Cash Hoarding!

Markets remain uncertain and the uncertainty has increased significantly since August last year. What started a simple crisis has turned malignant and spread beyond traditional banking. If banks collapsed, then the fear is not over yet. It has claimed its first non-banking victim and ultimately has changed the landscape of banking system.

What I observed is that money market rate spreads have pushed wider and steeper on account of well known credit fears and less known cash hoarding. Despite intervention by central banks, I still see a great preference for liquidity as global money market liquidity squeeze shows no sign of abating.

The term structure of money market interbank credit spreads has steepened massively and that reflects systemic credit fears as well as balance sheet liquidity ratios.

Public authorities have yet to let any other major players default, and the US even has nationalized Freddie, Fannie, AIG and facilitated other take-overs. In the UK, Northern Rock was nationalized and the US is poised to introduce legislation that will allow the Federal Government to buy dodgy mortgage.

If the situation is as simple as it sounds and as market has endured several false dawns in the last five quarters, perceptions are not change that easily. To date, the system has continued to throw up new challenges and unexpected crisis and each time, the stated losses are rising. It is natural for pricing to be reset into a higher range in reflection of risk premium of current state.

Traders like me call it premium to be paid for ‘liquidity retention’. Liquidity injection by central banks has not been able to keep the 1M and 3M rates in the previous neighbourhood, which already gone up by at least 40-80 basis points already.

By now, a good treasurer should already err on the side of caution as opposed to more adventurous lenders.

The Half-Life of Fannie Mae and Freddie Mac

If the post Bear Stearns bailout can last nine weeks, the Fannie Mae and Freddie Mac bailout rally is likely to be shorter than that. It remains uncertain if it represents a definitive bottom for financial risks. According to Moody’s, the global issuer-weighted speculative default rate rose 20bps to 2.65% in August, an increase from 2.45% in the prior month and up 121bps since the same month last year. This is the ninth consecutive monthly increase in the global speculative grade default rate and the rating agency now forecasts a 4.9% default rate by the end of this year.

The injection by the Treasury of up to US$100bn each into Fannie and Freddie is one more signals that the US is taking the same path trodden by Japan in the 1990s. And it would not be surprised, if the Feds to own more than 60% of the US mortgage market within just few years. Fannie and Freddie produce the credit growth and Treasury buys their mortgage backed securities (MBS) so that they can create even more. This in turn, will raise the risk in Treasury yields as the Treasury will need to issue more debts. If I am right, I could be damn right because as the yield curve is upward shifting, commercial credit defaults will rise rapidly and bad debts will increase in accordance, and this is exactly how the powers of creative destruction will eventually come back to US.

According to some estimates that come to my attention, it will take about another 2 ½ years to absorb the excess housing inventory. House prices may need to adjust another 12-15% before housing affordability to make it attractive. In my own opinion, the de-leveraging process has hardly started in the US. The US consumer debt relative to assets is at an all time high, of around 21% versus an average of 15% in the early part of 1990s. One should not forget that bulk of 1H US growth this year came from tax cuts and net exports.

Based on these observations, the S&P 500 is facing a downside risk of 5.5-10.1% from current 1,267. Corporate earnings are still 8% above trend in the US and almost double in the case of Europe. Usually, earnings typically trough around 155 below trend and majority of time, equities do not trough until earnings are below trend.

In essence, I remain conservative because of the high inventory of unsold houses, large delinquency pipelines, fairly tight underwriting standards, and weak macroeconomic fundamentals related to the health of the consumer.

I think the dollar has large net long speculative positions and remain a net seller in current rally.

Russia: We Are Back!

Over the Labor Day, Russian President Medvedev laid out five points that will define Russian foreign policy ahead – loosely as I understand it – 'We're Back'. This is critical point of view as the geopolitics of Russia would have significant implications from energy prices, commodity markets, and trade patterns.

Ever since the collapse of Soviet Union, it has been a social catastrophe, far from being ruled by intellectuals; it was being ruled by thugs, running as if they were Americans. The pride of once powerful Soviet Union could not be simply ignored. In all of this, there are underlying momentum to create the conditions for cultural renaissance and it is within this context that Russia is back for it once not to be socially ostracized following the end of Cold War.

As I see it, as the Prime Minister Vladimir Putin and President Dmitri Medvedev are shaping things up, social structure is once again going through a round of massive reorganization, free expression is being tempered etc. All this means that a state would not longer ruled by the market, instead the market is submitting to the state.

