Promod Radhakrishnan's Instablog Promod Radhakrishnan has been associated with the financial services industry for over 10 years, with a background in wholesale banking, capital markets & risk management. He is also passionate about technology solutions and process optimization for the industry. Being an active investor for the past several years, Promod's key areas of focus are macro economics and sectoral analysis (financials, technology). Avoiding technicals, Promod loves to focus on macro trends and company fundamentals and valuation . Most of his opinions are macro in nature, though he does bet on individual stocks based on the above mentioned focus areas. Promod Radhakrishnan http://seekingalpha.com A view - The new normal & impact on Retail over the next 12 months http://seekingalpha.com/instablog/136739-promod-radhakrishnan/38628-a-view-the-new-normal-impact-on-retail-over-the-next-12-months?source=feed 38628 As compared to earlier expectations, the main indices saw a remarkable rally over the last 2 months, fuelled by arguably good third quarter results from a majority of companies across sectors. Now that the DJIA hovers around the 10,400 mark and emerging markets have mostly recovered from the Dubai World impact, the rest of the year and early 2010 does look rosy for the optimists. Especially given the reasonably welcoming statistics on unemployment released last Friday, which saw unemployment dropping to 10% (the first ever drop in the last several quarters i guess) and employers cutting fewer jobs than in prior months.

I do personally believe and agree to the fact that a recovery is very well underway - but still stick to the view point that we are going to continue to see a new normal with lower consumer spending, greater savings & investments and a more tempered retail and construction growth. WIth unemployment still set to stay above 9% at least for the next 12 months & the impact that the down turn has had on consumer psyche, i will bet on a few trends continuing to hold momentum [as compared to averages over the 5 years pre-recession]. Just to highlight a few which outline the line o:
  • A higher proportion will continue to shop for perishables and consumer durables from lower-prices department chains (read Walmart, Costco, BJ, Aldi etc). But niche health-oriented stores like Whole Foods should continue to draw new customers though.
  • Given the significant price differentials, online retailers like Amazon and to a lower extent ebay will continue to build their consumer base across segments - but, especially on consumer electronics and even some high-value retail items like perfumes!
  • In the broadline retail segment, low-price should still continue to draw customers - JC Penney should hold ground against a Macys for example
  • Though the teen segment still has some strength in higher-priced apparel, i still would bet on an Aeropostale (P/E of below-10!) as against Abercrombie & Fitch or American Eagle for example
  • On the Food sector, food-at-home players like General Mills, Campbell should see increased growth (globally in this case) as compared to restaurant chains.
     

Having said that, there still is enough steam in the very high end to perk up valuations further - Tiffany's, Saks for example. It's the higher-priced mass-market retailers that should underperform if a new normal is indeed the reality. With the same view, housing prices in the low-to-mid and extremely high end should see a higher uptick over the next year as against the upper middle segment - the incentive expiring by April 2010 will create a big 'non-seasonal' fluctuation in buying staistics though.


On a more-macro angle, discretion is probably the better option. Like Dubai World was an eye opener to bulls in the high-yield/high-risk bond market, there are probably several skeletons to come out in many sectors, especially commercial real estate for example. To sum up, it's still better to bet on price-value plays and fundamentals as against exuberant growth in higher-end sectors which rely on a rapid uptick in consumer spending.

 


Disclosure: Long ARO, will be long WMT!]]> Sun, 06 Dec 2009 11:46:52 -0500 As compared to earlier expectations, the main indices saw a remarkable rally over the last 2 months, fuelled by arguably good third quarter results from a majority of companies across sectors. Now that the DJIA hovers around the 10,400 mark and emerging markets have mostly recovered from the Dubai World impact, the rest of the year and early 2010 does look rosy for the optimists. Especially given the reasonably welcoming statistics on unemployment released last Friday, which saw unemployment dropping to 10% (the first ever drop in the last several quarters i guess) and employers cutting fewer jobs than in prior months.

I do personally believe and agree to the fact that a recovery is very well underway - but still stick to the view point that we are going to continue to see a new normal with lower consumer spending, greater savings & investments and a more tempered retail and construction growth. WIth unemployment still set to stay above 9% at least for the next 12 months & the impact that the down turn has had on consumer psyche, i will bet on a few trends continuing to hold momentum [as compared to averages over the 5 years pre-recession]. Just to highlight a few which outline the line o:
  • A higher proportion will continue to shop for perishables and consumer durables from lower-prices department chains (read Walmart, Costco, BJ, Aldi etc). But niche health-oriented stores like Whole Foods should continue to draw new customers though.
  • Given the significant price differentials, online retailers like Amazon and to a lower extent ebay will continue to build their consumer base across segments - but, especially on consumer electronics and even some high-value retail items like perfumes!
  • In the broadline retail segment, low-price should still continue to draw customers - JC Penney should hold ground against a Macys for example
  • Though the teen segment still has some strength in higher-priced apparel, i still would bet on an Aeropostale (P/E of below-10!) as against Abercrombie & Fitch or American Eagle for example
  • On the Food sector, food-at-home players like General Mills, Campbell should see increased growth (globally in this case) as compared to restaurant chains.
     

Having said that, there still is enough steam in the very high end to perk up valuations further - Tiffany's, Saks for example. It's the higher-priced mass-market retailers that should underperform if a new normal is indeed the reality. With the same view, housing prices in the low-to-mid and extremely high end should see a higher uptick over the next year as against the upper middle segment - the incentive expiring by April 2010 will create a big 'non-seasonal' fluctuation in buying staistics though.


