The recent banking bailouts get some academic underpinning in a new working paper from the International Monetary Fund.
“Banking bailouts in periods of significant financial distress may be justified to avoid an economically costly and persistent credit crunch,” the paper finds.
While not official IMF policy, the paper by Fabien Valencia suggests that the financial health of the banking system may be a significant contributor to the propagation of economic shocks, especially negative ones. “Banks’ precautionary motive insulates lending from shocks up to some size, but for larger shocks the economic consequences of the ensuing credit crunch may be significant.”
The paper develops a bank model to study credit crunches and their real effects. In the model, banks maintain a precautionary level of capital that serves as a smoothing mechanism to avert disruptions in the supply of credit when hit by small shocks. “However, for larger shocks, highly persistent credit crunches may arise even when the impulse is a one time, non-serially correlated event.”
From a policy perspective, the model justifies the use of public funds to recapitalize banks following a significant deterioration in their capital position.
Not sure if this is a sign that the credit crisis has touched bottom, but for the second straight week a non-financial post was the hot topic at Research Recap this week. Moody’s downgrade of the independent oil refining industry was the most-read post by far. Moody’s said a perfect storm of steeply falling demand and continued additions to refining capacity are hitting independent oil refiners’ profit margins, and the industry is expected to experience maximum stress through at least 2009. What’s more, the demand changes are structural and enduring.
Some of the same factors could mean that Exon Mobil’s (NYSE: XOM) record $14.8 billion quarterly profit will be the high water mark for profits for some time. Breakingviews notes in the New York Ties that the days of $145 a barrel are over, at least for the foreseeable future. “With oil now trading at around $65 a barrel, it will become harder to obscure the industry’s biggest challenge: declining reserves and increasingly inhospitable host nations.” Exxon Mobil must now consider buying a rival at home to protect itself from a worsening environment toward Big Oil abroad, breakingviews says.
Meanwhile, back on the credit crisis front, a consensus seems to be gathering around regulation of credit default swaps. Even though the demise of Lehman Brothers did not result in the feared unraveling of the CDS market, it remains clear that greater transparency and some sort of central clearing facility is needed. CreditSights thinks the ICE/TCC proposal has become the front runner over the CME/Citadel version. ICE got a further boost Thursday with its acquisition of The Clearing Corporation.
Worries about credit card debt continued to weight heavy, led by Moody’s prediction that writeoffs are likely to exceed the peak of previous recessions. Now Fitch Ratings notes that the recent jump in one-month LIBOR, combined with increasing chargeoffs and lower yields on credit cards, is creating a situation that will put U.S. credit card ABS transactions to the test over the next few months. “While spread compression due to the LIBOR jump alone is not a cause for rating action, the compounding effect of rising chargeoffs and higher funding costs could hasten rating actions going forward, particularly at the subordinate note level”.
Not to be outdone,corporate bonds continued to attract negative attention, with Fitch saying the junk bond default rate may reach a record level, and Standard & Poor’s predicting the rate may triple over the next year, reaching close to 10% under a pessimistic scenario.
Research Recap Quote of The Week:
…predictions of a third-wave of ‘liberalism’ — on the scale of the New Deal or Great Society-eras — is very premature. - Oxford Analytica
Even if the democratic party wins the White House and expands its majorities in Congress in next week’s elections, a major shift to the left on domestic policy is unlikely to materialize, according to Oxford Analytica.
The most likely election outcomes have strong echoes of the 1992 contest, OxAn says in a new report. “On that occasion, Bill Clinton defeated the elder President George Bush by just under 5% of the popular vote, the Democrats held some 257 seats in the House of Representatives, and commanded 57 seats in the Senate. However, this outcome did not result in Democratic hegemony over either domestic or foreign policy; indeed, the Republicans rebounded with a crushing victory in mid-term congressional elections two years later.”
This suggests that predictions of a third-wave of ‘liberalism’ — on the scale of the New Deal or Great Society-eras — is very premature.
“History suggests that the passage of major legislation does not necessarily correspond to periods of single party control, or come via congressional votes along partisan lines. Obama’s ambitious legislative agenda, including major healthcare reform, is unlikely to pass without some Republican support. Democratic dominance in Washington would not, of itself, lead to a significant transformation of domestic policy. Implementing the most ambitious elements of the party’s agenda, particularly healthcare reform, will still be very challenging. However, solid Democratic control on Capitol Hill would allow a president of the same party considerable leeway abroad.”
The market for collateralized debt obligations is unlikely ever to fully recover from the credit crunch, no matter how much better the credit rating agencies get at assessing the risks of the complex structured finance derivatives, a new working paper* published by Harvard Business School argues.
Some practitioners believe that the credit crunch of 2007 and 2008 will work itself out, as such episodes tend to do, and the market for structured credit will return as before, the paper’s authors write.
