In a new analysis of the hedge fund industry, Moody’s suggests that the credit squeeze has uncovered underlying weaknesses in some hedge funds.
“Volatile and adverse market conditions have undermined the investment strategies of many funds, resulting in record losses and severe deterioration of net asset values (NAV). The industry is also struggling to cope with record redemptions as nervous investors react to bad news or seek to cover losses incurred elsewhere.”
Moody’s sees a link between these market-related pressures and operational stresses, though the diverse nature of the hedge fund industry makes it difficult to draw generalized conclusions about the causal relationship between financial stress and operational quality, Moody’s says in Market Turmoil Increases Stress on Hedge Fund Operations.
The severe underperformance of many hedge funds in the current economic downturn can have at least three implications for operational quality:
- Severe underperformance may itself be symptomatic of latent deficiencies in the hedge fund’s operational infrastructure, which is typically organized around the goal of avoiding such outcomes.
- Poor performance may lead to unusually high redemption activity, creating pressure to invoke gates or suspend redemptions entirely. Elevated redemptions also raise the importance of the valuation processes at a time when market illiquidity can make it difficult to obtain independent corroboration of fair values. Moody’s considers valuation to be among the most critical operational processes for a hedge fund.
- Even if a firm’s people, processes and systems are performing as expected, at some point the financial distress associated with a severe and protracted economic downturn raises the risks of senior staff turnover, management distraction, disruption of risk management and other operational processes.
This report examines these implications as well as the related links between financial under-performance and operational risks.
While the current market upheaval has painfully revealed areas of existing and potential operational weakness, it has also presented an opportunity for many hedge funds to correct and upgrade their operational infrastructure.
Slumping global economic growth and the fragile condition of many large global financial institutions are posing a major challenge to foreign banks in China, according to Oxford Analytica.
The aspirations of foreign banks to dominate among high net-worth individuals — the rising middle-class — have been put on indefinite hold as depositors begin a flight to safety back to large Chinese state banks, presumed to be guaranteed by the Chinese government, OxAn says. Meanwhile, the quality of credit is beginning to deteriorate rapidly on foreign banks’ balance sheets.
Slumping global growth is the first serious challenge faced by foreign banks operating in China. As interest margins fall and non-performing loans increase, foreign banks will have to decide about their strategies there:
- NPLs. Foreign banks started from a low base in both loans outstanding and distressed loans. Lending last year grew by a healthy 25%, but NPLs grew much faster. Although the NPL ratio remains just below 1%, NPLs growing at the same rate in 2009 would begin to cause a problem for foreign banks by year-end.
- Interbank lending. On the interbank market, Chinese banks, which tend to have cash surpluses, have begun showing a marked reluctance to lend to foreign banks, which borrowed aggressively in 2008 in order to expand their loan portfolios. Average daily borrowing of foreign banks on the interbank market fell from over 20 billion renminbi in September to less than 10 billion renminbi in November.
- Weak bases? Regulators have become increasingly worried about the generally weak deposit base of foreign banks and concurrent aggressive lending, which resulted in a loan-to-deposit ratio of over 100% in 2008. If NPLs increase suddenly, foreign banks would be much more vulnerable to losses in confidence than Chinese banks, which have much lower loan-to-deposit ratios.
- Margins pressure. More recently, foreign banks have faced a rude awakening when the State Council encouraged banks to reduce the interest rates of existing mortgages. Chinese banks, which put profit second to political signals, readily reduced mortgage rates. Foreign banks were forced to follow suit, and this will have squeezed their profits.
The opening of the Chinese banking sector to foreign entities continues apace, albeit incrementally, and the Chinese authorities have resisted any temptation to halt the process in the midst of the global financial crisis. Some barriers nevertheless remain in place. For example, the authorities recently made clear that individual foreign banks still cannot own over 20% of a Chinese bank.
However, the most difficult problem now faced by foreign banks in China is their reputational fall in the midst of the financial crisis.
The outlook for HSBC (London: HSBCA) and Citibank, (NYSE: C) previously two of the most commercially aggressive foreign banks, has become less certain. Hong Kong-based BEA suffered a mild run in September. The recent sale of Chinese bank stakes by the Royal Bank of Scotland (London: RBS) and Bank of America (NYSE: BAC) mostly reflected the two banks’ need to raise capital in the midst of distress. However, the excitement about the Chinese banking market of a few years ago is also wearing thin.
