The prospect of UK mortgage borrowers sliding into a negative equity scenario increased today as UK house prices showed their biggest annual fall in July since Nationwide’s housing survey was introduced in 1991.
The 8.1% annual decline came after house prices dropped by 1.7% in July, the BBC reports. The average home now costs £169,316 which is nearly £15,000 cheaper than in the same month last year.
This news adds credence to Standard & Poor’s assessment that “the current run of house price declines raises the prospect of negative equity for a large number of homeowners, a situation not seen since the 1990’s house price recession.”
In a report prepared prior to the latest Nationwide numbers, S&P says its economists “forecast a further drop of around 17% before prices flatten off in 2009.”
In this scenario, a significant number of UK mortgage borrowers would fall into negative equity.
Moody’s has researched the risk of negative equity using loan-by-loan data for a sample of over two million outstanding U.K. mortgages, and estimates that:
- The average UK mortgage has a loan-to-value (LTV) ratio of only about 54%.
- Nevertheless, around 70,000 (0.6%) of U.K. borrowers are currently in negative equity.
- A further house price decline of 17% would raise this number to about 1.7 million (14%).
- Borrowers in the buy-to-let and nonconforming sectors are more exposed to negative equity under this house price decline assumption.
Moody’s is paying increasing attention to the potential damage to US banks’ long-term franchises caused by persistent negative headlines about losses and writedowns.
In its Commentary on US Banks’ First Quarter Earnings, Managing Director Robert Young writes that a bank may have substantial capacity to handle even severely stressed asset quality and high credit costs over a four- to six-quarter period. “However, this level of credit costs can lead to a bank’s management reporting an additional four to six quarters of operating losses — and likely creating negative headlines and incurring damage to its reputation in the process.”
We are focused on the implications for this with regard to the long-term health of a bank’s franchise. We’ll be studying management actions (such as business-line divestitures), as well as customer behavior and market share, as we consider lasting franchise deterioration in our ratings.
Young writes that “liquidity continues to be a keen focus for us, but we don’t expect it to drive widespread ratings changes. Earnings and capital, as a result of asset quality deterioration, are key concerns, and franchise risk has increased – particularly for those banks that are most exposed to headline risk or persistently negative news flow. “
Other key points from other Moody’s contributors to the Commentary:
- Under the most likely scenario of an extended period of sizeable credit costs, banks have less ability to generate capital internally. Low price-to-book values suggest constraints on capital-raising. Banks now find themselves with limited financial flexibility.
- Merrill Lynch’s settlement with monoline insurer XL was for about 20 cents on the dollar of the current value of the insured protection. This may also set a new precedent for any monoline that would consider agreeing to any form of recouponing or collateral posting.
- If stock prices and asset valuations continue to remain pressured, we would expect more banks to take goodwill write-downs in the coming quarters.
The pace of growth in online retail spending slowed during the past two months, despite the distribution of economic stimulus payments, new data from comScore shows.
The year-on-year growth rate fell from 15% in April to 12% in May and 11% in June. Total U.S. online retail sales (excluding travel) reached approximately $31 billion in Q2 2008.
ComScore said its research reveals that fully two thirds of consumers said they had not planned to spend their stimulus checks and rather intended to use the cash to pay off debt or put the money into savings.
In addition, it’s likely the impact of the stimulus may have been felt more offline, where a variety of merchants made it particularly easy for consumers to cash their checks at retail stores.
Video Games, Consoles & Accessories remains one of a handful of high-performing online retail categories, rising 73 % in Q2 2008 versus the same quarter year ago on the strength of consoles like the Nintendo Wii. Furniture, Appliances & Equipment (up 65%) was another top performer, while Home & Garden (up 23%), Event Tickets (up 22%), and Sport & Fitness (up 21%) also performed significantly better than the average.
Flowers, Greetings & Miscellaneous Gifts, Jewelry & Watches, Computers, Peripherals & PDAs, Toys & Hobbies, and Music, Movies & Videos all experienced declines versus last year.
The US homeowners insurance industry will report a modest underwriting loss in 2008 as rates fall due to excess capacity, an abundance of reinsurance options as well as regulatory and political pressures, Fitch Ratings says. In a new report on the industry, Fitch notes that although insurers have experienced improved underwriting results over the past six years, market fundamentals have deteriorated recently.
The industry failed to produce an underwriting profit for 15 years prior to 2003. Fitch believes that poor underwriting results in the homeowners
business originated from the line serving more as a “loss leader” to attract automobile insurance business for many insurers. Other explanations for underperformance include artificially low prices to increase market share and a lack of sophistication regarding catastrophe management.