We hold the more skeptical view that the market for structured credit appears to have serious structural problems that may be difficult to overcome.
“As we have explained, these claims are highly sensitive to the assumptions of (1) default probability and recovery value, (2) correlation of defaults, and (3) the relation between payoffs and the economic states that investors care about most. Beginning in late 2007 and continuing well into 2008, it became increasingly clear to investors in highly-rated structured products that each of these three key assumptions were systematically biased against them. These investors are now reluctant to invest in securities that they do not fully understand.”
The ability to create large quantities of AAA-rated securities from a given pool of underlying assets is likely to be forever diminished, as the rating process evolves to better account for parameter and model uncertainty, the authors write. “The key is recognizing that small errors that would not be costly in the single-name market, are significantly magnified by the collateralized debt obligation structure, and can be further magnified when CDOs are created from the tranches of other collateralized debt obligations, as was common in mortgage-backed securitizations. The good news is that this mistake can be fixed. For example, a Bayesian approach that explicitly acknowledges that parameters are uncertain would go a long way towards solving this problem. Of course, adopting a Bayesian perspective on parameter uncertainty will necessarily mean far less AAA-rated securities can be issued and therefore fewer opportunities to offer investors attractive yields.”
“Additionally, investors need to recognize the fundamental difference between single name and structured securities, when it comes to exposure to systematic risk. Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole. In particular, senior structured finance claims have the features of economic catastrophe bonds, in that they are designed to default only in the event of extreme economic duress.”
Because credit ratings are silent regarding the state of the world in which default is likely to happen, they do not capture this exposure to systematic risks. The lack of consideration for these types of exposures reduces the usefulness of ratings, no matter how precise they are made to be.
*The Economics of Structured Finance by Joshua D. Coval (Harvard), Jakub Jurek (Princeton), Erik Stafford (Harvard).
As in the previous quarter, the global credit crisis dominated Research Recap’s Top Ten Posts of the third quarter, with only one post not related in some way to the market meltdown. Many of the posts turned out to be prescient, led by Fitch Ratings’ July warning that US Mortgage Insurers’ Troubles May Worsen. This prediction was borne out this month when Moody’s put several of the insurers on watch for possible downgrade.
In the runner-up spot was NERA Economic Consulting’s July report Subprime-Related Litigation on the Rise, which was buttressed by a Stanford Law School analysis showing that subprime lawsuits were running at double last year’s pace.
The bronze medal goes to the lone non-financial post, Ernst & Young’s July report US Oil Production Flat Over Past 4 Years, published near the peak of the recent oil price spike.
The fourth place post based on the International Monetary Fund’s December 2007 report examining the Role of Hedge Funds in Subprime Crisis Examined is approaching Hall-of-Fame status, consistently featuring among our top posts nine months after it was first published. The IMF also featured in the fifth place post in which Oxford Analytica drew on IMF and OECD data in September to conclude that Speculation Does Not Explain Apparent Housing Overvaluation.
The sixth place post based on a June Moody’s report, Global Junk Bond Default Rate Doubled in First Five Months, now seems modest. Standard & Poors now expects the speculative default rate to triple in the next 12 months. Standard & Poor’s served up the seventh most popular post, in which the ratings agency accurately assessed that Lehman Failure’s Impact on European Banks would be significant.
In what now seems like understatement, the eighth place post based on a June report from Audit Integrity was also right on the money: Credit Default Swaps Adding Rather Than Mitigating Risk? Moody’s July Guide To Interpreting Mark-to-Market Losses of Monolines took the ninth spot.
In what may now seem like wishful thinking, rounding out the top ten on a more optimistic note was KPMG’s July report Greentech Expected to Lead Resurgence of IPOs in 2010.
The credit default swaps market fared batter than expected in the wake of the failure of Lehman Brothers, according to a survey by Moody’s. However, Moody’s still sees the possible failure or failures of other large CDS market participants as a continuing source of systemic risk.
The bankruptcy of Lehman Brothers has put the CDS market to an unprecedented test and has resulted in losses in the hundreds of millions dollars for a number of Moody’s-rated firms, but these CDS market disruptions have not, in and of themselves, resulted in the downgrade of any rated company to date, Moody’s said.
In Moody’s opinion, it is highly unlikely that the CDS market would have been able to deal effectively with a simultaneous default by AIG — probably the largest net seller of CDS protection.
The survey of the major Moody’s-rated banks and insurance firms active in the CDS market suggests that the overall market has fared better than many observers had anticipated.
Lehman’s bankruptcy, although resulting in sizable losses for a number of market participants, did not lead to the unraveling of the CDS market.
Nonetheless, the emergency unwinding of Lehman’s CDS book by major dealers and hedge funds though the “Risk Reduction Trading Session” on the weekend preceding Lehman’s anticipated bankruptcy filing demonstrates that the structure of the over-the-counter CDS market is ill-equipped to reliably deal with such events, Moody’s said.