On a more-macro angle, discretion is probably the better option. Like Dubai World was an eye opener to bulls in the high-yield/high-risk bond market, there are probably several skeletons to come out in many sectors, especially commercial real estate for example. To sum up, it's still better to bet on price-value plays and fundamentals as against exuberant growth in higher-end sectors which rely on a rapid uptick in consumer spending.

 


Disclosure: Long ARO, will be long WMT!]]> wmt cost bj jcp m aeo anf aro wfmi gis cpb amzn Need for a balanced and practical approach - Regulating the OTC Derivatives market http://seekingalpha.com/instablog/136739-promod-radhakrishnan/31911-need-for-a-balanced-and-practical-approach-regulating-the-otc-derivatives-market?source=feed 31911 As legislators prepare to move ahead in debating the recently introduced draft bill on regulating OTC derivatives, several observers have questioned the need for the bill to be diluted, both in terms of coverage and in terms of regulatory oversight mandated. With over USD 600 trillion in notional amount & the stigma attached to CDS instruments (thanks to AIG) due to the current financial crisis, it is easy for one to be led astray and push for a total clamp-down on the market. However, we need to ensure this is looked at from the right perspective.

Regulation is very much needed and so is enhanced reporting and disclosure - without going in to an argument on Value at Risk Vs notional amounts, the very fact that US financial firms make over USD 30-40 billion+ in annual profits from such instruments gives an idea of the level of implied risk in this segment of the financial market. However, it is to be noted that not all of the volume is driven by speculative positions. To put this in perspective, a majority (65%+) of the USD 600 trillion notional pertains to Interest Rate Swaps (IRS) and close to 10% pertains to Currency swaps; and only about USD 60 trillion pertains to the much-vilified CDS bucket. And this is not to say that CDS as an instrument has any inherent flaws - it is as much necessary to create a vibrant credit market as is oil futures and options for a vibrant crude oil market.

More over, close to USD 60 trillion of the USD 600 trillion notional pertains to positions by non-financial firms, where they are hedging real risk associated with variables like interest rates, foreign exchange rates and commodity prices to reduce profit volatility related to factors not linked to their core business. Also, a significant portion of the IRS market would be covered swaps with hedged counter-positions on the books of financial services firms (banks using a pay floating-receive fixed swap to hedge interest rate risk on their floating rate loan pools for example).

To put it in a nut shell, the OTC derivatives market plays a significant role in maintaining a well-oiled financial services world. Over-regulation without understanding the true nature of the market kills the industry and reduces liquidity from the financial services market as a whole. The very nature of customization associated with loan tenures, currency positions etc is what makes the market so difficult to be managed through a pure exchange-driven mechanism. This is the very reason for large delays between trade execution and settlement, and hence accumulation of settlement risk. A regulatory push towards enhanced disclosure and reporting, and hence supervisory review of systemic risk, is a good idea - but draconian rules related to reporting or margining will add disproportionate costs and hence eventually strangles the industry.

Having said this, the directive towards moving a larger portion of the OTC Derivatives volume to central clearing houses is laudable. This is as much a solution to industry woes as for regulators' woes - the positive industry response to DTCC's Trade Information Warehouse a few years back & success of other service providers like Markit and TriOptima clearly shows that there is proven business value attached to central parties which can facilitate information exchange and drive information accuracy. However, a few points need to be noted:
  • Centralized clearing houses do create systematic risk due to aggregation of risk to a single counterparty. So, unless strict norms around capitalization of these clearing houses is part of the mandate, the move could be counter-productive in the longer term.
  • What is more important than centralized information is how regulators and industry uses this information. Unless there is a good mechanism to roll up exposures across related parties and highlight areas of risk concentration, along with a clear mechanism of regulating the same by supervisory oversight, the central clearing house solution doesn't provide any real relief. For example, several large US firms had exposures to multiple Lehman entities (collateral pledged with Lehman US and Lehman UK separately for example) and since analysis of rolled-up exposures to Lehman group as a whole was not done or acted upon, realization of the overall exposure happenned only post-event.
  • Margining requirements have to be as tight on non-financial firms as on financial services firms. I do not personally agree with the opinion that stricter margining requirements dilutes business value for firms using it as a true hedge. I agree that it does entail added costs to doing business, but if the regulation is lax towards non-financial firms in this area, it leaves a big loop hole. Nothing stops rogue financial arms of oil companies or any others from creating Enron-like situations due to unregulated open exposures in derivative positions.

To summarize, we do need fresh regulations on facilitating centralized counterparty driven clearing, enhanced reporting and stricter margin requirements; however, regulators need to work closely with industry leaders and industry SROs to ensure that we create an environment for controlled growth and not lead to total market constriction. On the same note, we have to be careful on diluting rules for select areas of the market - since loop holes almost always are exploited by smart players in the market!

 
]]> Fri, 16 Oct 2009 19:26:56 -0400 As legislators prepare to move ahead in debating the recently introduced draft bill on regulating OTC derivatives, several observers have questioned the need for the bill to be diluted, both in terms of coverage and in terms of regulatory oversight mandated. With over USD 600 trillion in notional amount & the stigma attached to CDS instruments (thanks to AIG) due to the current financial crisis, it is easy for one to be led astray and push for a total clamp-down on the market. However, we need to ensure this is looked at from the right perspective.

Regulation is very much needed and so is enhanced reporting and disclosure - without going in to an argument on Value at Risk Vs notional amounts, the very fact that US financial firms make over USD 30-40 billion+ in annual profits from such instruments gives an idea of the level of implied risk in this segment of the financial market. However, it is to be noted that not all of the volume is driven by speculative positions. To put this in perspective, a majority (65%+) of the USD 600 trillion notional pertains to Interest Rate Swaps (IRS) and close to 10% pertains to Currency swaps; and only about USD 60 trillion pertains to the much-vilified CDS bucket. And this is not to say that CDS as an instrument has any inherent flaws - it is as much necessary to create a vibrant credit market as is oil futures and options for a vibrant crude oil market.