State Farm and Allstate (NYSE: ALL) represent the two largest homeowners writers, with 35% of total homeowners premium, but performed worse than the average for the top 10 writers over the past five years. The longer term underperformance by State Farm and Allstate can be attributed to greater catastrophe exposure, which has since been addressed by both companies with more robust reinsurance and risk management programs.
The major writers of homeowners insurance appear well positioned from a balance sheet perspective as market pricing softens and catastrophe exposure continues to grow.
Underwriting performance in homeowners is likely to further deteriorate into a larger underwriting loss through 2009 as there are no indications that market competitiveness in the broader insurance industry is abating.
The key factor looking further ahead is whether insurers will revert to the past loss leader approach to homeowners as competition and growth challenges mount in their other personal lines business.
The full report titled Homeowners Insurance Market: Challenges Ahead, Best Years in the Past is available for purchase.
The expansion of biofuels production is responsible for the lion’s share of the runup in food and feed commodity prices, according to a Working Paper published by the World Bank.
The paper, A Note on Rising Food Prices, which does not represent the official view of the World Bank, estimates that “the combination of higher energy prices and related increases in fertilizer prices and transport costs, and dollar weakness caused food prices to rise by about 35-40 percentage points from January 2002 until June 2008.”
These factors explain 25-30 percent of the total price increase, and most of the remaining 70-75 percent increase in food commodities prices was due to biofuels and the related consequences of low grain stocks, large land use shifts, speculative activity and export bans.
While other estimates agree that biofuels have contributed to higher food commodity prices, the paper’s estimate is much higher.
This reflects author Donald Mitchell’s argument than speculative activity and export bans that may have contributed to higher prices are in essence a “knock-on” effect of increased biofuels production from food and feed crops.
While he acknowledges that export controls have had an impact, notably in the rice market, he is skeptical about the effect of speculative activity: “The impact on prices is hard to quantify and most studies do not find that such activity changes prices from the levels which would have prevailed without such activity…”
The paper’s policy recommendations: “Removing tariffs on ethanol imports in the U.S. and EU would allow more efficient producers such as Brazil and other developing countries, including many African countries, to produce ethanol profitably for export to meet the mandates in the U.S. and EU. Biofuels policies which subsidize production need to be reconsidered in light of their impact on food prices.”
Felix Salmon at Portfolio.com compares the final paper with an earlier leaked version and finds little evidence of the censorship reported by The Guardian.
Sophisticated technology-based banking techniques cause financial institutions to lend more, often beyond their profit-maximizing capability, according to a new Working Paper published by the International Monetary Fund. What’s more, it is the “bad banks” that extend the most credit and take on more risk than they would otherwise.
The paper, Innovation in Banking and Excessive Loan Growth, does not represent the IMF’s official view, but provides interesting reading. Authors, Daniel C. Hardy and Alexander F. Tieman write that with hindsight, it appears that the uncertainty of technology-based models was under-estimated in the case of subprime mortgages, and too much reliance was placed on data gathered in a period of unusually favorable macroeconomic conditions
Innovations in loan technology may lead even reputable, good banks to expand lending excessively in order to demonstrate their confidence in their loan technology, and weaker banks may be tempted to imitate then in order not to reveal their weaknesses.
A bank may be especially loath to reveal that it has less confidence in its skills than its rivals by being reluctant to extend large amounts of credit on this basis. Thus, credit volume becomes a signal of a bank’s confidence in its loan technology, and funding costs increase for banks that do not demonstrate this confidence.
Banks employ different levels of loan technologies, such as credit screening and risk management models, techniques, and procedures, characterized by a general loan portfolio parameter. Better loan technologies increase the marginal value of extending credit, i.e., that banks with higher loan technology parameters (“good banks”) have better screening and management techniques and benefit from those by generating on average higher returns.
Financiers (wholesale and depositors), however, have only an estimate of the true loan portfolio parameter, which can be informed by, e.g., reports from rating agencies and historical data. Banks perceived by financers as having a higher loan portfolio parameter are able to pay less for their funding, both on the wholesale credit markets, as well as for deposits.
Then, banks have an incentive to signal good screening techniques and solid risk
management practices. This holds for banks that indeed have such top-of-the-line loan technologies in place, but also for the banks that do not possess these technologies (“bad banks”). Hence, in order to distinguish itself from the signal a bad bank might produce, a good bank might need to extend more credit than it would in the full-information situation.
As marginal costs for the bad bank are always higher than for the good bank, a separating point will always exist. In case the profits beyond this point remain higher than the profits the good bank could reap when the market cannot distinguish it from other bank (as is the case in a pooling equilibrium), the good bank will rationally extend credit and take on more risk over and above its full-information level.
In a pooling equilibrium, it is the bad banks that extend more credit and take on more risk than they would otherwise.
