Friday 25th July 2014
slib33
FRIDAY ANALYSTS TICKER: July 25th 2014 - According to Adam Cordery, global head of European fixed income, Santander Asset Management, and fund manager for the Santander Euro Corporate Short Term and Euro Corporate bond funds, “Pricing of risk assets doesn’t offer much of a margin for error at the moment. And now Europe is starting to go on holiday, market liquidity may get poorer than normal, and any buys today may well have to be holds until September. It is always interesting to note what yields are required to attract clients to financial products. Twenty years ago, bond funds offering yields of 10%+ could generally attract lots of client interest very quickly. However as rates have come down over the years, so the yields clients demand have fallen. Now 4% seems to be the new 10%, he say. Cordery thinks that unfortunately, investors often want today the yield/risk mix that was available last year, so the products that get launched, sold and bought in size may be more risky than people think. “Products with 4% yield will sell well today, but to get to a 4% yield in Euro you need to invest in a portfolio with an average rating of single-B, and that is far from being risk-free. I get the impression the conventional wisdom today is to think that interest rates must surely go up soon and the main risk to bond portfolios is an increase in bund yields. Because of this many investors are buying short-duration products and floating rate notes, perhaps viewing them as a safe choice, almost like cash. It is possible however that these products may yet prove to have a considerable sensitivity to changes in credit market spreads and/or bond market liquidity, and may prove to be no protection at all.” - Commenting on the RBS share price jump, Dr Pete Hahn of Cass Business School, says “It's hard to tell whether the RBS share price jump today is more about relief or optimism. The former is about fewer fines, fewer losses on loans, and fewer costs in a shrinking business and possibly dividends for shareholders. And there's the rub, owning shares (as opposed to interest bearing debt) should be about optimism and long-term growth in dividends. But from a shrinking business? Few would argue that RBS' retail and corporate bank had efficiencies to be gained and cash flow that might be converted to dividends; yet like most banks, RBS' cost of equity remains stubbornly and appropriately above its ability to provide a return on that equity. For shareholders, current improvements should mean dividends in the medium term but a recognition that RBS may lack any merit for new investment and delivering any long-term dividend growth - not good. While many large retail banks are getting safer, in some aspects, and we often speak of them in terms of moving toward utility type models, banks take risks, are cyclical, face competition, have new business challengers, and are simply are not utilities. Investors shouldn't get ahead of themselves here.” - According to the monthly survey held by the central bank of Turkey, the country’s capacity utilization (CU) rate declined slightly to 74.9% in July from 75.3% in June. Meanwhile, seasonally adjusted (SA) CU also declined to 74.3% from 74.7% in June, writes Mehmet Besimoglu at Oyak Yatirim Research. As for manufacturing confidence, the index declined to 109 from 110.7 in May. On SA basis, the index also edged down slightly to 106.4 from 107.2. SA capacity utilisation was broadly stable in 1H14, averaging at 74.7%. This is the same level with the 2013 average. Despite the political turmoil and volatility in financial markets, activity has been relatively resilient. Export recovery & government spending supported production in 1H. Following the elections, public spending relatively decelerated. The turmoil in Iraq also decelerated export recovery from June. Nevertheless, we still expect 3.5% GDP growth in 2014, writes Besimoglu.

The Knotty Question of Regulation

Tuesday, 01 July 2008
The Knotty Question of Regulation First came the collapse of its hedge funds; then the mammoth losses tied to mortgage-portfolio write downs. In March, dark clouds circling over Bear Stearns’ Manhattan headquarters suddenly collapsed into a vortex that reduced the former investment giant to a near-worthless pile of debris. Were it not for the sudden resourcefulness of the New York Federal Reserve, things may have turned out even worse. Now a chorus of finger-pointing regulators insist that investment banks be held accountable--before another Bear is let loose. From Boston, Dave Simons reports. http://www.ftseglobalmarkets.com/
First came the collapse of its hedge funds; then the mammoth losses tied to mortgage-portfolio write downs. In March, dark clouds circling over Bear Stearns’ Manhattan headquarters suddenly collapsed into a vortex that reduced the former investment giant to a near-worthless pile of debris. Were it not for the sudden resourcefulness of the New York Federal Reserve, things may have turned out even worse. Now a chorus of finger-pointing regulators insist that investment banks be held accountable--before another Bear is let loose. From Boston, Dave Simons reports.
On the weekend of March 14th , the New York Federal Reserve gave its blessing (in the form of a $30bn no-risk financing agreement) to JP Morgan Chase & Co to acquire the remains of the 84-year-old Bear Stearns for a mere $2 per share, later sweetened to $10. The takeover bid was officially approved by shareholders in late May. Speaking shortly after the crisis was resolved, US Treasury Secretary Henry Paulson noted that the Bear Stearns episode “raises significant policy considerations that need to be addressed.” The collapse, said Paulson at the time, underscores the rapidly changing role of non-bank financial institutions as well as the interconnectedness among all financial establishments. These changes “require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability,” he added.