More over, close to USD 60 trillion of the USD 600 trillion notional pertains to positions by non-financial firms, where they are hedging real risk associated with variables like interest rates, foreign exchange rates and commodity prices to reduce profit volatility related to factors not linked to their core business. Also, a significant portion of the IRS market would be covered swaps with hedged counter-positions on the books of financial services firms (banks using a pay floating-receive fixed swap to hedge interest rate risk on their floating rate loan pools for example).

To put it in a nut shell, the OTC derivatives market plays a significant role in maintaining a well-oiled financial services world. Over-regulation without understanding the true nature of the market kills the industry and reduces liquidity from the financial services market as a whole. The very nature of customization associated with loan tenures, currency positions etc is what makes the market so difficult to be managed through a pure exchange-driven mechanism. This is the very reason for large delays between trade execution and settlement, and hence accumulation of settlement risk. A regulatory push towards enhanced disclosure and reporting, and hence supervisory review of systemic risk, is a good idea - but draconian rules related to reporting or margining will add disproportionate costs and hence eventually strangles the industry.

Having said this, the directive towards moving a larger portion of the OTC Derivatives volume to central clearing houses is laudable. This is as much a solution to industry woes as for regulators' woes - the positive industry response to DTCC's Trade Information Warehouse a few years back & success of other service providers like Markit and TriOptima clearly shows that there is proven business value attached to central parties which can facilitate information exchange and drive information accuracy. However, a few points need to be noted:
  • Centralized clearing houses do create systematic risk due to aggregation of risk to a single counterparty. So, unless strict norms around capitalization of these clearing houses is part of the mandate, the move could be counter-productive in the longer term.
  • What is more important than centralized information is how regulators and industry uses this information. Unless there is a good mechanism to roll up exposures across related parties and highlight areas of risk concentration, along with a clear mechanism of regulating the same by supervisory oversight, the central clearing house solution doesn't provide any real relief. For example, several large US firms had exposures to multiple Lehman entities (collateral pledged with Lehman US and Lehman UK separately for example) and since analysis of rolled-up exposures to Lehman group as a whole was not done or acted upon, realization of the overall exposure happenned only post-event.
  • Margining requirements have to be as tight on non-financial firms as on financial services firms. I do not personally agree with the opinion that stricter margining requirements dilutes business value for firms using it as a true hedge. I agree that it does entail added costs to doing business, but if the regulation is lax towards non-financial firms in this area, it leaves a big loop hole. Nothing stops rogue financial arms of oil companies or any others from creating Enron-like situations due to unregulated open exposures in derivative positions.

To summarize, we do need fresh regulations on facilitating centralized counterparty driven clearing, enhanced reporting and stricter margin requirements; however, regulators need to work closely with industry leaders and industry SROs to ensure that we create an environment for controlled growth and not lead to total market constriction. On the same note, we have to be careful on diluting rules for select areas of the market - since loop holes almost always are exploited by smart players in the market!

 
]]> aig Do we have a sustained economic recovery yet? http://seekingalpha.com/instablog/136739-promod-radhakrishnan/31168-do-we-have-a-sustained-economic-recovery-yet?source=feed 31168 Forecasts and projections galore over the past 3-4 months as the DJIA (read market indicators) gradually worked its way almost inching up to the 10,000 mark. Thankfully, unlike the all-pervading gloominess in early March, the biggest question currently in the minds of market pundits and investors is whether the rally is sustainable. Led from the front by Roubini, there are several economists forecasting a double dip recession and the market reverting back to pre-rally levels. Though I personally agree more with Summers than Roubini, it's difficult to stretch the optimism at this point to say that the market is completely on track to a V-shaped reversal.

A quick look a factors which support the sustained rally camp:

  • Job losses are stabilizing - by labor department statistics, total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with lossses averaging 645,000 per month from November 2008 to April 2009.
  • Manufacturing supplier and purchaser indexes are up - for example, the Institute of Supply Management PMI index has gradually increased from 40.1 in April 2009 to 52.6 in Sep 2009, showing an uptick in 4 out of 5 month-to-month instances.
  • Home price decline has been stopped across all major regions, with month-on-month price ncreases reported for Sep 09. Also, both new and existing home inventory are down to the 7-8 month levels as compared to the 11+ months inventory in Q4 2008 and Q1 2009.
On the other hand, those forecasting a double dip recession point to lack of fundamental strength in key indicators
  • Corporate budgets are generally flat and employers have not started hiring. This is supported by continued increase in unemployment, reduction in hours worked and lack of strong private sector new employment generation
  • Manufacturing stats are just showing a blip to shore up inventories back to minimum levels
  • Home foreclosure rates have not slowed down and home prices have not yet shown a consistent upward trend

Let's take a look at some of the key numbers from April to Sep 09 (wherever data is available):
 Apr-09May-09Jun-09Jul-09Aug-09Sep-09
Personal consumption expenditure (USD trillion)9.189.199.209.229.31 
Unemployment rate (%)8.909.409.509.409.709.80
ISM index40.1042.8044.8048.9052.9052.60
Bank lending (USD btrillion)9.259.349.339.269.209.11
New home sales (annualized)352000346000384000429000426000 

As can be seen clearly, while new home sales and manufacturing indicators (using PMI as a proxy) has shown notable progress over the past 6 months, bank lending has yet to show any progress of improvement and so is the unemployment rate. This probably confirms the view that there is still quite some way to move forward for a sustainable recovery. Also, considering near-flat trends for personal consumption expenditure and hence fundamental demand drivers in general, it is perhaps easier to agree with the view that manufacturing stats are up primarily due to re-stocking pressure - due to drastic production cuts and abnormally low inventory levels during the past few quarters as against demand-driven growth.