The cash rich state-owned banks continue to have a large advantage, which has been helped by the recent flight to safety by Chinese depositors.
In tough times, the government is also structuring policies that decrease bank margins. Surviving and thriving in the largest banking market in the world turns out to be much tougher than anticipated. The larger players will hang on, but expectations are probably being adjusted downward.
For details see CHINA: Foreign banks take a crisis hit.
The telecommunications industry has the largest number of debt issuers poised for “upward Migration,” Standard & Poor’s says in its latest “Rising Stars” report.
The only addition to the potential upgrade list since S&P’s December report, Canada-based telecommunications provider BCE Inc., (TSX: BCE) leads the list of largest potential rising stars, poised to ascend to investment grade with about US$7.68 billion in rated debt.
Global potential rising stars are defined as entities that are rated ‘BB+’ with either a positive outlook or with ratings on CreditWatch with positive implications.
The key points from this month’s report are:
Globally, rising star potential remains limited at 14 issuers, constituting US$16.71 (€12.66) billion in rated debt. By comparison, this is just two more issuers than the 50-month low of 12 issuers in July 2008
- In 2008, 40 issuers globally crossed over to investment grade from speculative grade, affecting debt worth US$171.5 (€130.08) billion, more than one-third of which is attributed to the sovereign rating change on the Federative Republic of Brazil. This compares with a tally of 36 issuers in 2007, with total rated debt worth US$71.81 (€54.39) billion.
- So far this year, only one rising star has emerged, British Energy Group PLC, after it was acquired by Electricite de France S.A., which has most recently demonstrated a strong pledge of financial support for the company.
Diversification will not be enough to shield major industrial conglomerates from the global recession.
In a new report, Conglomerates 2009 Outlook: Pick Your Spot, CreditSights notes that despite the intrinsic value of diversity to business risk profiles, the peer group of companies is starting to feel the impact of this global slowdown. “Companies with a less cyclically diversified business portfolio, material financial services operations, or significant exposure to consumer spending are likely to face pressure on credit fundamentals and ratings downgrades in this down-cycle.”
Given the broad-based global weakness in many end markets and still uncertain economic and financial market conditions, we move down our sector recommendation to marketweight. The sector has lost its “defensive” appeal.
CreditSights “continues to feel comfortable with the cyclically-diverse business portfolio of United Technologies (NYSE:UTX) along with its application of prudent financial policies and maintain our overweight recommendation on the credit. We move down our previous overweight recommendations on GE (NYSE: GM) and 3M (NYSE: MMM) to now be marketweight given the expected pressure on earnings of GECC and the slowdown in consumer spending impact on MMM’s earnings”
Fitch Ratings largely concurs, issuing a cautionary report on conglomerates on Jan 22, U.S. Diversified Manufacturing: 2009 Outlook:
Diversified industrial companies face difficult economic conditions across most of their markets. If economic trends and credit markets fail to stabilize during 2009, negative rating actions could eventually become more common.
However, Fitch anticipates that ratings will be generally stable through at least the near term, reflecting relatively strong financial profiles at many issuers who benefited from strong global growth prior to 2008. These issuers have sufficient flexibility to adjust to a temporary decline in earnings and cash flow while maintaining credit measures consistent with existing ratings.
Fitch said the companies most at risk for potential rating downgrades include those that have financial subsidiaries (Textron [NYSE:TXT]), automotive exposure (Johnson Controls [NYSE: JCI]), or higher-than-normal debt levels as a result of earlier acquisitions (Eaton Corp. [NYSE: ETN]), or other discretionary spending.
CreditSights maintains its strong underweight recommendation on Textron and has added Parker-Hannifin (NYSE:PH) Cooper Industries (NYSE: CBE), Rockwell Automation (NYSE: ROK) and Dover Corp. (NYSE: DOV), to its underweight list.
The International Monetary Fund offers a particularly blunt and bleak verdict in its latest World Economic Outlook Update:
- Global growth in 2009 is expected to fall to ½ percent when measured in terms of purchasing power parity and to turn negative when measured in terms of market exchange rates. This represents a downward revision of about 1¾ percentage point from the November 2008 WEO Update.
- Helped by continued efforts to ease credit strains as well as expansionary fiscal and monetary policies, the global economy is projected to experience a gradual recovery in 2010, with growth picking up to 3 percent.