It is not a surprise to me if Russia's borders aim to be at its height looked more like the Soviet Union than they looked like Russia today. And that could make Russia to be extraordinarily powerful. If anything to go by, the recent clashes with US-allied Georgia are a sign towards a greater confrontation with its former union members. Already, the pain is immediately felt by Turkish exporters, who are facing risk of losing market due to delayed orders.

I will put it this way - Russia's mood has reached the kind of "historically unprecedented, positive extreme", and as Russia is celebrating explosive economic growth, huge oil revenues, and the "heroic" leadership of Vladimir Putin, its desire to reclaim the resources of satellite states lost upon the collapse of the U.S.S.R. make future border conflicts likely. The ethnic diversity within these states represents conflicts-in-waiting for the xenophobia that attends bear markets.

Vladimir Putin is assembling an economic machine powerful enough to force Europe, the US and Asia to their knees. Europe is importing around one-third of its natural gas from Russia. Imagine this - China is hungry for more natural gas. Russia changes the flow of its pipelines, channeling more to China and less to Europe, without any drop in its own revenue. Europe's industrial costs rocket, home heating becomes exorbitant and the EU economy collapses. That event will make the mid-1970s OPEC crisis seem trivial. In 1979, with oil prices at historic highs, the Soviet Union swaggered into Afghanistan. In 1991, with oil prices at record lows, the Soviet empire disintegrated. With oil now in a sustained boom, Russia is once more showing its claws.

First Housing Market, Now Banks and Next Insurance Companies!

The second quarter FDIC banking profile report shows a higher number of 'problem' banks to 117 from 90 a quarter ago. Value of assets 'in pain' rose to US$78 billion from US$26 billion and it is very likely that more banks will come on the list due to credit concerns.

It is no surprise to me at all as this is a result as the industry has begun to shed assets, declining deposits and as credit rating agencies continue to downgrade subordinated debt and preferred stock from A- to BBB+ and BBB- respectively. All non-senior ratings were placed on Watch Negative until Treasury's intentions are clarified.

Housing market will continue to ease for some time until home prices approach levels consistent with underlying rents, suggesting that the rising trend of troubled loans shows no sign of abating. Some observers are suggesting that a slower pace of home price decline could continue for a rather substantial period, perhaps 6 quarters or more. The number of homes for sale and under construction was off by 6.6% in July. This suggests that residential construction will be weak in the 3Q08 and that the decline will be similar to the second quarter's decline of almost 24% on an annualized basis. Separately, Fannie and Freddie are reporting increases in delinquency rates of 6 and 8 bps from 1.3% and 0.9% in June and July respectively.

In my own opinion, this is yet to be the main course. Get ready for the latest chapter in the crisis beyond sub-prime saga - the hits in the insurance industry. News earlier this year that insurance giant AIG had taken a charge of $5 billion related to mortgage credit derivatives catapulted the sector onto center stage. That was followed by a forecast from rating agency Fitch that the life insurance sector would take losses of up to $8 billion -- all related to home loans made to borrowers with sketchy credit histories. The way assets in mortgage-backed securities are reported, there could be problems lurking in the future, even if balance sheets look solid now. A significant portion of life insurers' assets is generally in mortgage-backed securities and other assets like stocks or venture capital, because the long-dated nature of the liabilities gives life insurers the opportunity to add some risk in exchange for larger return. On average, a life insurance company held about 30% of its assets in mortgage-related securities, vs. about 23% for health insurers and 19% for property/casualty companies.

Unlike banks, which value of debt held must be marked to the lower of cost or market -- the same is not true in insurance regulations. The very people charged with ensuring that insurance companies have adequate capital to meet their obligations allow the firms to value bonds held at their original par value, even when the market price is clearly substantially lower. The rules on when to mark down the value of debt reported to the state regulators are a little murky, but if the debt goes into default it must be immediately reduced in value and there is where the time bomb lies.

And in the case of health insurers like Aetna, UnitedHealth, WellPoint, the cash needs are much nearer term -- less than a year in many cases because of the constant need for medical cost reimbursement. As such, they are typically invest in liquid short-term assets such as asset-backed commercial paper and collateralized debt obligations. Those are some of the very same securities which have been hardest hit in the credit crunch.

Credit Spreads Widening!

It is a common question, but definitely a common answer that when is the credit crisis going to end? Credit spreads have been rising and are getting ever more volatile, and this is a tell-tale sign that I monitor the waning of the credit crisis.

US banks are going to roll over almost US$800 billion in medium term debt in the next 16 months and a lot of it is in 2-3 year floating rate notes. With the rising credit spreads, this means that they will have to sell more assets or raise very expensive equity capital. Banks will get into trouble more quickly than you can think of, if they cannot raise capital, sell assets or borrow money due to perceived distress.