Unless increased bank lending and government driven spending initiatives create enough employment, personal consumption expenditure would not pick up sufficiently to drive back demand for products and services. This, along with a sustained uptick in both personal and business confidence indices, is required to pave the way to recovery over the next few quarters.

Finally, i personally think that we are more on the way to a 'New normal' as against the pre-crisis economy - as I opined in the previous article too. The impact created due to the crisis is significant enough to affect long-term trends in spending and saving patterns, if not financial services lending patterns too! This will prevent a drastic v-shaped reversal hoped by early-mover market bulls. However, there is enough initial momentum to continue a path to recovery and hence there is no reason to expect a decline of market indicators back to the Q1 2009 levels. From a numbers perspective, i would rather bet on a slow, but volatile climb of the DJIA to 11,000 levels by Q3 2010 as against a 7000 or a 14000!

Due to the same reality, there is not enough fundamental strength for the drastic surge in retail stocks. Manufacturing stocks should see a tempered rise while home builder stocks, especially luxury builders, have quite a way to go before high multipliers are justified. I would personally bet on financial services picks with healthier balance sheets or consumer non-durables, and not retail at this point!

]]> Sat, 10 Oct 2009 18:09:54 -0400 Forecasts and projections galore over the past 3-4 months as the DJIA (read market indicators) gradually worked its way almost inching up to the 10,000 mark. Thankfully, unlike the all-pervading gloominess in early March, the biggest question currently in the minds of market pundits and investors is whether the rally is sustainable. Led from the front by Roubini, there are several economists forecasting a double dip recession and the market reverting back to pre-rally levels. Though I personally agree more with Summers than Roubini, it's difficult to stretch the optimism at this point to say that the market is completely on track to a V-shaped reversal.

A quick look a factors which support the sustained rally camp:

  • Job losses are stabilizing - by labor department statistics, total nonfarm payroll employment declined by 263,000 in September. From May through September, job losses averaged 307,000 per month, compared with lossses averaging 645,000 per month from November 2008 to April 2009.
  • Manufacturing supplier and purchaser indexes are up - for example, the Institute of Supply Management PMI index has gradually increased from 40.1 in April 2009 to 52.6 in Sep 2009, showing an uptick in 4 out of 5 month-to-month instances.
  • Home price decline has been stopped across all major regions, with month-on-month price ncreases reported for Sep 09. Also, both new and existing home inventory are down to the 7-8 month levels as compared to the 11+ months inventory in Q4 2008 and Q1 2009.
On the other hand, those forecasting a double dip recession point to lack of fundamental strength in key indicators
  • Corporate budgets are generally flat and employers have not started hiring. This is supported by continued increase in unemployment, reduction in hours worked and lack of strong private sector new employment generation
  • Manufacturing stats are just showing a blip to shore up inventories back to minimum levels
  • Home foreclosure rates have not slowed down and home prices have not yet shown a consistent upward trend

Let's take a look at some of the key numbers from April to Sep 09 (wherever data is available):
 Apr-09May-09Jun-09Jul-09Aug-09Sep-09
Personal consumption expenditure (USD trillion)9.189.199.209.229.31 
Unemployment rate (%)8.909.409.509.409.709.80
ISM index40.1042.8044.8048.9052.9052.60
Bank lending (USD btrillion)9.259.349.339.269.209.11
New home sales (annualized)352000346000384000429000426000 

As can be seen clearly, while new home sales and manufacturing indicators (using PMI as a proxy) has shown notable progress over the past 6 months, bank lending has yet to show any progress of improvement and so is the unemployment rate. This probably confirms the view that there is still quite some way to move forward for a sustainable recovery. Also, considering near-flat trends for personal consumption expenditure and hence fundamental demand drivers in general, it is perhaps easier to agree with the view that manufacturing stats are up primarily due to re-stocking pressure - due to drastic production cuts and abnormally low inventory levels during the past few quarters as against demand-driven growth.

Unless increased bank lending and government driven spending initiatives create enough employment, personal consumption expenditure would not pick up sufficiently to drive back demand for products and services. This, along with a sustained uptick in both personal and business confidence indices, is required to pave the way to recovery over the next few quarters.

Finally, i personally think that we are more on the way to a 'New normal' as against the pre-crisis economy - as I opined in the previous article too. The impact created due to the crisis is significant enough to affect long-term trends in spending and saving patterns, if not financial services lending patterns too! This will prevent a drastic v-shaped reversal hoped by early-mover market bulls. However, there is enough initial momentum to continue a path to recovery and hence there is no reason to expect a decline of market indicators back to the Q1 2009 levels. From a numbers perspective, i would rather bet on a slow, but volatile climb of the DJIA to 11,000 levels by Q3 2010 as against a 7000 or a 14000!

Due to the same reality, there is not enough fundamental strength for the drastic surge in retail stocks. Manufacturing stocks should see a tempered rise while home builder stocks, especially luxury builders, have quite a way to go before high multipliers are justified. I would personally bet on financial services picks with healthier balance sheets or consumer non-durables, and not retail at this point!