Just as last summer’s illiquidity-fueled downdraft prompted calls for universal limits on leveraging, the Bear Stearns experience has critics taking aim at current regulatory standards. These they argue are in need of a substantial overhaul. An important question arising from this development is: how best to carry out these measures? Another is: if those measure are a good idea, why have they not been addressed sooner?

US Federal Reserve Bank chairman Ben Bernanke vigorously defends the Bear bailout, noting that “recent events have demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets”. Detractors offer a much less sanguine assessment. One notable hand-wringer is former St. Louis Fed president William Poole, who thinks that, “It is appalling where we are right now … we’ve become a backstop [sic] for the entire financial system.”

Indeed, by all accounts the Fed checkbook may be in for more plundering in the coming weeks and months. In May, Congress put in an emergency call, imploring the Fed to swap Treasury notes for bonds backed by student loans. And with the peak of the credit crisis still months (or perhaps even years off according to some experts) the Fed may have to contend with many more foundering companies arriving in the dead of night, cap in hand. Was the Fed correct in intervening on Bear’s behalf? John Halsey, a former senior managing director at Bear Stearns, says that, given the circumstances, the Fed had to take action. Had Bear failed, says Halsey, “Our financial system would have failed as well. The dollar, already weakened, would have plummeted, and it would have hastened the inevitability of the dollar’s demise as the world’s reserve currency. Stocks would have dropped, markets would have crashed and stopped trading. In effect, Bear shareholders were sacrificed for the good of the system. That said, I do not think it will have much effect on decision making or risk taking.”

The Fed’s willingness to get behind one near disaster after another fails to address some key underlying issues: namely lack of transparency, as well as the enormous complexity of modern financial products, that has rendered normal pricing metrics obsolete. JPMorgan’s valuation gyration over Bear Stearns’ share price is the latest evidence that all is not right. “Free markets can only function in a system where a company’s creditworthiness can be assessed independent of a letter grade supplied by a rating agency,” remarks Jacki Zehner, founding partner of Circle Financial Group, a New York-based private wealth management operation. In reality, says Zehner, this is simply no longer the case. “Before one can declare that this financial crisis is over, the markets have to be able to make this kind of assessment. Unfortunately, we are not there yet.”

Though the Fed may have had little choice but to step in on Bear’s behalf given the magnitude of the counterparty risk, other companies in a similar predicament but with a slower bleed rate may not be as fortunate. Says Erik Sirri, director of the Securities and Exchange Commission’s (SEC’s) trading and markets division, “I think when one of these firms gets into trouble rapidly, liquidity support is needed.” Should that unraveling occur more slowly, however, “that liquidity support may not be needed.”

“Others will fail, though it is not clear what will happen when they do,” says Zehner. “I believe the Fed can and will prevent any sort of systemic collapse which they may have witnessed had they not come to the rescue of Bear. But there will be more problems. Exactly how and where is a difficult bet indeed.”

In the aftermath of Bear, slower client activity, below-normal principal and proprietary trading results and losses from the tightening of structured credit liabilities are just a few of the factors weighing on the investment-banking industry, notes analyst William F Tanona in a recent research paper. Some have been more generous than others. In contrast to Oppenheimer & Co. analyst Meredith Whitney’s assessment of Citigroup’s “antiquated and disparate systems and technology,” Ladenburg Thalmann’s financial institutions analyst Richard Bove sees a much brighter future for the bank. Bove notes that Citi’s turnaround potential is “so significant, it could carry the stock to multiples of its current price.”

While the longer-term picture may be positive--particularly given the prospect of further Fed interventions nonetheless, US banks are in all likelihood looking at a prolonged period of belt tightening and super-scrutiny. “It is truly amazing to see how slow analysts have been in bringing down earnings estimates for the investment banks,” says Halsey. “Of course, at some point soon the bulls will probably be able to point to some very favourable year-over-year comparisons. But the fact remains that the entire sector is going to have to learn to live with much less leverage--and that many of their biggest earning sectors will never recover.”