Moody’s noted that major dealers also did not suffer losses in excess of their ratings-tolerance on CDS contracts referencing Lehman Brothers as an obligor, despite the low auction-determined settlement price of 8.625 cents on the dollar for Lehman’s senior bonds.
The report also discusses what Moody’s characterizes as “encouraging progress” among market participants and regulators to move the CDS market, or at least a portion of it, to a central counterparty model. If implemented effectively, a central clearinghouse could substantially reduce, although not completely eliminate, counterparty and trade replacement risks. It could also impose economic limits on effective leverage and excessive credit exposure by requiring protection sellers to post appropriate initial margin.
For details see: “Credit Default Swaps: Market, Systemic, and Individual Firm Risks in Practice.
Meanwhile, CreditSights has updated its Q & A on the regulatory options for the CDS market with a comparison of two leading alternatives. CreditSights sees the ICE/Clearing Corp proposal – known as the ICE TCC – as the likely frontrunner. “The ICE TCC is designed in a unique way, offering exchange-like features of standardized contracts without the actual listing of exchange contracts.”
The other big factor that makes the ICE TCC a likely frontrunner is the fact that it comes with a “built in” regulator via the Federal Reserve.
“According to testimony before the House and Senate last week, the ICE will, in cooperation with its partners – Markit, RiskMetrics, and Clearing Corp - form a limited purpose bank which will be a New York trust company that is a member of the Federal Reserve system and the New York Banking Department (the state level banking regulator in New York). ”
CreditSights also critiques the competing CME/Citadel proposal, which includes many features of an exchange mechanism, with all counterparties having the ability to face the CCP, and standard margin bonds posted, not on the basis of credit quality from the participant, but rather on the undulations and volatility of the instrument itself – in this case, CDS.
Voters in 36 states will decide on 153 tax-related measures and bond authorizations on Nov. 4, but only a handful of them have the potential to impact credit quality, said Standard and Poor’s RatingsXpress Credit Research.
Massachusetts heads the list with Question 1, which asks voters whether they approve halving, then repealing the state income tax by 2010. S and P points out that the income tax accounts for about 40 percent of the state’s revenues.
If this ballot initiative receives voter approval, we would place all Massachusetts’ general obligation (GO) bonds on CreditWatch with negative implications, pending legislative deliberation on the measure.
North Dakota residents will vote on whether to reduce personal and corporate income tax rates, which would reduce revenues by an estimated 16 percent.
Oregon’s Measure 59 asks voters to decide whether to remove a cap on the amount of federal income taxes a resident can deduct from taxable state income. If the measure passes, S and P predicts the state will need to make major changes to maintain a balanced budget.
California has more than $16.83 billion in new state-supported debt authorizations on the ballot, which if passed, would add to the $58.6 billion of unissued state debt that has already been authorized and the $57.6 billion of currently outstanding state GO bonds.
S and P has written previously about California’s Proposition 7, which would require government-owned utilities to generate 20 percent of their electricity from renewable energy by 2010, 40 percent by 2020 and 50 percent by 2025 for all utilities.
For details on the ballot referendums in all 36 states, see “Income Tax Cuts Have the Most Significant Credit Implications Among November Ballot Measures.”
Standard & Poor’s sees a growing role for the private sector in helping build and refurbish basic infrastructure during a time of declining tax revenues. Faced with a lack of funds to repair and construct transportation infrastructure, countries around the globe are increasingly turning to privatization as a solution, S&P says in a new report.
The idea has been around for a while, particularly in Europe. France, for example, has relied on private funding for more than 3,000 miles of intercity highways since World War II. Now, following Europe’s lead, the U.S. and countries in Asia and Latin America are also looking to investors to help rebuild and refurbish transportation grids that simply can’t meet the needs of growing populations.
With a crumbling transportation infrastructure built largely in the mid-20th century, the U.S. alone faces a funding shortfall of more than $1.5 trillion for repairs in the next half-decade, according to the American Society of Civil Engineers.
“In Standard & Poor’s Ratings Services’ view, this has led states and municipalities to increasingly look at privatization of roads, bridges, and airports as the only viable option.”
The U.S. model for PPPs generally allows the private-sector entity to control a public asset over an extended period of time, typically ranging from 75 to 99 years–much longer than the 25 to 35 years elsewhere in the world. At the end of the concession, the municipality would either reclaim the asset or look for another privatization deal.
The true PPP pioneer continues to be Chicago. In 2005, the city leased the 7.8-mile Chicago Skyway to a foreign group for $1.8 billion. And after Chicago last year sold a number of municipal parking lots to Morgan Stanley for $563 million, it now plans to privatize Midway Airport in what would be the first deal of its kind in the U.S.