]]> The case for a new normal http://seekingalpha.com/instablog/136739-promod-radhakrishnan/23010-the-case-for-a-new-normal?source=feed 23010
As compared to what has been traditionally decade long recession-boom cycles, we are probably seeing a series of heightened, but faster cycles during this decade. Without too much of doubt, we can say that the US central government responses to both the 2000-'01 downturn and the 2008-'09 downturn has been led/driven by monetary policy. Not often have we seen Fed rates fall, rise and then fall so drastically in a span of 8-9 years - this coupled with a consistently loose fiscal policy has perhaps exacerbated the speed of economc cycles. I am not saying that one should find fault with the Fed's rapid response to the current down-turn - in fact, i agree with the view that nothing short of such a reponse would have helped push the economy out of a recession spiral faster this time around. To understand this, we have to compare the Fed's response to the Japanese central bank's response to their down-turn which started in January 1990. Bank of Japan took 17 months to make its first interest rate cut, and even after that, it relied more on fiscal policy and government funded projects rather than use monetary policy as a tool to steer the economy. The success/failure of such a strategy is known to all of us - it created a prolonged period of stagnation, though it did manage to avoid a recession. Having said that, should we say the current direction of US monetary and fiscal policy would take the economy in the right direction long-term - it's doubtful to say the least.

In the Fed's last rate-setting meeting, the board of governors almost unanimously supported a dove-ish monetary policy - this essentially means an unwritten commitment from the Fed to keep rates near sub-zero levels, helping a rapid pick up in the credit cycle - that assuming inflation stays within 'acceptable limits'. On the fiscal policy front, though there has been quite a lot of lip-service to fiscal discipline from the current government, we haven't yet seen any concerete action/plan yet. The latest in a series of 'government-funded' initiatives, the health care plan, sees an additional 2 trillion USD of spend over the next 10 years - and apart from either a possible drop in service/care levels or a rise in taxes, the only 'funding' mechanism we have seen is a piddly USD 80 billion deal that the White House supposedly has ironed out with the big pharma manfacturers! If we combine the above stands on monetary and fiscal policy, we have the stage set for another cycle of unreasonable growth backed by high fiscal deficits and loose credit standards. Based on advances in distressed bonds, corporate bonds and munis over the last quarter, it already seems that the financial sector has picked on the thread. Add to that an agonisingly slow pace of regulatory reform - and there is a significant risk of a too-rapid turn around before we fix some of the fundamentals.

Why can the Fed not set an internal target for economic and market activity (economic growth, market indicators etc) and rigidly follow a monetary policy which can control expansionary cycles and curtail market booms? Instead of using inflation as the sole leading indicator for monetary policy, the Fed should play a more active role in tracking key indicators and not restrain itself from pulling the trigger if it sees unreasonable moves. Pure free market advocates would loath such a Fed avatar, but we have already seen what happens if the Fed stays in its Greenspan mode. It's amply clear that the current market culture driven by quarterly results, bloated profits and huge bonuses can never be self-correcting or self-regulated. Uni-directional Fed policies targeted at avoiding recessions and fueling growth cycles can only lead to unbridled activity in one or more of the asset markets. We probably need a more 'range'bound', directional fed policy for the next many years to help temper cycles and avoid asset bubbles.

On the fiscal front, an ever-expanding government reach is definitely not the solution to all ills. When comparing government-run programs in other countries, we often forget the size and nature of the beast here - most markets are too big in size and volume for the government to play an active role without compromising fiscal reponsibility. Government-run programs are fine provided it is targeted only at tha wekest links in soceity and provided there are clear stakeholders who fund the plan. Else, rising deficits would soon push external debt to over half of the national GDP and threaten the credibility of US treasuries. Many would point to an intermediate uptick in interest in treasuries and opine that foreign economies would continue pumping back money in to the US given clear signs of economic revival. However, we cannot expect this to be sustainable if central authorities continue with a loose monetary policy and a fiscal policy which promotes deficit spending without a clear plan of future curtailment. This can only yield one result long-term - a gradual move away from the dollar as the reserve currency and subsequent struggle in funding deficts through foreign money. Its difficult to ever assume that consumer savings would rise to a level that can fund such gargantuan deficits!

Regulatory reform is the third pillar which needs utmost attention. Among the broad outline of financial services regulatory reform moves that the Treasury Secretary announced months back, very few have seen implementation yet. A few of these are critical to be implemented befoire any serious market/economic uptick occurs:
  • Disclosure and regulatory guidelines for credit rating agencies
  • Market governance framework for OTC instruments, especially credit default swaps
  • Increased disclosure norms for non-bank financial services entities like hedge funds and private equity funds
  • Continued monitoring and regulation of financial services firm practices as related to consumer products/services (the only area we have seen some conceret action so far)
  • Policy outlining broad principles and limits for compensation policies at financial services firms (going beyond Ken Feinstein!)

Among the above, the last one would see the highest amount of debate and opposition. But unless there is either a central regulatory or self-regulatory control of compensation principles, top management & trader (key profit-driving) compensations would continue to be driven by immediate profits, which would in turn forec minimal alignment between risk management principles and corporate reward/compensation norms. Because irrespective of the nature and volume of regulatory overhaul and international guidelines like Basel II, there is enough ingenuity in the financial system to unearth loopholes and drive short-term profit and compensation maximization. And that combined with loose federal monetary/fiscal oversight would prevent any sustainability of economic growth long-term.