Is reform needed?

It was the late economist Hyman Minsky who suggested over 20 years ago that “in a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators.” While it may be impossible to prevent changes in the structure of portfolios from occurring, said Minsky, “if the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.”

Speaking at a conference held in Minsky’s honour, Paul McCulley, managing director of fixed-income specialist PIMCO, said that recent events demonstrate how little attention has been paid to Minsky’s words over the last two decades. While initiatives such as Basel I and most recently Basel II may be a step in the right direction, “neither of those arrangements fundamentally addresses the explosive growth of the shadow banking system,” thinks McCulley, referencing the radically leveraged, off-balance sheet vehicles that were so successful in helping institutions sidestep imposed limitations.

To make matters worse, regulators have consistently turned a blind eye to the goings-on within the investment-banking sector, even as the crisis in liquidity was growing more palpable. Their inaction prior to last summer’s meltdown left the banking system vulnerable to the catastrophic run on liquidity that set the stage for innumerable hedge-fund collapses, and ultimately the fall of Bear Stearns, say observers.

In an effort to deflect further criticism, the SEC has wasted little time getting on the case, and has already made clear its intentions to increase the transparency of liquidity and capital positions held by the likes of Morgan Stanley, Lehman Brothers and Merrill Lynch through its consolidated supervised entities (CSE) program. SEC chairman Christopher Cox said the commission wants the changes to take affect prior to the implementation of the new internationally accepted standards for capital and liquidity as set forth in Basel II. Cox has admitted that insufficient regulatory standards in all likelihood helped foster the conditions that led to the Bear crisis. “It’s difficult for anyone to say the system worked or that the regulatory gap that exists in statute lacks any consequence,” said Cox.

Halsey, however, calls the commission’s sudden interest “laughable.” “Where were they when these problems were developing?” he asks. As it relates to the current real estate crisis, “the SEC, banking regulators and especially the Fed were absolutely facilitators to the mess. Alan Greenspan’s legacy has been destroyed.”

To begin to remedy the situation, all institutions that are given access to the Fed’s discount window “must at the same time have pari passu regulatory oversight,” argues McCulley. While banks will undoubtedly balk at such an arrangement, they may have little choice but to play ball. After all, offers McCulley, “if you have access to the Fed’s discount window, the Fed should (and will, I strongly believe) have the power to supervise and regulate your business.” Such increased oversight could take the form of raising core capital requirements, while increasing risk and liquidity management, he adds.

Although regulators appear anxious to expand their legal authority over the investment banking sector, it’s up to lawmakers to ensure that it happens. Speaking before a Senate panel in May, former Clinton administration SEC chairman Arthur Levitt said that “Congress must face these conflicts of interest issues head on, or at least empower the SEC with the proper oversight and disciplinary powers that will enable them to do the job.” As for the near-term direction of the investment banking sector as a whole, Halsey believes that a fundamental shift has already occurred, one that favours the likes of JPMorgan over Goldman Sachs and Morgan Stanley. While product innovation will once again take place and attract new talent and capital, “it will take years for that to happen. In the meantime, the likes of CDOs, CDSs and all mortgage-related trading will deliver a fraction of the profits that stoked Wall Street for so long.” Accordingly, Halsey sees the prospect for a significant brain drain from the various institutions as return on capital founders. “Bright, hungry guys will continue to leave to pursue innovation and profits at hedge funds. That will hurt banks and investment banks alike.”

Can increased regulation be truly effective so long as institutions are allowed to stay one step ahead through the creation of the kind of product embellishments that helped precipitate the crisis in the first place? Absolutely not, says Halsey. Wall Street can afford to hire the best and the brightest and spend more on financial innovation than regulatory bodies can budget for, says Halsey, and as a result, no individual or group can effectively anticipate innovation. Hence, the need for broad, highly flexible guidelines that can compensate for these future product developments.

“As a young guy at Bear, I remember thinking how creative the people who structured collateralised mortgage obligations (CMOs) must have been to come up the concept of interest only strips (IOs) and principal only strips (POs),” recalls Halsey. “By the time they had become commonplace, we were already onto trading inverse floaters. It quickly became apparent that if you could imagine a cash flow of any kind--backed by any kind of credit; then you could create a bond that mimicked such a cash flow. In short, the possibilities of creating new products with unknowable risks when applied to the financial system are endless.”

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