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we’ll do our best.
So much has happened this month, it's hard to know where to begin. It’s been a month to end all months with one monumental crisis following another. At times, events were moving so quickly it was hard to keep up. Many analysts I know stayed up all night, several times, as developments and markets spiraled out of control in what’s being called a "financial tsunami".
What lies ahead is unknown because massive changes are still taking place as the worst financial crisis since the Great Depression unfolds.
We do know that this is clearly the end of an era and the beginning of a new one, and we’ll all be affected in one way or another.
LENDER OF LAST RESORT
For now, opinions are running rampant and although we can make some valid assumptions, no one actually knows how this will all end up. Here’s why…
As you all know, the bailouts this month were massive and truly mind boggling, but the big spending actually started before. First, there was the $150 billion in stimulus checks, booming money supply, super low interest rates and the Bear Stearns bust.
Then came the takeover of Fannie Mae and Freddie Mac, which made the government responsible for about half of the mortgages in the U.S. , totaling about $5 trillion. This amounted to the biggest bailout ever, costing $200 billion. But if just 10% of those loans have to be covered, it would mean another $500 billion and this alone equals the size of the entire annual defense budget...
Then things really intensified.
A HOUSE OF CARDS
Lehman Brothers went bankrupt, Merrill Lynch agreed to be bought and the foundation of the financial system took a serious blow. Wall Street started to panic and the Federal Reserve, along with the world’s largest central banks, poured unprecedented amounts of money into the banking system to provide ever more liquidity as stocks fell sharply and the banking situation grew more serious.
The government then took over AIG, to avoid the worst collapse in history of the U.S. ’s largest insurer. Money market funds, which have always been considered safe, came under pressure. Worried investors started pulling out of these to preserve their savings, resulting in the Fed also having to lend banks about $400 billion in guarantees to meet these withdrawal demands. The bottom line was that in just one week, the Fed spent over $1 trillion to keep things going.
Next, Washington Mutual failed, which was the biggest bank failure in U.S. history. While all this was happening, the bailout package was a top priority. Bernanke and Paulson were desperate to get it passed, and fast. The President pushed for it too as they all warned that the alternative would be far worse.
PANIC SET IN
But the House rejected it and this shocked the markets. The Dow plunged in its biggest one day loss ever, dropping $1.3 trillion, which was way more than the $700 billion requested in the bailout.
Seeing the market’s reaction, the package then passed quickly but stocks continued falling sharply anyway. The general feeling was that the $700 billion won’t be enough and the plan is insufficient. Some feel this could be like the initial low estimates for the Iraq war and the final bailout tally could be $2 to $5 trillion, or more.
REALITY HITS MAIN STREET
Meanwhile, folks on Main Street were generally against the package. They simply didn’t trust it or the politicians. Once they saw the stock market’s reaction to the no vote, however, many people changed their minds as it became more obvious that this wasn’t simply a plan to bailout the mistakes made by greedy Wall Street big shots.
People saw the writing on the wall and realized that this would affect everyone, resulting in a worsening economy, more job losses and no credit. And since U.S. retirement assets are already down $2 trillion in the past 15 months, dropping 401 and real estate values, bank failures and insecurity are also taking their toll.
The economy is the number one concern for most people and they’re irritated at the mud slinging direction the election has taken while the priority issues take a back seat. So it’ll be interesting to see how the election unfolds too.
DELICATE GLOBAL FINANCIAL SYSTEM
There’s no question these are dangerous times and the financial world is in uncharted waters. The global financial system is on very thin ice, teetering on collapse. Last week's coordinated interest rate drop by seven central banks clearly illustrates this because it was the first time ever that so many central banks lowered rates together and by half a percent. They’re literally pulling out all the stops to revive lending and the world economy. In Canada, there is another half-point drop in the Bank of Canada rate expected.
Will these efforts work? Will they be enough? Those are the most important unanswered questions of the day and only time will tell, but we should know much more in the critical month or so ahead. Why?
HYPER-INFLATION OR DEFLATION?
The Fed is spending money at an astronomical rate. It’s creating this money out of thin air by monetizing bad debts and whatever else it has to. Remember, this is on top of all the other ongoing government expenses and it’s extremely inflationary.