]]> Sun, 16 Aug 2009 18:20:28 -0400
As compared to what has been traditionally decade long recession-boom cycles, we are probably seeing a series of heightened, but faster cycles during this decade. Without too much of doubt, we can say that the US central government responses to both the 2000-'01 downturn and the 2008-'09 downturn has been led/driven by monetary policy. Not often have we seen Fed rates fall, rise and then fall so drastically in a span of 8-9 years - this coupled with a consistently loose fiscal policy has perhaps exacerbated the speed of economc cycles. I am not saying that one should find fault with the Fed's rapid response to the current down-turn - in fact, i agree with the view that nothing short of such a reponse would have helped push the economy out of a recession spiral faster this time around. To understand this, we have to compare the Fed's response to the Japanese central bank's response to their down-turn which started in January 1990. Bank of Japan took 17 months to make its first interest rate cut, and even after that, it relied more on fiscal policy and government funded projects rather than use monetary policy as a tool to steer the economy. The success/failure of such a strategy is known to all of us - it created a prolonged period of stagnation, though it did manage to avoid a recession. Having said that, should we say the current direction of US monetary and fiscal policy would take the economy in the right direction long-term - it's doubtful to say the least.

In the Fed's last rate-setting meeting, the board of governors almost unanimously supported a dove-ish monetary policy - this essentially means an unwritten commitment from the Fed to keep rates near sub-zero levels, helping a rapid pick up in the credit cycle - that assuming inflation stays within 'acceptable limits'. On the fiscal policy front, though there has been quite a lot of lip-service to fiscal discipline from the current government, we haven't yet seen any concerete action/plan yet. The latest in a series of 'government-funded' initiatives, the health care plan, sees an additional 2 trillion USD of spend over the next 10 years - and apart from either a possible drop in service/care levels or a rise in taxes, the only 'funding' mechanism we have seen is a piddly USD 80 billion deal that the White House supposedly has ironed out with the big pharma manfacturers! If we combine the above stands on monetary and fiscal policy, we have the stage set for another cycle of unreasonable growth backed by high fiscal deficits and loose credit standards. Based on advances in distressed bonds, corporate bonds and munis over the last quarter, it already seems that the financial sector has picked on the thread. Add to that an agonisingly slow pace of regulatory reform - and there is a significant risk of a too-rapid turn around before we fix some of the fundamentals.

Why can the Fed not set an internal target for economic and market activity (economic growth, market indicators etc) and rigidly follow a monetary policy which can control expansionary cycles and curtail market booms? Instead of using inflation as the sole leading indicator for monetary policy, the Fed should play a more active role in tracking key indicators and not restrain itself from pulling the trigger if it sees unreasonable moves. Pure free market advocates would loath such a Fed avatar, but we have already seen what happens if the Fed stays in its Greenspan mode. It's amply clear that the current market culture driven by quarterly results, bloated profits and huge bonuses can never be self-correcting or self-regulated. Uni-directional Fed policies targeted at avoiding recessions and fueling growth cycles can only lead to unbridled activity in one or more of the asset markets. We probably need a more 'range'bound', directional fed policy for the next many years to help temper cycles and avoid asset bubbles.

On the fiscal front, an ever-expanding government reach is definitely not the solution to all ills. When comparing government-run programs in other countries, we often forget the size and nature of the beast here - most markets are too big in size and volume for the government to play an active role without compromising fiscal reponsibility. Government-run programs are fine provided it is targeted only at tha wekest links in soceity and provided there are clear stakeholders who fund the plan. Else, rising deficits would soon push external debt to over half of the national GDP and threaten the credibility of US treasuries. Many would point to an intermediate uptick in interest in treasuries and opine that foreign economies would continue pumping back money in to the US given clear signs of economic revival. However, we cannot expect this to be sustainable if central authorities continue with a loose monetary policy and a fiscal policy which promotes deficit spending without a clear plan of future curtailment. This can only yield one result long-term - a gradual move away from the dollar as the reserve currency and subsequent struggle in funding deficts through foreign money. Its difficult to ever assume that consumer savings would rise to a level that can fund such gargantuan deficits!

Regulatory reform is the third pillar which needs utmost attention. Among the broad outline of financial services regulatory reform moves that the Treasury Secretary announced months back, very few have seen implementation yet. A few of these are critical to be implemented befoire any serious market/economic uptick occurs:
  • Disclosure and regulatory guidelines for credit rating agencies
  • Market governance framework for OTC instruments, especially credit default swaps
  • Increased disclosure norms for non-bank financial services entities like hedge funds and private equity funds
  • Continued monitoring and regulation of financial services firm practices as related to consumer products/services (the only area we have seen some conceret action so far)
  • Policy outlining broad principles and limits for compensation policies at financial services firms (going beyond Ken Feinstein!)

Among the above, the last one would see the highest amount of debate and opposition. But unless there is either a central regulatory or self-regulatory control of compensation principles, top management & trader (key profit-driving) compensations would continue to be driven by immediate profits, which would in turn forec minimal alignment between risk management principles and corporate reward/compensation norms. Because irrespective of the nature and volume of regulatory overhaul and international guidelines like Basel II, there is enough ingenuity in the financial system to unearth loopholes and drive short-term profit and compensation maximization. And that combined with loose federal monetary/fiscal oversight would prevent any sustainability of economic growth long-term.

]]> Early exuberance - are we getting ahead of ourselves? http://seekingalpha.com/instablog/136739-promod-radhakrishnan/9228-early-exuberance-are-we-getting-ahead-of-ourselves?source=feed 9228 It's suprising that merely two months after the PPIP was announced, with foul play cries from critics on 'too much of government/tax payer support', there is already indications of a lack of interest in the program from larger banks. The treasury secretary himself referred to this in a recent interview. This is primarily due to a rapid 30-45 day surge in stock market indicators, with early talks of the recession slowing down.