Roughly, typical corporation now are paying 315 basis points from a low of 70 basis points more than a similar longer-dated US Treasury. And in the case of high yield market, the spreads on average, have risen from 240 basis points to over 860 basis points. The spread between LIBOR and the Fed fund rate stood in excess of 700 basis points, from historical average of 350 basis points. LIBOR may be the most important rate at all, as so many contracts, including US and European mortgages are based upon. Hedge funds, mortgage banks, large and small corporations and a host of interest rate sensitive investment deals are based on LIBOR.

As a result, I spotted a continued weakness in high grade new issue supply this month – the weakest since 2003. YTD the high grade supply was S$543 billion, about US$112 billion behind last year's pace. High yield and leveraged loan supply also remained muted as only US$5 billion priced.

Denial and Despair in 'Ketuanan Melayu'

The cycle begins with denial, and ultimately ends up in despair. At first, we denounce that anything is wrong but we have always an instinct to sniff out who is imitating Pinocchio.

The idea of 'Ketuanan Melayu' (Malay Supremacy) is meaningless though it may be de jure, if the reality that the non-Malays are not been subscribing to it. The enforceability by force of 'Ketuanan Melayu' in its true sense of manipulation by the Malay supremacists for their own political agenda, if their rhetoric without the back up of actually uplifting their community with substance, then the perceived incremental change will be at the expense of its own people.

On the other hand, if 'Ketuanan Melayu' is enforceability by natural masses acceptance, then the Malay Supremacy issue would have no standing whatsoever. By having a frontal attack on the rights on non-Malay Malaysians will surely and slowly a two steps backward in having a united and harmonious Bangsa Malaysia.

The world has moved forward. Old politic on racial divide is no longer part of current practice, but it seems this business is thriving here. The minority elite of so-called Malay supremacists allegedly are championing Malays rights are actually betraying its own people, and the Malay masses are caught by manipulation of the minority elite in the name of 'raison d'etre' are experiencing a natural death.

As long as non-Malays are subtly under political oppression, it remains a long despair for 'Ketuanan Melayu'. Over the last 5 years under Badawi's administration, I sense that the intensity of 'Ketuanan Melayu' indeed has increased, and all this taking place as the Malays masses continue to be economically oppressed by its own minority elite.

Who benefit from all this play? Only the minority elite that carry the name of Malay supremacists are the one that is truly reaped the rewards with the scraps being thrown to the rest of the Malay community as well as at the expense of non-Malays, otherwise this is a true reflection of the practical bankruptcy of Ketuanan Melayu'.

Fukuda - Gone with the winds

I was caught off-guard when PM Fukuda announced his intention to resign. In my previous posting (28 August 2008), I highlighted that it would be a tough time for Fukuda ahead, but I never expect such shock could come in such timing considering that it was just a month after the Cabinet shuffle.

The Fukuda's discord with the New Komeito Party, whose support is vital for the LDP had recently grown sharper and the amount of politicking in terms of new appointment is tremendously challenging.

Fukuda's speech in his inauguration as Prime Minister remained very fresh in my memory that 'I take this office knowing of the difficulties that lie ahead' and 'This Cabinet will fight with its back to the wall'.

Following the news, I expect a weaker JPY, stocks and JGBs to rise on the weakness of equity market, pretty similar to the last year's dramatic resignation of PM Abe. However, this time around, I foresee that the impact is likely to be range bound. So far neither Nikkei futures nor FX market are showing any reaction. The question is whether this will mark the dismantling of the coalition and possibly the end of the LDP - in a sense the completion of a process started in 1993 when the LDP were voted out but clawed their way back in. Perhaps, markets are already getting used to political dynamics in Japan. More likely is that we could see thin trading to continue as Japan's political situation has become "another factor of uncertainty" on top of the existing woes the market faces such as a bleak global economic outlook and credit worries.

Assuming that LDP Secretary General Taro Aso becomes Prime Minister, I see a good potential for a rebound in JPY assets, riding on his popularity and as his policy focus will shift towards more fiscal expansion from fiscal retrenchment. Aso would likely prioritize stimulating the struggling Japanese economy ahead of cutting down the government's huge debt, perhaps abandoning a goal of a balanced budget within the next few years. If the likelihood of more JGB issuance becomes a much more likely scenario, longer-term yields in Japan could move higher.

Short term, Aso premiership might therefore lift consumer confidence a little and help to ease policy gridlock. With Fukuda increasingly seen as a lame duck, the markets will probably regard any change of leadership as a 'good thing'.