Normally, there is a lag of about a year or so between money creation and inflation but eventually, what’s recently happened will result in massive inflation, a much lower U.S. dollar and a soaring gold price. This is inevitable but not necessarily.
The bottom line is this, if the banks start to lend again, then the economy will be on the road to recovery and inflation. But we know the banks are scared and they’re being extremely cautious, for good reason. So if the banks decide not to lend and instead just sit on their cash, then the inflation process will freeze.
In other words, the risk of deflation has greatly increased. Inflation is not a given and much will depend on what the banks do, or don’t do in the period just ahead. The Fed is providing the ammunition but the banks have to use it. If they don’t, the outcome could be much different than what most analysts feel is a done deal.
WHAT TO DO
At this point, it’s best to be prepared for either outcome.
That means gold and commodities (despite their recent collapse) for inflation and cash for deflation, at least until we see how things unfold.
For now, important changes are taking place but that also means challenges and opportunities.
This may all end up differently than what we initially thought, but we’ll adapt and keep an open mind. Whatever lies ahead, the current challenge is getting safely from here to there relatively unscathed and we’ll do our best.
Monday, August 25, 2008
Global Uncertainty -- The Credit Crisis Legacy
The recent gyrations in world capital markets have left investors exhausted. True, oil prices have fallen from their most vertiginous highs, the dollar is a bit stronger, and the stock market has actually risen over the past month. But none of those things have happened in a smooth and steady fashion. The stock market’s “ascent,” in particular, has come straight out a carnival's rollercoaster blueprint. Since the beginning of July, there have been six days on which the Standard & Poor 500 has gone up or down by at least two per cent, and daily moves of more than one per cent—like the ones we saw at the start of last week—have come to seem practically routine. Precipitous falls in the market have frequently been followed immediately by sharp rallies, and vice versa. And, while some of these moves have been occasioned by real news, more often it’s been impossible to tell just what made investors so damn exuberant or so gloomy.
Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is “uncertainty”: investors’ sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we’ve been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?
Much of what’s happening is a function of what economists call “herding.” In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That’s why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don’t know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.
Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early sixties suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities. In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified. Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.
Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: the S. & P. 500 has fallen almost fourteen per cent this year. Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.
So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic. Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.
Not that long ago, stock-market volatility appeared to be a thing of the past; between the end of 2003 and the end of 2006 there were only two days with moves of two per cent. But, ever since the credit crisis began, big moves have become common. The conventional explanation for this is “uncertainty”: investors’ sense of what the future holds is in constant flux, so stock prices are, too. But, in the dearth of new news, you might expect uncertainty to result in tentative oscillations, rather than in the huge waves of buying and selling that we’ve been seeing. In this market, the same traders who on Tuesday seem convinced that the apocalypse is nigh are, on Wednesday, just as sure that we’ve weathered the storm. If investors are unsure about tomorrow, why are they acting so certain about today?
Much of what’s happening is a function of what economists call “herding.” In conditions of uncertainty, humans, like other animals, herd together for protection. In unstable markets, this leads to trend-following: buy when others buy, sell when they sell. Many studies have found that mutual-fund managers herd, for a couple of important reasons. First, herding offers money managers the reassurance that their performance, whether good or bad, won’t diverge too much from the norm. It also gives them a chance to piggyback on the knowledge of their competitors. That’s why, when a stock starts to rise, traders often assume that there must be a good reason, and therefore buy in order not to miss the party. This can create a feedback loop: as more people buy the stock, the more certain others become that there must be a good reason to do so (even if they don’t know what that is). And these feedback loops have been accentuated by the spread of quantitative-trading strategies that explicitly aim at riding the herd effect. These strategies can magnify trends instead of countering them. The result is that an individual stock can move up or down ten per cent on a day with no real news.
