Wednesday, October 21, 2009

Commercial Real Estate and Bank Capital

Lesley Deutch, VP at John Burns Real Estate Consulting, gives a very negative outlook for commercial real estate in this week's Advisor Perspectives newsletter. She argues the fallout in commercial real estate will hit commercial banks harder than residential mortgages. One of the reasons for this is that banks hold a much greater percentage of commercial mortgages than residential mortgages.


Commercial banks hold about 45% of all commercial real estate mortgages, compared to 21.3% of residential mortgages (though residential mortgages are a bigger market). Deutch expects banks to recover less than 20% of their CRE loans and predicts government involvement to exceed what we've seen so far. I doubt much of these losses will come from further declines in prices, which seem to have bottomed:

Monday, October 19, 2009

October 19th, 1987

Today is the 22nd anniversary of Black Monday, when stocks around the world crashed one after the other on October 19, 1987. The Dow fell almost 23% and continued downward over the next week. A year later, however, it was almost back to 1987 levels. I consider Black Monday a shot over the bough, that is, a telling glimpse into the greatest problems of modern finance. Here are the lessons we should have learned from 1987:

Sunday, October 18, 2009

A "Sucker's Rally"

The Business Insider has an interesting gallery of prominent analysts who called the stock market rally since March a "bear market rally" and advised clients to take money out of equities. Here's a graphical representation:



Not surprisingly, the bears who most accurately predicted the crash, such as Nouriel Roubini, John Mauldin, and David Rosenberg, were also among the first to call the rise in stocks a "sucker's rally."

Monday, October 12, 2009

Perspectives on America's Decline, Part 1

Have the days of US global domination come to an end? Conventional wisdom seems to believe that it has. A recent Rasmussen poll showed only 32% of Americans believe America's best days are yet to come. 62% say today's children will not be better off than their parents, up 15% since the beginning of 2009.

As a student of history, I've decided to look at historical theories on the causes of an empire's decline and assess the degree to which these theories apply to the present day US. Today, I will consider the theory of tolerance put forth by Yale Law School professor Amy Chua in her 2007 book Day of Empire.

Chua argues one of the driving forces behind the rise and fall of a hyperpower--a global, unchallenged hegemon--is tolerance of people. Chua argues that religious, ethnic, and racial tolerance (relative to other nations) is indispensable to becoming a hyperpower. Furthermore, a hegemon's power will decrease as its tolerance decreases.

The British Empire

Chua traces the root of the British Empire back to 1689, when a new tolerance for Jews, Huguenots, and Scots brought new skills that built the foundation of Empire. In 1689, France rather than England was the most likely successor to the Netherlands as Europe's greatest power. France had a much bigger population, a stronger economy, and a bigger military, but England eventually triumphed because of its human capital.

Sunday, October 11, 2009

Assessing the President

Historically, there is no statistically significant relationship between stock prices and presidential approval ratings. In fact, Richard Brody shows in his classic study of public opinion, Assessing the President, that even macroeconomic performance is more often than not an inadequate predictor of public opinion.* However, for the Obama administration there has been an unusual inverse relationship between the economy and public approval.

From today to the inauguration, the correlation between the S&P 500 and total approval of the president is -0.794. This strong relationship is the result of one of the strongest equity rallies in history and the quick end of Obama's honeymoon period.



Another interesting correlation is that between the US Dollar and Obama's approval. The correlation since inauguration is a positive .822. There is mounting political pressure in the US for a stronger dollar (the GOP has started using the dollar's weakness to attack the President), even though a weak dollar is in many ways in Obama's interest. If the weak dollar policy ends up creating jobs, we will likely see the dollar-approval correlation turn negative.


Though the relationship between the dollar, stocks, and Obama's approval rating is statistically significant (a regression indicates stocks and the dollar have a 71.6% predictive power with p-values <.0001), there is no reason to think this is a causal relationship. (If anything, I'd think higher stocks are having a positive effect on Obama's approval rating because it indicates his policies are working. Apparently this doesn't seem obvious to everyone, such as Jim Cramer, who argued Obama's low approval rating are bringing up stock prices because investors believe a weaker Obama is better for business.)