The authors write that banking supervisors can play an important role in mitigating these effects of asymmetric information on financial system soundness. Banks will be loath to reveal their proprietary loan technology, so a full market-based or self-regulatory approach will not be effective.
However, supervisors can influence credit decisions through moral suasion, or by imposing additional capital and general provisioning requirements. They can also require a bank to improve its loan technology. Furthermore, supervisors can compel banks to disclose information about their loan technology, and check that this information is accurate.
The Offset Quality Initiative (OQI) has issued a white paper offering recommendations on how greenhouse gas offsets should be incorporated into cap-and-trade policies.
The paper “Ensuring Offset Quality: Integrating High Quality Greenhouse Gas Offsets Into Cap-and-Trade Policy,” provides a laundry list of guidelines to ensure the integrity of offsets and ensure consistency.
The OQI is a coalition of six leading non-profit organizations—The Climate Trust, Pew Center on Global Climate Change, California Climate Action Registry, Environmental Resources Trust, Greenhouse Gas Management Institute, and The Climate Group.
A rigorous and adaptable offset program design can ensure that offsets play a valuable role in an effective cap-and-trade system.
According to the paper, Regulatory Offset Programs should:
Ensure High Environmental Integrity. Environmental integrity—defined as the achievement of real, measured reductions in emissions—should be the primary objective of any offset policy.
Be Accurate. Quantification and baseline assessments should strive to be accurate in the accounting and calculation of GHG emission reductions. Methodological selection should be conservative to ensure that offsets are not overestimated and uncertainties are reduced as far as practicable.
Ensure That Offsets are Not Double Counted. Only one ton of offset credit should be created by one ton of GHG reductions, and this credit should only be allowed to count once towards any GHG reduction requirement.
Include Multiple Greenhouse Gases. GHG regulation should, at a minimum, cover all six categories of greenhouse gases: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), perflurocarbons (PFCs), hydrofluorocarbons (HFCs), and sulphur hexafluoride (SF6).
Include Broad Sector Coverage. Offset policy should be designed to take advantage of a wide variety of emission reduction opportunities in uncapped sectors where acceptable standards of offset quality can be met.
Not Restrict Offset Eligibility by Geographic Source. Because GHGs accumulate both uniformly and globally in the atmosphere, the location of an emission reduction is immaterial to its climate change impacts.
Establish Reasonable Offset Crediting Periods. Predefined project crediting periods send important market signals to project developers and other market participants, but regulators will have to carefully assess the relative merits of different crediting periods on various project sectors and types when crafting offset rules.
Exclude Forward Crediting But Allow Forward Selling. Credits should only be issued on an ex post basis after reductions have been verified, and thus forward crediting should not be allowed.
Avoid Quantitative Restrictions on Offset Supply and Use. By lowering the cost of the total system, the use of offsets could allow for the implementation of a more stringent cap, which would result in even greater emission reductions in both the near- and long-term.
Be Transparent. The standards and processes governing offset projects should be developed and implemented in an open and transparent manner and well-defined in regulation in order to ensure credibility and reduce uncertainty for investors.
Incorporate Hybrid Offset Project Assessment Methodologies. All potential offset projects must be assessed both to determine their eligibility and to establish a means of quantifying the reductions.
Allow for Adaptation and Adjustment. GHG emission-reduction systems should be flexible yet comprehensive.
Have a Centralized Offset Program Administrator. This authority should have the ability to make necessary decisions and should be capable of doing so in a timely and transparent fashion
Link With Other GHG Trading and Offset Systems. Where practical, emerging regulatory regimes should be designed to be as compatible as possible with other existing and emerging regimes, both domestically and internationally (as long as those regimes have high environmental integrity).
Securities class-action lawsuits sparked by the subprime crisis and credit crunch continue to rise and are on a pace to more than double the total for 2007. However, securities lawsuits in other areas are down from last year. According to latest data from Cornerstone Securities and the Stanford Law School Securities Class Action Clearinghouse.
About half of the filings so far in 2008 were driven by the subprime mortgage/credit crunch, with 58 filings in the first half of the year containing related allegations, the Mid-Year Assessment shows. This compares with 30 in the second half of 2007 and 9 in the same period of last year for a total of 39 in all of 2007. (In an earlier report, NERA Economic Consulting counted 56 year-to-date subprime-related lawsuits through April 21.)
If the filing rate for the first half of the year continues in the second, 220 securities class actions will be filed in 2008, up from 173 in 2007 and 115 in 2006.
The first half of this year also saw a surge in suits related to auction rate securities, according to the Assessment.
The Financial sector had the most securities class action filings for the third straight six-month period, with 63 filings in the first half of 2008—up from 30 in the second half of 2007 and 19 in the first half of 2007. This sector also registered more filings than all other sectors combined. The subprime/credit crunch fallout drove this spike, with almost all the Financial sector filings involving related allegations. In 2007 and the first half of 2008, 87 of the 97 subprime/credit crunch-related filings were in the Financial sector.