Uncertainty also stimulates big moves because traders react to it in an unusual way. Work done by Daniel Ellsberg in the early sixties suggests that, faced with ambiguity, most people try to minimize possible losses. But there’s considerable evidence that many traders, by contrast, deal with ambiguity by trying to maximize potential gains—thus the familiar dictum that volatility creates opportunities. In part, this is because it’s the job of traders to trade. But it’s also because market professionals appear to be chronically overconfident. A 2005 study of traders and investment bankers at two large banks, for instance, found that they significantly overestimated their knowledge of finance and the accuracy of their predictions. A 2002 survey of experienced foreign-exchange traders found, similarly, that they were far more sure of their market forecasts than performance justified. Overconfidence matters, because it can encourage excess trading. A study of individual investors by the economists Markus Glaser and Martin Weber, for instance, found that investors who thought more highly of their ability also traded more. What’s worse, the effect seems to be magnified in times of uncertainty. The business-school professors Itzhak Ben-David and John Doukas, in a study based on twenty years of trading by institutional investors, found that when there’s a profusion of “ambiguous information” about stocks investors trade more frequently, not less. And they do so even though, on average, they end up losing on their trades.
Oddly, then, the very things—uncertainty and lack of information—that might seem to make less trading and smaller bets advisable are pushing stock-market traders in the opposite direction. And this tendency is exacerbated by the fact that we are in a down market: the S. & P. 500 has fallen almost fourteen per cent this year. Mebane Faber, of Cambria Investment Management, recently did a study showing that, historically, volatility is significantly greater in down markets than in up ones. One likely reason is that traders, like gamblers, often find themselves “chasing losses”—if you’ve lost a lot, it’s tempting to make big bets, in an attempt to get your money back.
So far, all this volatility has had little lasting effect on the value of the stock market. But in the long run volatility is a very bad thing, because it makes ordinary investors less inclined to trust markets. As a corrective to the recklessness of recent years, this might seem desirable, but too much risk aversion makes capital more expensive for everyone from businesses to homeowners, and the economy less dynamic. Once we get a clearer idea about the future, today’s volatility should diminish. But for now we’re stuck in a Yeatsian market: the best lack all conviction, while the worst are full of passionate intensity. Let’s hope the center can hold.
Friday, May 30, 2008
Credit Crisis To Last Into 2009
A growing number of bank analysts are saying the Global Credit Crisis will extend well into 2009, if not beyond.
This means more pressure on financial stocks and bank balance sheets; banks have added $25 billion to loss reserves so far, but face mounting consumer credit losses in a second wave of the crisis that some bank executives have acknowledged will be worse than the first, which has cost hundreds of billions of dollars in write-downs and losses.
Wall Street’s originate-to-distribute model, designed to mitigate risk by spreading it around, actually exacerbated those risks. It encouraged banks to loosen lending standards because more loan volume meant higher profits; then it led to over-leverage, and finally to complacency. More and more paper dollars were created for trading on the assumption that housing prices would always go up.
The first wave of the crisis affected trading books, but the second will hit lending.
As long as housing values were rising, borrowers could refinance in perpetuity to avoid default. Losses mounted when the refinancing option disappeared. Banks relied too heavily on the securitization markets to boost lending to consumers, particularly in the form of mortgages.
In time, some lending will return, but the sky-high revenues of recent years will be hard to reclaim.
The banking sector’s pullback in lending will cause further painful losses. Many believe banks will have to reserve an additional $170 billion through the end of next year just to keep up with estimated loan losses. “New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors”.
Here in Canada, an accepted truism of the global banking crisis is that the big Canadian banks have done rather better than their global peers, avoiding the worst of the writedowns.
Commentators and analysts have spouted words of comfort about the Canadian banking sector for months, and even Federal Finance Minister Jim Flaherty noted in April after meeting the big bank chiefs in Toronto that Bay Street has avoided the worst pitfalls that have beset banks elsewhere.
But that idea is becoming increasingly difficult to uphold as a few of the Canadian banks ratcheted up their losses in second-quarter results announced this week.
Almost all the bank chiefs warned, too, about slowing capital markets and rising loan losses.
The notion that Canada's banks are relatively unscathed is starting to look like misplaced optimism.
Royal Bank of Canada, the country's biggest bank, confirmed Thursday that its writedowns on structured products now stand at $1.6-billion - a sum that would have been unthinkable last year when Canada's banking sector was on a long winning streak.
RBC chief Gord Nixon was "not happy" about his bank's writedowns, but you have to wonder what he thought of the charges at Canadian Imperial Bank of Commerce, which now total $6.7-billion after the bank acknowledged its investments in structured products produced another $2.5-billion in losses in the second quarter.