However, once in a blue moon, these correlations are significant and explanatory. The stock market crash following the collapse of Lehman Brothers was one of the main reasons Obama was elected president (which says a lot about how the American public views Obama). Gallup charted opinion of Obama during fall 2008 versus negative views of the economy:

If you look at the chart above, you see Obama only took the lead after the collapse of Lehman Brothers on Sept. 15 when negativity surged. Also, Obama's lead spiked October 8, during the Dow's most dramatic decline of the crash:


The high negative correlation between stock prices and Obama's approval rating is likely a coincidence. But there are real implications to this correlation. As stocks go up, the severity of the financial crisis declines. As the intensity of crisis decreases, the harder it becomes to push through effective reform. During the Great Depression, it took five years of misery before Congress pushed through meaningful reforms. In a previous post, I discussed how, from the perspective of some markets, this crisis looks very similar to past crises (1987) that ended up with no material reform. In electing Obama, the electorate voted for change. Now that in retrospect the crisis seems less dangerous than it was, the need for change becomes less apparent. Obama won the election more narrowly than people remember. It took one of the most unstable economic moments in US history to grant Obama his narrow lead. We really shouldn't be surprised that the public responded dramatically to Obama's ambitious changes. The response to Healthcare reform would likely have been much different had markets not recovered so fast.


* On a side note, one of Brody's findings in Assessing the President is that approval of a Democratic president increases as unemployment grows and falls as unemployment shrinks. However, the relationship between inflation and a democratic president's approval rating is negative, meaning approval falls when inflation rises. For Republicans on the other hand, inflation is positively correlated with approval while unemployment is negatively correlated (as one would expect). This might reflect the different expectations voters have for democratic and republican presidents. Therefore, when a democrat curbs inflation, he is rewarded with higher approval than a republican might otherwise get, because it is unexpected.

Friday, October 9, 2009

Weak Dollar Will Normalize Trade Imbalances and Unemployment

The best recent policy response to the financial crisis didn't come from the G20 but from the foreign exchange market. This week the dollar fell aggressively against many currencies, driven by an Australian rate increase and a report claiming Arabs, Chinese, and Russians were conspiring to stop pricing oil in dollars. But the dollar was set to depreciate anyway due to an increasing debt and a dovish Federal Reserve. A weak dollar will have a positive effect on normalizing trade imbalances, if it lasts.

A falling dollar is a great stimulus to the US manufacturing base. Historically, manufacturing profits are inversely related to the value of the dollar.

From 1990 to 1995, the dollar stayed around the same level. But in 1995, the dollar started rising steadily, eventually peaking in 2002 after rising 51%. During this time, exports decreased by half:
During this period, exports in China and Japan surged. China's reserves quadrupled and Japan's reserves almost tripled. (For more information, see Robert Blecker's paper, "The Benefits of a Weak Dollar" at the Economic Policy Institute.) The strong dollar also had a large effect on jobs. See this figure on the effect of China's artificially low currency on employment and trade:

The map below shows the damage per state (see Robert Scott's paper here). Note that politically sensitive states such as Ohio, Michigan, and Florida have suffered some of the biggest losses.
Simon Johnson from MIT wrote a recent article arguing the weaker dollar is a part of Obama's plan to win the midterm elections by stimulating the manufacturing industry. Simon says NY Fed President William Dudley's recent comment that interest rates would stay low for the foreseeable comment was timed to send the dollar lower after the Australian rate hike. If rates stay low in the US for longer than other countries, there is an opportunity for a carry trade between the dollar and a currency that is likely to increase rates sooner (e.g. Korea, Australia, China or Switzerland).

Fundamentally, the dollar has nowhere to go but down. With high fiscal debt, loose monetary policy, and trade deficits, the dollar is fundamentally unattractive. Furthermore, there is likely to be significantly less demand for dollars in the future. The second largest holder of US debt, Japan, is highly indebted (debt to GDP of 170%) and aging. The savings rate has been steadily decreasing and will continue to reduce demand. Furthermore, the number one holder of US debt, China, is actively (and publicly) trying to diversify from the dollar.

But while the dollar may go down and start to normalize trade in the short-term, there is reason to be skeptical that this will occur for longer periods of time. Asian nations will not let the dollar get too low. Already we have seen Asian countries respond to the falling dollar. Yesterday, the FT reported Asian central banks aggressively bought the dollar on Thursday. Thailand, Malaysia, Taiwan, Hong Kong, and Singapore made substantial purchases, though they merely slowed the dollar's decline. A key aspect of this intervention was that it was coordinated.