It's indeed glad to see early-stage trend changes in unemployment, housing stats (new & existing), consumer spending, industrial spending - a possible early signal that the steepness of the downturn has been arrested. But that's just about it at this point - the economy as a whole is still showing negative growth, housing prices are still showing no signs of any significant bounce & overall consumer sentiment is still negative. Given this background, it would be suprising if banks bask in the short term uptick in stock market indicators and show lax interest in participation in the PPIP program. None of the basic drivers - house prices, unemployment rate - have shown a marked movement towards positive territory, and hence its too early to expect quick reduction in credit card delinquencies, loan write-offs or foreclosures. Also, the credit market as a whole has been next-to-inaccessible for a larger part of the population due to extremely stringent lending norms and a sudden uptick in lending (especially mortgage) rates. This is dangerous - it increases the risk of at-the-brink consumers stepping in to delinquency due to insufficient means for availing short-term increases in credit, and thus flexibly manage their debt.

Another reason for the early exuberance, and hence perceived lack of interest in PPIP, might be the result of the bank stress tests that was announced in early May. However, one needs to understand that the 'stress' parameter values used were pretty mild by current standards - looks at this:
The stress test’s “more adverse” scenario, factored in ONLY the following worst case scenarios for GDP, unemployment and housing prices (as described in detail in The Supervisory Capital Assessment Program, Design and Implementation released by the Fed on April 24, 2009):

GDP:
- a decline of -3.3% in 2009
- increase of 0.5% in 2010

Unemployment:
- civilian unemployment of 8.9% in 2009
- civilian unemployment of 10.3% in 2010

House prices:
- declines of -22% during 2009
-7% in 2010

Given the nature of the downturn and the depth of the crisis, the worstcase values used for GDP are pretty mild - especially 2010 numbers. Also, unemployment numbers assumed in worstcase are way too mild - we are already close to 8.5% in Q2 2009! House price decline numbers are probably realistic even in worst case scenario considering the decline that this parameter
has already seen over the past 30 months! On top of this, only a 2-year stress scenario was used as against a more stringment 5 or 10 year scenario - we are talking of 'stress testing' and hence scenarios need to assume worst case numbers/assumptions.

The fact that the Fed/Treasury allowed many large TARP recipients to repay the money in light of the above stress test results does park serious concern. I agree that some of these institutions are fundamentally sound even in this environment, but not all. Letting banks with pass marks after a mild stress test and then allowing them to ease out of regulatory control (especially on executive compensation) by allowing TARP money repayments show serious laxness on the regulators.

Just to sum it up, we should all be happy to see an uptick in indicators and see the economy reviving. I also believe in the government needing to support this economy and market in ways that are mandated by the current environment. But its not common sense to let go of this opportunity to clean up bank/financial company balance sheets and forge a stronger culture of risk management. This can only lead to future peril and a possible relapse of recessionary trends. The current situation was clearly caused by lax risk management and poor regulatory and governance framework - and unless this fundamental issue is corrected, we are never going to come out of the rut clean.

Also, the situation has to be seen in an even larger context - treasury funding itself might be constrained due to a drastic increase in federal debt. Several of the large sovereign investors in treasuries (notably the BRIC countries) have already expressed serious concerns of the high-level of treasury debt floated these days, lack of focus on reigning in deficits longer term, and hence the risk posed due to an over-reliance on the US dollar as the reserve currency! This limits future treasury/governmant ability to fund and support the market, and hence it is all the more imperative to do it right this time!

Disclosure: None

]]> Sat, 20 Jun 2009 15:06:59 -0400 It's suprising that merely two months after the PPIP was announced, with foul play cries from critics on 'too much of government/tax payer support', there is already indications of a lack of interest in the program from larger banks. The treasury secretary himself referred to this in a recent interview. This is primarily due to a rapid 30-45 day surge in stock market indicators, with early talks of the recession slowing down.

It's indeed glad to see early-stage trend changes in unemployment, housing stats (new & existing), consumer spending, industrial spending - a possible early signal that the steepness of the downturn has been arrested. But that's just about it at this point - the economy as a whole is still showing negative growth, housing prices are still showing no signs of any significant bounce & overall consumer sentiment is still negative. Given this background, it would be suprising if banks bask in the short term uptick in stock market indicators and show lax interest in participation in the PPIP program. None of the basic drivers - house prices, unemployment rate - have shown a marked movement towards positive territory, and hence its too early to expect quick reduction in credit card delinquencies, loan write-offs or foreclosures. Also, the credit market as a whole has been next-to-inaccessible for a larger part of the population due to extremely stringent lending norms and a sudden uptick in lending (especially mortgage) rates. This is dangerous - it increases the risk of at-the-brink consumers stepping in to delinquency due to insufficient means for availing short-term increases in credit, and thus flexibly manage their debt.

Another reason for the early exuberance, and hence perceived lack of interest in PPIP, might be the result of the bank stress tests that was announced in early May. However, one needs to understand that the 'stress' parameter values used were pretty mild by current standards - looks at this:
The stress test’s “more adverse” scenario, factored in ONLY the following worst case scenarios for GDP, unemployment and housing prices (as described in detail in The Supervisory Capital Assessment Program, Design and Implementation released by the Fed on April 24, 2009):

GDP:
- a decline of -3.3% in 2009
- increase of 0.5% in 2010

Unemployment:
- civilian unemployment of 8.9% in 2009
- civilian unemployment of 10.3% in 2010

House prices:
- declines of -22% during 2009
-7% in 2010

Given the nature of the downturn and the depth of the crisis, the worstcase values used for GDP are pretty mild - especially 2010 numbers. Also, unemployment numbers assumed in worstcase are way too mild - we are already close to 8.5% in Q2 2009! House price decline numbers are probably realistic even in worst case scenario considering the decline that this parameter
has already seen over the past 30 months! On top of this, only a 2-year stress scenario was used as against a more stringment 5 or 10 year scenario - we are talking of 'stress testing' and hence scenarios need to assume worst case numbers/assumptions.