RBC and CIBC now share the ignominy of featuring among the global banking top 40 for largest writedowns and credit losses since the banking sector was thrown into crisis last year. (Writedowns refer to structured products being marked to market value, whereas credit losses reflect expected and actual loan defaults.)
RBC sits at number 40 and CIBC's latest charges mean it has leapfrogged up the league table [according to the latest data from Bloomberg], moving into 16th spot above Germany's West LB -- which has taken US$4.8-billion in writedowns and is the subject of a European Union bailout plan -- and Societe Generale, which has incurred US$6.3-billion in writedowns.
In proportion to the size of the bank's assets before the full impact of the crisis hit last year, CIBC's losses are as bad as those of UBS -- the Swiss bank that has suffered US$38.2-billion in writedowns -- and worse than the losses recorded by HSBC Holdings (US$19.5-billion) and JP Morgan Chase & Co. (US$9.7-billion). CIBC's losses as a proportion of total assets are almost as severe as those of Citigroup Inc. (US$43-billion) the poster child for the financial crisis.
Picking on RBC and CIBC alone highlights an important point -- not all Canadian banks are equal when it comes to the financial crisis. Toronto-Dominion Bank has supposedly incurred no writedowns. Bank of Montreal, National Bank of Canada, and Bank of Nova Scotia escaped major writedowns this quarter, but their combined writedowns on structured products stand at more than $1.8-billion since the crisis began.
Leaving writedowns aside, Canadian bank CEOs have painted a bleak picture this week for their outlook on the remainder of 2008.
Even Toronto-Dominion Bank chief Ed Clark -- one of the few CEOs in North America or Europe who can truly claim to have steered his bank through the financial crisis without taking a big hit -- is projecting no earnings growth in 2008 for his bank, amid rising loan losses, stifled investment banking activity, and the potential spillover from the U.S. economic slowdown into Canada.
Still, there are some positives for the Canadian banks.
Their writedowns are so far on paper only, and if the market for certain structured products turns around they will reverse some of their losses, as BMO did this week, announcing it made a gain of $42-million on investments that had previously been written down.
More importantly perhaps, Canada has so far not seen a house price slump like the U.S. and some parts of Europe.
Certainly some Canadian banks are exposed to the collapse of the U.S. housing market through their U.S. subsidiaries -- notably RBC bumped up the provision for loan losses at its bank in Florida and other southern states. But the biggest advantage the Canadian banks have over their peers around the world is the strength of the Canadian economy and their strong domestic retail operations. Let's hope this continues.
This means more pressure on financial stocks and bank balance sheets; banks have added $25 billion to loss reserves so far, but face mounting consumer credit losses in a second wave of the crisis that some bank executives have acknowledged will be worse than the first, which has cost hundreds of billions of dollars in write-downs and losses.
Wall Street’s originate-to-distribute model, designed to mitigate risk by spreading it around, actually exacerbated those risks. It encouraged banks to loosen lending standards because more loan volume meant higher profits; then it led to over-leverage, and finally to complacency. More and more paper dollars were created for trading on the assumption that housing prices would always go up.
The first wave of the crisis affected trading books, but the second will hit lending.
As long as housing values were rising, borrowers could refinance in perpetuity to avoid default. Losses mounted when the refinancing option disappeared. Banks relied too heavily on the securitization markets to boost lending to consumers, particularly in the form of mortgages.
In time, some lending will return, but the sky-high revenues of recent years will be hard to reclaim.
The banking sector’s pullback in lending will cause further painful losses. Many believe banks will have to reserve an additional $170 billion through the end of next year just to keep up with estimated loan losses. “New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most draconian of investors”.
Here in Canada, an accepted truism of the global banking crisis is that the big Canadian banks have done rather better than their global peers, avoiding the worst of the writedowns.
Commentators and analysts have spouted words of comfort about the Canadian banking sector for months, and even Federal Finance Minister Jim Flaherty noted in April after meeting the big bank chiefs in Toronto that Bay Street has avoided the worst pitfalls that have beset banks elsewhere.