The Asian countries that intervened likely did so primarily to stay competitive with China, which re-pegged the renminbi to the dollar in July 2009. This re-pegging of the renminbi means that whenever the dollar significantly weakens, a large number of central banks must intervene if they want to compete with China. This could mean a floor for the dollar. It could also be a bullish indicator for US treasuries, as foreign central banks may buy treasuries to push the dollar higher.

Wednesday, October 7, 2009

Lehman Brothers' Liquidity Ratio

In my last post, I discussed the irrelevance of the G20 compensation agreement as well as why higher capital requirements are not a panacea for banks. Today I will look at some of the details of new US liquidity regulation. The FT reported last week that US regulators are working on new rules aimed at helping banks avoid the sudden funding withrawals that doomed Bear Stearns and Lehman Brothers. These regulations would require banks to operate under new liquidity ratios as well as capital ratios. Capital requirements wouldn't have saved Lehman, which had 11% tier 1 capital at the time of its bankruptcy, but what about liquidity ratios?

One ratio would compare a bank's assets to its stable sources of funding. Lehman revealed on Sept. 10, 2008 (4 days before bankruptcy) in an accelerated Q3 guidance call that its funding position was "stable." At this point, Lehman had $211bn in secured funding from tri-party repos. Comparing the $211bn in short-term funding to its 600bn of long-term assets (meaning a stable funding to assets ratio of 58%) illustrates Lehman's vulnerable position. But it's not that simple. Of those $211bn, $115bn were in treasuries and agencies, which is very reliable collateral. Of the remaining 96bn, $39bn is central bank eligible and could be used for emergency funds from the Fed. Now the $211bn has been whittled down to $57bn, of which $25bn is investment grade fixed income and liquid equities. So, we are left with a measly $32bn of risky short-term funding, only 16% of total assets. Will regulators demand short-term liquidity must be less than 16% of total assets? Who knows, but it could easily be more. 16% short term funding is not that high. This example merely underscores the drastic effect minor funding gaps can have. That's the thing about liquidity--you either have it or you don't.

This exercise shows the massive difficulties facing regulators in coming up with liquidity ratios. Much like capital ratios, the devil is in the details. Regulators must ensure companies do not find the equivalent of a credit default swap for liquidity ratios, (referring to the role CDS played in keeping bank capital ratios artificially low).

Tuesday, October 6, 2009

Capital Requirements and the G20

At the start of the G20 last week, Sarkozy and Merkel pushed hardest for comprehensive limits on executive compensation. However, by the end of the week, they were less insistent on strict limits to executive compensation, even stating that increasing capital requirements would achieve the same goal.

The G20's compensation agreement is irrelevant. The agreement states regulators should limit bonus payments "when it is inconsistent with the maintenance of a sound capital base." In other words, if banks don't have enough capital, then regulators can limit payouts. The second part of the compensation agreement decrees that a substantial part (40%-60%) of senior bankers' bonuses will be deferred. This part of the agreement is equally worthless because it is already standard practice at most banks.

Finally it is crystal clear: bank regulation after the greatest financial crisis since 1929 will focus on higher, risk-adjusted capital requirements. The general consensus is that regulators will increase capital requirements from 4% of total assets to 8% and hasten the implementation of Basel II.

But it is much more important to address the mechanics of regulatory arbitrage that can take advantage of "risk-based" capital. Regulators must address the arbitrary calculation of tier I capital. Allowing banks to judge the riskiness of their own assets will never be adequate because risk can easily be mispriced. The FDIC's Sheila Bair criticized Basel II in 2007 for this exact reason::

There are strong reasons for believing that banks left to their own devices would maintain less capital -- not more -- than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did.
Bair is right. Lehman had 11% tier 1 capital when it failed, more than twice the requirement. Its total capital ratio was at 16.5%, well above the 10% regulatory threshold (see here). Under the new compensation and capital regulations, Lehman right before its collapse would be able to pay its executives whatever they liked, as long as they paid 50% of it in stock. It would also have sufficient capital.

(I wonder if European emphasis of executive compensation versus capital requirements is driven by a different societal perspective or industry structure. European banks generally have much lower capital ratios than American ones. Furthermore, this capital is often hybrid debt with no real ability to cover losses, as capital is supposed to. Some European banks even include certain deferred taxes in their tier 1. How can deferred taxes ever be used to cover losses?)