- However, the outlook is highly uncertain, and the timing and pace of the recovery depend critically on strong policy actions.
- Downside risks continue to dominate, as the scale and scope of the current financial crisis have taken the global economy into uncharted waters.
- In addition, the risks of deflation are rising in a number of advanced economies, while emerging economies’ corporate sectors could be badly damaged by continued limited access to external financing.
The main risk is that unless stronger financial strains and uncertainties are forcefully addressed, the pernicious feedback loop between real activity and financial markets will intensify, leading to even more toxic effects on global growth.
Furthermore, while fiscal policy is providing important short-term support, the sharp increase in the issuance of public debt could prompt an adverse market reaction, unless governments clarify their strategy to ensure long-term sustainability.
Among the IMF’s prescriptions:
“Policy efforts so far have addressed the immediate threats to financial stability (through liquidity support, deposit insurance, and recapitalization schemes), but they have done little to resolve the uncertainty about the long-term solvency of financial institutions. The process of loss recognition and restructuring of bad loans is still incomplete.”
Therefore, financial sector policies should focus on advancing this process by forcing credible and coordinated loan loss recognition and by providing public support to the viable financial institutions.
Standard & Poor’s offers a comprehensive analysis of what it sees as growing risks to corporate ratings in Russia in Global Economic Downturn Emphasizes Russia Country Risks.
The global economic turmoil is bringing Russian country risk to the fore, S&P says. “At this stage, we believe that our corporate ratings are consistent with our view that the country environment for a ‘typical’ top-tier Russian company is broadly consistent with the high ‘BB’ category, and that in very specific cases where country risks are well mitigated, the strongest companies can achieve investment-grade ratings.”
Institutional weakness has always been the key country risk pressuring our corporate credit ratings in Russia.
When institutions are weak, implementation of regulations and legislation becomes uncertain and decisions can be driven by personalities or vested interest groups. Personal or political motives can prevail over economic rationale and result in decisions that are difficult to predict and explain from a purely business standpoint. The impact of institutional weakness on corporate credit quality can have several dimensions:
- An uncertain regulatory and legal environment;
- Weak governance; and
- Informal financial arrangements with limited transparency and questionable enforceability.
Other risks include:
- Uncertain Enforcement Of Regulations And Legislation
- Confidence Concerns Fueling Leverage Hike And Capital Flight
- Weak Governance And Control
- Liquidity And Foreign-Exchange Risks
“Stop the decline in asset prices,” PIMCO’s Bill Gross exhorts in his February Investment Outlook. Who (other than short sellers) can argue with that sentiment? Many (such as Credit Writedowns) might argue with the efficacy or wisdom of government intervention to artificially prop up prices. The track record on this score does not inspire confidence. A contrary argument is that excesses must be flushed out of the system before a true recovery can occur and attempts to hinder that process will only prolong the agony.
However, desperate times call for desperate measures, so it worth considering Gross’s plea, especially given his track record and PIMCO’s close relationship with the TARP program and the Treasury department.
PIMCO’s advice to policymakers is as follows: you can’t bail out everyone, yet economic recovery is not possible unless certain critical asset sectors are not only reliquefied, but rejuvenated in price.
“Policymakers should not focus entirely on one-off bailouts of large real estate developers, municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather, they should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even investment grade corporate bonds is a necessary step towards eventual economic revival.”
But one thing is certain: an economic recovery is dependent upon commercial real estate prices stabilizing and most retail stores staying open for business in the months and years ahead.
A new working paper* published by Harvard Business School argues that domestic saving is a prerequisite for greater economic growth in less technologically advanced countries.
The paper suggests that entrepreneurs from less developed nations frequently lack the experience and expertise to develop cutting edge technology. They require foreign experts and foreign direct investment (FDI) to pursue such ventures. Such relationships inherently involve moral hazard.
Foreign investors are hesitant to join with domestic businesses unless the local entrepreneur has already saved and invested sizable resources in the enterprise. Therefore domestic saving in these countries is necessary to create economic growth through FDI and innovation.
The paper found that an increase in the saving rate in the previous 10 years by 10 percentage points leads to an increase in the average growth rate of the next 10 years of 1.3 percentage points
Such saving and growth relationships cannot occur in technologically advanced nations. In these countries, entrepreneurs are more familiar with advanced technology and do not require foreign experts and investment. Without this FDI, domestic saving has no effect on economic growth. The smaller the gap between domestic entrepreneurs and experience in advanced technology, the less foreign investment is required.