But that idea is becoming increasingly difficult to uphold as a few of the Canadian banks ratcheted up their losses in second-quarter results announced this week.
Almost all the bank chiefs warned, too, about slowing capital markets and rising loan losses.
The notion that Canada's banks are relatively unscathed is starting to look like misplaced optimism.
Royal Bank of Canada, the country's biggest bank, confirmed Thursday that its writedowns on structured products now stand at $1.6-billion - a sum that would have been unthinkable last year when Canada's banking sector was on a long winning streak.
RBC chief Gord Nixon was "not happy" about his bank's writedowns, but you have to wonder what he thought of the charges at Canadian Imperial Bank of Commerce, which now total $6.7-billion after the bank acknowledged its investments in structured products produced another $2.5-billion in losses in the second quarter.
RBC and CIBC now share the ignominy of featuring among the global banking top 40 for largest writedowns and credit losses since the banking sector was thrown into crisis last year. (Writedowns refer to structured products being marked to market value, whereas credit losses reflect expected and actual loan defaults.)
RBC sits at number 40 and CIBC's latest charges mean it has leapfrogged up the league table [according to the latest data from Bloomberg], moving into 16th spot above Germany's West LB -- which has taken US$4.8-billion in writedowns and is the subject of a European Union bailout plan -- and Societe Generale, which has incurred US$6.3-billion in writedowns.
In proportion to the size of the bank's assets before the full impact of the crisis hit last year, CIBC's losses are as bad as those of UBS -- the Swiss bank that has suffered US$38.2-billion in writedowns -- and worse than the losses recorded by HSBC Holdings (US$19.5-billion) and JP Morgan Chase & Co. (US$9.7-billion). CIBC's losses as a proportion of total assets are almost as severe as those of Citigroup Inc. (US$43-billion) the poster child for the financial crisis.
Picking on RBC and CIBC alone highlights an important point -- not all Canadian banks are equal when it comes to the financial crisis. Toronto-Dominion Bank has supposedly incurred no writedowns. Bank of Montreal, National Bank of Canada, and Bank of Nova Scotia escaped major writedowns this quarter, but their combined writedowns on structured products stand at more than $1.8-billion since the crisis began.
Leaving writedowns aside, Canadian bank CEOs have painted a bleak picture this week for their outlook on the remainder of 2008.
Even Toronto-Dominion Bank chief Ed Clark -- one of the few CEOs in North America or Europe who can truly claim to have steered his bank through the financial crisis without taking a big hit -- is projecting no earnings growth in 2008 for his bank, amid rising loan losses, stifled investment banking activity, and the potential spillover from the U.S. economic slowdown into Canada.
Still, there are some positives for the Canadian banks.
Their writedowns are so far on paper only, and if the market for certain structured products turns around they will reverse some of their losses, as BMO did this week, announcing it made a gain of $42-million on investments that had previously been written down.
More importantly perhaps, Canada has so far not seen a house price slump like the U.S. and some parts of Europe.
Certainly some Canadian banks are exposed to the collapse of the U.S. housing market through their U.S. subsidiaries -- notably RBC bumped up the provision for loan losses at its bank in Florida and other southern states. But the biggest advantage the Canadian banks have over their peers around the world is the strength of the Canadian economy and their strong domestic retail operations. Let's hope this continues.
Tuesday, May 27, 2008
Higher Oil Prices Not Necessarily Shocking.
Much has changed in the decades since embargoes and war in the Middle East upset oil markets.
We've become much more energy efficient. Computers have made us more productive. And we've learned to temper our inflation expectations.
Consider that gleaming stainless steel refrigerator in your kitchen.
It isn't just the colour that has changed since you were a kid.
The average refrigerator is 70 per cent more energy efficient and nearly a third larger than in the early 1970s.
The transformation goes a long way to explaining why oil at more than $130 (U.S.) a barrel isn't likely to rattle the global economy as badly as the oil shocks of the 1970s and 1980s. The same holds true for cars, air conditioners and many other energy-sucking machines.
"Despite the surge in oil prices this decade, there are scant signs that the current oil shock is affecting the global economy in a manner similar to the 1970s," according to a report last week by Goldman Sachs economist Jim O'Neill.
