LOM News

Sub-Prime Problems Resurface

June 25, 2007- Last week, there was further evidence that woes in the US sub-prime housing market have the potential to cause anxiety across the entire breadth of credit markets. Just when the average opinion had become comfortable with the idea that there would be no spillover it was revealed that two Bear Stearns hedge funds had suffered heavy losses on sub- prime bets. The funds were, of course, heavily leveraged and the fear was that lenders who had seized the collateralised debt obligations (CDOs) would liquidate them rapidly.

This would have initiated a write-down of holdings at many financial institutions, potentially resulting in multi-billion dollar losses and liquidity problems. Some of these CDOs are relatively illiquid assets carried at inflated prices on the books, and the holders may not be keen to mark them to market. At the time of writing, there were moves underway for Bear Stearns itself to bail out one of its hedge funds, by taking on the loans to stop creditors from conducting a fire sale. The credit-market scare had somewhat modest ripple effects on other markets. But given the highly leveraged environment in which we live, it is unlikely that we have witnessed the last fright of this sort. And it is quite possible that the next credit-market event will have a more serious impact than the ones so far.

The markets for CDOs and credit default swaps have grown tremendously in recent years and nobody knows how well they will stand up to a truly stressful event. To use the lingo of risk management, the system has not been stress-tested. Many banks that have extended loans to financial entities engaged in riskier strategies have sought to reduce their own exposure by parcelling the loans and moving them off book. But several bank CEOs have recently recognised that this isn’t an entirely adequate solution to the problem. Central banks are also unsure about how the new world works. To partially cover their derrière in case a blow-up occurs, many governors have issued warnings about the excess lending and leverage. But this is disingenuous because the central banks have also been responsible for the easy monetary conditions that have encouraged risk taking. The financial system is more globalised and integrated than any other part of the world economy. But central banks are essentially national entities who engage in a limited degree of cross-border cooperation. The closest thing to a global central bank is the Bank for International Settlements. But it has primarily an advisory role with regard to member banks. In the opinion of some observers, risk is still under-priced in financial markets.

The bond-market sell-off a few weeks ago wasn’t a prelude to a significant re-pricing of risky assets. Credit-market spreads are still relatively low, and emerging stock markets are hovering near their highs. In China, investors are unconvinced about the authorities’ resolve to tighten credit conditions. “A” shares have pretty much recouped the ground they had lost at the beginning of the month.

The Vix and Move indices which had spiked higher, earlier on, have retreated, signifying a greater comfort level with risk in the stock and bond markets, although the Move index remains somewhat jumpy. As for flows, recent Treasury department data show more foreign appetite for US stocks than for bonds. In particular, the Asians are showing some reluctance to buy Treasuries, though the Japanese are as keen as ever to lap up the supply. The US housing market is still in the doldrums. Rising interest rates have pushed 30-year mortgage rates up substantially, which will hurt households with adjustable-rate mortgages. Meanwhile, lending standards have tightened for those with a poor credit profile.

Some homeowners have experienced a drop in home value, even as their financing costs will adjust to a higher rate.Confidence among homebuilders is at a very low level, as buyers stay away. The trend in new-home sales is far from encouraging, and housing starts have, thus far, failed to rebound. So, all in all, some caution is warranted regarding the sustainability of the current growth rebound in the US. The Japanese economy is doing relatively well, driven primarily by rapid growth in the global economy. On the domestic front, capital spending is fairly robust, but household expenditure is lacklustre. The forward outlook is still largely dependent on how well the world economy performs.

The stock market is mainly driven by foreign participants. News about the state of the US economy often leads to significant moves in the market as exporters’ fortunes are reassessed. In addition, the value of the yen is an important influence, with investors looking favourably on a weaker currency. Some of the best-performing sectors of the Topix index are trading houses and industrial stocks that are geared to the global economy. The yen experienced a rally in late February, but has been losing ground steadily since then, against both the euro and the USD. Cheap as the currency may be, the flows are not favourable to a strengthening trend taking hold. For one thing, Japanese corporations are engaged in quite a bit of foreign direct investment. For another, yield-starved domestic investors continue to buy higher yielding fixed-income instruments abroad. However, the Europeans are particularly upset about the sharp appreciation of the euro versus the yen and are likely to increase pressure on the Japanese. Eurozone officials are, of course, concerned about trade issues. But looking at it from the investor’s point of view, a German investing in the Japanese stock market on an unhedged basis would have seen about half her gains eaten up by currency losses.

As for the Americans, they aren’t so keen to strong-arm Japan on currency issues. They have their hands full tackling the big boy on the block, namely China. Besides, Japan is being courted as an important ally in the strategic game of containing China. So prospects for yen appreciation are slim. However, an economic or credit shock to the global system could increase risk aversion sufficiently to result in a sharp revaluation of the currency. Japan’s stock market is cheap relative to the global average -- on a price-to-earnings basis - - and has been so for quite a while. It is also one of the worst performing indices among the majors, year-to-date. As one newspaper headline put it, buying the Japanese stock market has often been a triumph of hope over experience.Fundamental valuations aren’t necessarily going to help unless there is high-octane fuel in the form of sentiment to drive the market higher.

Currently, there isn’t much momentum evident in the broad index. A quantitative model that takes account of all the relevant factors is currently recommending a sell signal for the EWJ, which is the MSCI-based exchange traded fund for Japan, expressed in US dollars. The model switched from buy to sell in late March. The moral of the story is that valuation isn’t the only thing, and it pays to switch in and out of a market. As a long-only model it has beaten the buy-and-hold strategy by a wide margin over the past 3 years or sub-periods thereof. And, there are infrequent trades since it is aimed at making tactical asset allocation decisions rather than engaging in short-term trading.