The fact that the Fed/Treasury allowed many large TARP recipients to repay the money in light of the above stress test results does park serious concern. I agree that some of these institutions are fundamentally sound even in this environment, but not all. Letting banks with pass marks after a mild stress test and then allowing them to ease out of regulatory control (especially on executive compensation) by allowing TARP money repayments show serious laxness on the regulators.

Just to sum it up, we should all be happy to see an uptick in indicators and see the economy reviving. I also believe in the government needing to support this economy and market in ways that are mandated by the current environment. But its not common sense to let go of this opportunity to clean up bank/financial company balance sheets and forge a stronger culture of risk management. This can only lead to future peril and a possible relapse of recessionary trends. The current situation was clearly caused by lax risk management and poor regulatory and governance framework - and unless this fundamental issue is corrected, we are never going to come out of the rut clean.

Also, the situation has to be seen in an even larger context - treasury funding itself might be constrained due to a drastic increase in federal debt. Several of the large sovereign investors in treasuries (notably the BRIC countries) have already expressed serious concerns of the high-level of treasury debt floated these days, lack of focus on reigning in deficits longer term, and hence the risk posed due to an over-reliance on the US dollar as the reserve currency! This limits future treasury/governmant ability to fund and support the market, and hence it is all the more imperative to do it right this time!

Disclosure: None

]]> TARP Stress tests PPIP PPIP on its way to execution mode http://seekingalpha.com/instablog/136739-promod-radhakrishnan/1911-ppip-on-its-way-to-execution-mode?source=feed 1911 With Blackrock, TCW and most probably PIMCO submitting bids as Asset Managers for the legacy securities program, the PPIP program has definitely gotten the kick start it needed!

There is definitely still a lot of skepticism in the program - however some provisions that have become clearer as the program reaches execution phase should give some comfort to skeptics.

Again, to reiterate fundamentals, this US program is far better than similar programs - unlike the UK Asset protection Program (see: http://www.hm-treasury...) for bad assets where exposure is not clearly ring-fenced, the US program has definite quantifiable upside and downside. Also, executive compensation restrictions for entities which invest money and avail government funding/debt for the same ensure asset managers clearly segregate agency functions and principal functions. 

However, the complex structure (of both the legacy loan and securities programs) and other parallel government initiatives in the credit markets make program administration tricky if not tough.

For example, the Home Mortgage Modification program under which the Treasury has earmarked money for mortgage servicers (see article: http://online.wsj.com/...) will pose questions on applicability of the subsidy to investors in the PPIP program - since the subsidy is targeted at servicers and not loan/asset owners. Similar programs would potentially increase book value of the loan pools and raise acquisition price for PPIP investors, but the actual subsidy is tied to servicers and would be lost to investors unless the servicing contract with the same servicer is retained durign period of ownership.

Another example of uncertaintly/complexity is the extent to which ongoing asset management strategies for the pool (as employed by selected asset managers), and management of the program in general would be subject to Treasury oversight, is not known yet. Some or all of these will become clearer as the program unfolds, but some amount of fluidity is unfortunately bound to prevail.

There's a lot of money and time invested in this program - and enough and more stakes for all parties to ensure it helps revive the distressed securities market and hence credit markets in general! The onus is on the Treasury to continue effective articulation of program logistics/operating model and also interlinkages with other credit market initiatives!

 Disclosure - None

 

]]> Sun, 26 Apr 2009 22:08:44 -0400 With Blackrock, TCW and most probably PIMCO submitting bids as Asset Managers for the legacy securities program, the PPIP program has definitely gotten the kick start it needed!

There is definitely still a lot of skepticism in the program - however some provisions that have become clearer as the program reaches execution phase should give some comfort to skeptics.

Again, to reiterate fundamentals, this US program is far better than similar programs - unlike the UK Asset protection Program (see: http://www.hm-treasury...) for bad assets where exposure is not clearly ring-fenced, the US program has definite quantifiable upside and downside. Also, executive compensation restrictions for entities which invest money and avail government funding/debt for the same ensure asset managers clearly segregate agency functions and principal functions. 

However, the complex structure (of both the legacy loan and securities programs) and other parallel government initiatives in the credit markets make program administration tricky if not tough.

For example, the Home Mortgage Modification program under which the Treasury has earmarked money for mortgage servicers (see article: http://online.wsj.com/...) will pose questions on applicability of the subsidy to investors in the PPIP program - since the subsidy is targeted at servicers and not loan/asset owners. Similar programs would potentially increase book value of the loan pools and raise acquisition price for PPIP investors, but the actual subsidy is tied to servicers and would be lost to investors unless the servicing contract with the same servicer is retained durign period of ownership.

Another example of uncertaintly/complexity is the extent to which ongoing asset management strategies for the pool (as employed by selected asset managers), and management of the program in general would be subject to Treasury oversight, is not known yet. Some or all of these will become clearer as the program unfolds, but some amount of fluidity is unfortunately bound to prevail.

There's a lot of money and time invested in this program - and enough and more stakes for all parties to ensure it helps revive the distressed securities market and hence credit markets in general! The onus is on the Treasury to continue effective articulation of program logistics/operating model and also interlinkages with other credit market initiatives!

 Disclosure - None

 

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