It's true that the magnitude of the price spike is impressive. Oil is up nearly 50 per cent this year and 85 per cent in the past two years.
And adjusted for inflation, oil has never been this expensive.
But for pure shock value the recent runup pales compared to 1973 when oil shot up nearly fivefold (to $12 a barrel from $2.50), or 1979 when the price of oil more than tripled (to $40 a barrel from $12).
More importantly, the economy is better equipped to withstand energy price surges. It now takes about half as much energy to produce a dollar of gross domestic product than it did in the early 1970s.
Over the past three decades, global energy intensity - energy consumption as a percentage of GDP - has declined 1.5 to 2 per cent a year. And today's high energy prices are likely to make us even greener by spurring a new round of conservation and energy efficiency.
Already, there are tentative signs that consumers are reacting to higher pump prices. In recent weeks, U.S. sales of sport utility vehicles and pickup trucks have fallen sharply. Gas demand is also down a bit, but consumption has proven to be stubbornly inelastic in recent years. Longer term, higher vehicle fuel economy standards would significantly curb per capita consumption in Canada and the United States - the two biggest energy guzzlers among the world's largest industrialized economies.
A lot more needs to happen. Goldman Sachs points out that Japan has been leading the way in reducing its dependence on foreign oil. If the United States, Russia, China and India matched those gains, global energy consumption could be cut by 20 per cent. The latter three have not had the infrastructure of oil dependency and addition ingrained into their culture--yet.
Countries must resist the temptation to limit the price of gas. And countries such as China, which already caps gasoline prices, should relax those controls and let prices rise. This will encourage conservation and spur the search for alternatives.
Energy efficiency is only part of the reason we're better off than in the 1970s.
Our economies are more knowledge-based than industrial-based. The service sector has taken over from manufacturing as the primary economic driver.
As a result, the consumption of oil - and energy in general - is less of a burden on the economy.
In the United States, for example, oil consumption sucks up 5.75 per cent of GDP, compared with 7.5 per cent in 1980.
By that measure, it would take a price of $172 a barrel to feel like 1980.
Even then, it's unlikely that high prices will unleash the kind of virulent inflation that occurred in the past. The simple answer is that inflation expectations are much lower now. Neither consumers, businesses, nor investors expect to be paying substantially more for most of the stuff they buy in the months ahead.
"Inflation expectations are much better anchored now than they were in the 1970s and 1980s," according to Goldman Sachs.
Assuming the world's major central banks are successful in keeping inflation at bay, pricey oil could have a silver lining.
Conservation and efficiency will cut carbon-dioxide emissions and make the planet cleaner. The market is sending clear signals. We just need to heed them.
Governments must avoid the temptation to intervene, except to aid those least able to cope. Consumers must continue to make wise energy choices. And producers must reinvest more of their profits into the quest for unconventional and alternative energy sources.
That will keep this shock from becoming truly shocking.
We've become much more energy efficient. Computers have made us more productive. And we've learned to temper our inflation expectations.
Consider that gleaming stainless steel refrigerator in your kitchen.
It isn't just the colour that has changed since you were a kid.
The average refrigerator is 70 per cent more energy efficient and nearly a third larger than in the early 1970s.
The transformation goes a long way to explaining why oil at more than $130 (U.S.) a barrel isn't likely to rattle the global economy as badly as the oil shocks of the 1970s and 1980s. The same holds true for cars, air conditioners and many other energy-sucking machines.
"Despite the surge in oil prices this decade, there are scant signs that the current oil shock is affecting the global economy in a manner similar to the 1970s," according to a report last week by Goldman Sachs economist Jim O'Neill.
It's true that the magnitude of the price spike is impressive. Oil is up nearly 50 per cent this year and 85 per cent in the past two years.
And adjusted for inflation, oil has never been this expensive.
But for pure shock value the recent runup pales compared to 1973 when oil shot up nearly fivefold (to $12 a barrel from $2.50), or 1979 when the price of oil more than tripled (to $40 a barrel from $12).
More importantly, the economy is better equipped to withstand energy price surges. It now takes about half as much energy to produce a dollar of gross domestic product than it did in the early 1970s.