This, of course, comes two decades after the U.K. began the trend by privatizing the British Airports Authority (BAA Ltd.), the government agency that owns the country’s biggest airports. In 1987, the British government sold 1.4 billion shares of stock to more than 2 million Britons in the landmark deal.
“Whether or not infrastructure becomes a desirable asset class for investors in the U.S. remains to be seen, especially in these times of economic and financial turmoil, ” S&P says.” With Wall Street suffering dizzying volatility, investors of all sorts becoming increasingly risk-averse–or, worse, strapped for cash–and the U.S. likely in a recession that could be long and deep, buyers for PPP projects may not be as enthusiastic as governments need them to be. On top of this, because there have only been a few such transactions in the U.S., uncertainty about long-term ramifications may make politicians and the public wary of jumping in.”
But Standard & Poor’s expects PPPs to grow as local governments face the need to build and refurbish basic infrastructure as tax revenues decline.
Despite the global macro-economic slowdown, downgrades of residential mortgage backed securities (RMBS) are likely to be limited to the junior notes in most affected sectors, according to Fitch Ratings.
The rating outlook for RMBS in several European countries, including Belgium, France, Greece, Ireland and the Netherlands, remains Stable.
In the UK non-conforming sector in particular, delinquency and repossession rates continue to rise. With negative events unfolding in the wider economy, further declines in these key metrics are expected to continue well into 2009. As a result, ratings are likely to be negatively affected for the remainder of 2008 and into 2009 – particularly since UK house prices are expected to remain under significant pressure during this timeframe.
Fitch notes, however, that its UK non-conforming index shows a wide array of performance and continued upgrades in the higher rating categories can still happen for transactions that have experienced significant de-leveraging and where arrears and loss performance is materially better than original expectations.
UK prime RMBS is expected to experience further deterioration in arrears performance. An increase in loss severities is expected within transactions, especially given that the UK has already seen an approximate 12% house price decline. Despite this deterioration in performance, it should be noted that these are from historically low levels. The outlook for the remainder of 2008 and into 2009 for UK prime RMBS is stable for older vintages but negative for more recent vintages.
Spanish RMBS is experiencing deterioration in collateral performance with rising arrears levels, albeit starting from a relatively low base. However, Fitch does not expect significant rating volatility in Spanish RMBS as many transactions have benefited from prepayments and transaction de-leveraging. The more recent vintages are, however, more vulnerable.
German RMBS transactions are expected to remain under pressure with higher-than-expected levels of arrears and, more concerning, significantly lower recoveries than originally assumed. Adjustments to Fitch’s Germany market value decline (MVDs) assumptions could have an impact on classes above the most junior tranches.
For details see Fitch’s European Structured Finance, RMBS Outlook – October 2008.
Despite falling commercial property values across Europe, the number of loans in payment default remains extremely low across European commercial mortgage-backed securities (CMBS), according to Fitch Ratings. “This will inevitably rise in the coming year as economies slow and corporate insolvencies increase, but is still not expected to be the principal cause for concern for CMBS ratings across the continent,” Fitch says in a new report. “It is the risk that borrowers will be unable to make their balloon payments at loan maturity that represents the greater risk.”
The combination of declining property values with a restricted new lending market, means that borrowers facing loan maturity in the near future may well struggle to make expected balloon payments, at least in a timely manner.
“Declines in European commercial property values have been greatest in the UK, while other property markets that contribute significant collateral to European CMBS, including Germany and France, suffered relatively slight value declines. This reflects the strength of the preceding boom in capital values in the UK and is likely to bring greater downward rating pressure on UK CMBS than in other European countries. However, rating actions are likely to be restricted to the junior tranches, with most senior tranches still adequately covered.”
“The weakening performance of the UK property market will only fully translate into the performance of CMBS when properties have to be sold or refinanced to repay the loans,” says Euan Gatfield, Senior Director, in Fitch’s EMEA CMBS team. “This is unlikely to be the case for many loans in the near future as they are not scheduled to reach maturity and, unless tenant defaults result in reduced cash flow, interest service payments are likely to be made until then.”
The German property market appears to have shown relative resilience to the credit crunch. This, coupled with the fact that German banks continue to have access to wholesale funding via Pfandbrief issuance, allowing them to continue lending in significant volumes, is supporting property values. Fitch, however, cautions that although the multi-family housing market remains stable and is set to produce steady rental income in support of many loans, the costs required to effectively operate a portfolio of multi-family housing have increased in many cases, leaving several borrowers at increased risk of loan payment defaults.
French occupational markets remain close to equilibrium and so again overall valuation declines in France are expected to be relatively muted. Markets focused on the financial services sector are likely to be the first to suffer, including the La Defense district of Paris. However, new development has been muted across Paris, limiting the likely effects of declining demand.
For details see Fitch’s European Structured Finance CMBS Outlook – October 2008.