The paper also answers critics in the form of a “growth causes savings” hypothesis. Proponents of this theory cite the example of post-war Korea where positive growth trends preceded increases in domestic saving. Upon further examination however, Korean saving and growth trends appear to result from unique conditions. Post-war damage estimates in Korea ranged from 86-200% of GNP. Infrastructure growth, especially in banking, necessarily preceded saving as interest rates had to stabilize before the public would reinvest. The paper concludes that, in the long term, saving causes growth in technologically developing countries.
*When Does Domestic Saving Matter for Economic Growth?
Philippe Aghion, Diego Comin, Peter Howitt, Isabel Tecu
Research Recap’s most viewed posts, attracting thousands of visitors, reflect the credit crisis that spread from the subprime mortgage meltdown throughout the US financial system and into markets and economies worldwide.
All of the top 10 posts and 19 of the top 20 were related to the credit crisis, and it was not until number 26 that a more positive post made the list.
Interestingly, some posts from early in 2008 remained well-read throughout the year as readers tried to make sense of the deepening credit crisis, particularly primer posts like the Research Primer on Credit Default Swaps and the IMF analysis of the role of hedge funds in the subprime crisis.
Research Recap’s Most Read Posts of 2008 were:
1. Warning Signs Seen in Rising Credit Card Delinquencies
(CreditSights – Mar 27)
2. Lenders Slow to Address Florida Mortgage Defaults
(Barrons - Apr 21)
3. Role of Hedge Funds in Subprime Crisis Examined
(International Monetary Fund – December 2007)
4. US Mortgage Insurers’ Troubles May Worsen
(Fitch Ratings – Jul 17)
5. 2007 Worst-Ever Vintage for US Subprime, Alt-A RMBS
(Standard & Poor’s Ratings Service – May 23)
6. Research Primer: Credit Default Swaps
(Fitch Ratings – Jan 14)
7. Alt-A Borrowers Looking More Like Subprime than Prime
(Fitch Ratings -Jun 2)
8. Global Junk Bond Default Rate Doubled in First Five Months
(Moody’s Investors Service – Jun 10)
9. Subprime-Related Litigation on the Rise
(NERA Economic Consulting – Jul 15)
10. What Lies Behind Higher US Negative Equity, Default Rates
(Bank for International Settlements -Dec 9)
With the credit crisis far from over, we would expect it to be a prominent topic again this year. With a new administration in place in Washington, we also expect to see infrastructure and greentech emerge as hot topics.
Click here to see The Top Posts of 2007.
Allowing bankruptcy judges to alter the terms of mortgages should not have any immediate impact on the ratings of securities backed by the affected mortgages, according to Fitch Ratings:
While there are still many unknowns to be determined before U.S. RMBS market participants can gauge the effect of proposed bankruptcy cramdown legislation on outstanding transactions, passage of such provisions are not likely to trigger immediate rating downgrades of transactions.
However, “Due to varying deal language, about 31% of Fitch rated Prime and Alt-A transactions have a greater risk of senior bond downgrades with the remaining 69% having limited risk.”
The Bankruptcy Reform Act of 1994 eliminated the risk of bankruptcy cramdowns on first mortgages secured solely by the debtor’s principal residence and, since then, Fitch has considered the risk of losses due to borrower bankruptcy filings as small. With the potential change in law that risk could become a more material one. The current proposed cramdown legislation provides a bankruptcy judge the ability to reduce the mortgage by a significant amount; the difference between the mortgage amount and today’s ‘market value’ of the property.
The rating implications of bankruptcy cramdown risk are amplified in certain existing Prime and Alt A RMBS transactions where bankruptcy losses are not allocated as typical credit losses. In these Prime and Alt-A transaction documents, the amount of bankruptcy loss that is to be allocated to the bonds in reverse sequential order is limited to a very small total, on the order of $100,000 to $300,000. Bankruptcy losses in excess of this limit are then allocated, pro rata, across the capital structure, Fitch said in a release.
“With regard to new ratings, given the level of uncertainty that would be introduced by the proposed law, Fitch would likely only assign ‘AAA’ ratings if all the losses from cramdowns were allocated as other losses are assigned, in reverse sequential order, as is the case for many current Prime and Alt A transactions. That decision would only be made definitively when an understanding of the final language of any proposed cramdown legislation was obtained.”