Over the past three decades, global energy intensity - energy consumption as a percentage of GDP - has declined 1.5 to 2 per cent a year. And today's high energy prices are likely to make us even greener by spurring a new round of conservation and energy efficiency.
Already, there are tentative signs that consumers are reacting to higher pump prices. In recent weeks, U.S. sales of sport utility vehicles and pickup trucks have fallen sharply. Gas demand is also down a bit, but consumption has proven to be stubbornly inelastic in recent years. Longer term, higher vehicle fuel economy standards would significantly curb per capita consumption in Canada and the United States - the two biggest energy guzzlers among the world's largest industrialized economies.
A lot more needs to happen. Goldman Sachs points out that Japan has been leading the way in reducing its dependence on foreign oil. If the United States, Russia, China and India matched those gains, global energy consumption could be cut by 20 per cent. The latter three have not had the infrastructure of oil dependency and addition ingrained into their culture--yet.
Countries must resist the temptation to limit the price of gas. And countries such as China, which already caps gasoline prices, should relax those controls and let prices rise. This will encourage conservation and spur the search for alternatives.
Energy efficiency is only part of the reason we're better off than in the 1970s.
Our economies are more knowledge-based than industrial-based. The service sector has taken over from manufacturing as the primary economic driver.
As a result, the consumption of oil - and energy in general - is less of a burden on the economy.
In the United States, for example, oil consumption sucks up 5.75 per cent of GDP, compared with 7.5 per cent in 1980.
By that measure, it would take a price of $172 a barrel to feel like 1980.
Even then, it's unlikely that high prices will unleash the kind of virulent inflation that occurred in the past. The simple answer is that inflation expectations are much lower now. Neither consumers, businesses, nor investors expect to be paying substantially more for most of the stuff they buy in the months ahead.
"Inflation expectations are much better anchored now than they were in the 1970s and 1980s," according to Goldman Sachs.
Assuming the world's major central banks are successful in keeping inflation at bay, pricey oil could have a silver lining.
Conservation and efficiency will cut carbon-dioxide emissions and make the planet cleaner. The market is sending clear signals. We just need to heed them.
Governments must avoid the temptation to intervene, except to aid those least able to cope. Consumers must continue to make wise energy choices. And producers must reinvest more of their profits into the quest for unconventional and alternative energy sources.
That will keep this shock from becoming truly shocking.
Tuesday, May 13, 2008
Capital Flight or Foreign Investment -- or History?
There are mixed signals for the global economy.
As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.
Why are investors taking so long to realize this critical distinction and its meaning?
Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.
Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.
Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.
Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.
The money is returning home, and the move is structural, not cyclical.
The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.
Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.
Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.
The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.
The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.
The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.
This used to be called capital flight, is now called foreign investment, and may shortly be history.
As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.
Why are investors taking so long to realize this critical distinction and its meaning?
Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.
Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.
Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.
Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.
The money is returning home, and the move is structural, not cyclical.
The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.
Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.
Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.
The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.
The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.
The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.
This used to be called capital flight, is now called foreign investment, and may shortly be history.
Thursday, April 3, 2008
International Investing With Exchange Traded Funds
While many Canadians prefer to invest domestically — either out of fear of the impact of a rising Canadian dollar or due to a perception of elevated risk in international equities — historically, this has not always been an ideal investment decision. According to statistics from CIBC Asset Management, Canadian and Global equities have each returned an average of 10.9% per year in Canadian dollars since 1950. The portfolio of Global equities, however, has demonstrated a lower level of volatility, as measured by the standard deviation of monthly returns. This may surprise some, but the lesson is clear: greater diversification reduces risk. Since most Canadian investors do not have sufficient knowledge or the time required to analyse and buy stocks of companies that operate on the other side of the world, many individuals purchase international mutual funds and rely on the expertise of professional money managers to actively manage this part of their portfolios. If one is a believer in passively managed approaches, due to the lower management fees, they can turn to exchange traded funds (ETFs) to provide the necessary international exposure. The increasing innovation in the world of ETFs has not left the international landscape untouched. Investors looking for passively managed baskets of international equities have many choices from which to choose.
