World Going for ‘U’ Recovery

I expect the de-leveraging in the core of the financial system to be continually on its intrinsically disorderly and destabilizing path. The order of economy downturn associated with credit crunches tends to be more ‘U’ shaped than ‘V’ shaped in character and it is unlikely that world is heading for a sustained satisfactory performance until the 3Q09 at the earliest.

Already I heard some troubles brewing in Asia with latest Bank of East Asia (BEA) is facing the challenges after thousands of customers queued to withdraw their savings. It is said that this bank has quite a significant exposure to US bankrupt bank Lehman Brothers and US insurer AIG. Last week, the bank revealed a trading loss of HK$93 million.

There are already symptoms of cash hoarding at banks and businesses, in turn will lower willingness to extend credit. Credit growth especially to household is slowing, despite the Herculean efforts of central banks. These are classic responses due to financial stability concerns. Private consumption – which the centre of growth of US economy – is likely to move at a new slower pace.

The housing adjustment is far from over even though there are tentative signs that it is easing at a much softer pace. From a simple sub-prime mortgages, risk lies now with prime & jumbo mortgages, Alt-A mortgages and home equity loans and home equity line of credit with a total combined exposure of more than US$4 trillion. Risk is that this confidence crisis, which started at residential property may be spread to its cousin at commercial property. Commercial construction could possibly weaken sharply next year. According to the Federal Reserve, around US$811 billion of commercial mortgages were issued since 2005 and we could see around US$35 billion loss from commercial real estate loans, if the severity rate were to reach 2003 peak (45%) and that defaults were to rise to 10% respectively.

Investors are rushing to buy Treasuries in a classic ‘flight to quality’. The 30 year T-Bond gained more than five points and 2 year T-Yields dropped by more than 50bps. Many analysts and traders are now expecting the Fed Reserve to begin cutting rates again.

Public capitalized intermediary will become a key component of the policy cocktail to deal with problems of the hour. Consistently, in bank after bank, the losses suffered from the mortgage and credit crisis have exceeded the amount of new capital they could raise. The pile up of derivatives greatly exceeds the total assets of the firm. For example, Merrill Lynch has US$4.2 trillion and Morgan Stantley has US$7.1 trillion worth of derivatives in their respective books. The empowerment given to these intermediaries and valuation uncertainties will make private financing difficult to arrange, in turn put risk to true belief of capitalism. I leave the eulogies to others!