John Gould, Vice President at Cornerstone Research and contributor to the report, said, “We have also seen a sharp increase in defendant firms’ average market capitalization losses associated with filings. The median loss in the first half of 2008 was $243 million, more than twice the historical average. Not since the period of heightened filing activity in 2000–02 have we seen market capitalization losses of this size among defendant firms.”
CreditSights welcomes Merrill Lynch’s (NYSE: MER) decision to take a markdown of $5.7 billion and raise up to $9.8 billion in capital.
In a new report Merrill Lynch: Clearing CDO Cobwebs, Can Investors be Constructive?, CreditSights says,“Net-net, we believe that Merrill’s actions today are a huge step in the right direction as it significantly reduced its ABS CDO and related monoline hedges while also increasing capital… following the current round of marks, we believe that Merrill may have put most of its CDO related marks behind it and raised capital to cover most of our other remaining hot stove marks.”
CreditSights also says Merrill’s moves makes the company “more appealing as a takeout candidate.”
Merrill has an attractive asset management business, a global capital market operation, a large stake in BlackRock, and a bank.
Many of these business units would make the company more attractive as a take over candidate, CreditSighs says. “We believe that in such case, potential acquirers could include Goldman Sachs, (NYSE: GS) HSBC (NYSE: HSBC), Bank of America (NYSE: BOA), and JPMorganChase (NYSE: JPM).”
CreditSights full analysis of Merrill’s moves is available for purchase.
Meanwhile, Moody’s has affirmed Merrill’s ratings at A2/stable after the moves.
A series of ad hoc fixes to the ambitious (and controversial) Basel II international banking regulations suggest the Basel Committee on Banking Supervision and International Organization of Securities Commissions is not fully addressing the risks facing the global banking system, in Oxford Analytica’s view.
As a result, unilateral regulatory moves in some countries are undermining confidence in the Committee, OxAn says in Basel reform agenda highlights flaws.
For example Swiss authorities have implied that Credit Suisse (NYSE:CS) and UBS (NYSE: UBS) may be subjected to special domestic capital measures.
It is estimated that if UBS were required to meet a 5% (capital-to-assets) leverage ratio the bank would have to shed nearly half its assets.
“This action could prompt some banking sector stock prices to plummet, thus increasing the strain and viability of some institutions that already face significant risks,” OxAn says.
The key proposed amendments to the Basel II regulations have focused on making regulatory capital requirements a more realistic reflection of trading book risks in light of lessons learned during the credit crisis.
Incremental risk charge. This additional amount of risk capital that banks must hold was originally proposed in October 2007 to cover the default risk associated with the increasing amounts of credit risk-related instruments residing on trading books.
In the latest proposals, the incremental risk charge (IRC) covers other kinds of risk not captured in the conventional measure of market risk — specifically known as value-at-risk (VaR).
In addition to default risk, credit rating migration risk, credit spread widening risk and the risk posed by significant moves in equity prices should also be reflected in the IRC.
Banking and trading books. Models used to calculate the IRC must be measured in a statistically consistent level with banking book risks — specifically, a 99.9% soundness standard over a one-year period. The Committee hopes this will reduce the asymmetry in regular capital treatment between trading and banking book assets, and remove the incentive for firms to move assets between the books for purposes of regulatory arbitrage.
Pricing and VaR models. It has long been observed that banks do not necessarily use completely consistent pricing and VaR models. This can encourage banks to hold less economic capital than they know is actually prudent. The new proposals explicitly state that risk factors deemed relevant for pricing should also be present in VaR models — unless a compelling argument for their omission can persuade the relevant regulator of the acceptability of such a situation.
OxAn sees two significant problems associated with the recent proposals and related regulatory moves:
- The IRC is incomplete as it omits other significant risk factors.
- Basel II’s patchy implementation and increasing complexity is creating an uneven, potentially unfair and uncertain regulatory landscape.
Non-IRC market risks. Trading book positions whose value depends solely on commodity prices, foreign exchange rates and the shape of the forward curve of interest rates are other sources of price risk not included in the IRC. The Committee stated that it is cognisant of the potential for these non-IRC market risks to create large trading book risks. However, it stated that it will be difficult for most banks to meet the operational and modelling requirements entailed by its current limited-scope IRC proposal.
Flawed regulation. This suggests the Committee is aware that its regulatory framework and fixes are flawed. However, it also suggests the Committee believes that some action is better than none. Indeed, the current proposals seek to address many of the risks that have been laid bare during the credit crisis.
Nonetheless, the Committee’s decision to delay addressing non-IRC factors currently suggests it is not grasping the scope of banking risks as firmly as it should.