Developed Markets
For investors that have a strong belief in the fortunes of the stock market of a specific developed nation, Barclays Global Investments offers ten ETFs that mimic the major indices of most Western European countries as well as one that tracks Japanese stocks. Investors looking for broader exposure can find regional ETFs such as the Vanguard European (VGK) or the SPDR DJ Euro Stock 50 (FEZ).
Dividend-Weighted
All of the ETFs launched by WisdomTree Investments track dividend-weighted indices, based on the belief these indices will outperform the market capitalization-weighted indices that are followed by many traditional ETFs. Funds offered include the WisdomTree DIEFA Fund (DWM)which tracks dividend-paying companies in Europe, the Far East, and Australasia. For Pacific Rim exposure, there is the WisdomTree Pacific Ex-Japan Total Dividend Fund (DND). 30% of this fund is in banks and, geographically, 57% of the fund is in Australian stocks.
Emerging Markets
Investors would be wise to exercise caution when considering emerging markets given the strong returns in recent years. Further advances may be more muted, and some markets may be due for a correction. Over the long-term, however, emerging market holdings can definitely improve overall portfolio returns, as economic growth in these regions is usually superior to that of developed nations. Claymore Investments has launched the first ETF designed to provide exposure to Brazil, Russia, India and China with its Claymore BRIC ETF (CBQ). Unlike most other international ETFs, this one is traded on the Toronto Stock Exchange. Those looking for exposure solely to China have limited options. Currently, there are no ETFs that track stocks on the red-hot Shanghai Stock Exchange. The iShares FTSE/Xinhua China 25 Index Fund (FXI) is a concentrated portfolio of 25 Hong Kong-traded stocks. Alternatively, the PowerShares Golden Dragon Halter USX China Portfolio (PGJ) is comprised of U.S.-listed companies that derive a majority of their revenue from China.
Latin America
For investors looking for Latin American Exposure, the ishares S&P Latin America 40 Index Fund(ILF) is available.
In conclusion, when it comes to international investing, you can create portfolios by regions, countries, global sectors or some combination of all these. No matter what your approach, Index Funds and ETFs can help you turn your ideas into a portfolio.
Developed Markets
For investors that have a strong belief in the fortunes of the stock market of a specific developed nation, Barclays Global Investments offers ten ETFs that mimic the major indices of most Western European countries as well as one that tracks Japanese stocks. Investors looking for broader exposure can find regional ETFs such as the Vanguard European (VGK) or the SPDR DJ Euro Stock 50 (FEZ).
Dividend-Weighted
All of the ETFs launched by WisdomTree Investments track dividend-weighted indices, based on the belief these indices will outperform the market capitalization-weighted indices that are followed by many traditional ETFs. Funds offered include the WisdomTree DIEFA Fund (DWM)which tracks dividend-paying companies in Europe, the Far East, and Australasia. For Pacific Rim exposure, there is the WisdomTree Pacific Ex-Japan Total Dividend Fund (DND). 30% of this fund is in banks and, geographically, 57% of the fund is in Australian stocks.
Emerging Markets
Investors would be wise to exercise caution when considering emerging markets given the strong returns in recent years. Further advances may be more muted, and some markets may be due for a correction. Over the long-term, however, emerging market holdings can definitely improve overall portfolio returns, as economic growth in these regions is usually superior to that of developed nations. Claymore Investments has launched the first ETF designed to provide exposure to Brazil, Russia, India and China with its Claymore BRIC ETF (CBQ). Unlike most other international ETFs, this one is traded on the Toronto Stock Exchange. Those looking for exposure solely to China have limited options. Currently, there are no ETFs that track stocks on the red-hot Shanghai Stock Exchange. The iShares FTSE/Xinhua China 25 Index Fund (FXI) is a concentrated portfolio of 25 Hong Kong-traded stocks. Alternatively, the PowerShares Golden Dragon Halter USX China Portfolio (PGJ) is comprised of U.S.-listed companies that derive a majority of their revenue from China.
Latin America
For investors looking for Latin American Exposure, the ishares S&P Latin America 40 Index Fund(ILF) is available.
In conclusion, when it comes to international investing, you can create portfolios by regions, countries, global sectors or some combination of all these. No matter what your approach, Index Funds and ETFs can help you turn your ideas into a portfolio.
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