Economic & Market Update: September 21, 2009

“The Recession Is Likely Over!”

The Fortigent Investment Research Team

http://www.Fortigent.com

Last Week’s Highlights:

Economics This Week:

Bernanke Goes Out On a Limb

A week which saw Ben Bernanke proclaim the country’s recession as ‘very likely over,’ also witnessed the equity markets continue to plod their course higher on the belief that the esteemed Mr. Bernanke’s comments are indeed true.  By the end of the week, the S&P 500 index tacked on an additional 2.5% to its tremendous run. 

Corporate credit markets responded in similar fashion, with the JP Morgan High Yield index up 2.9% and the Credit Suisse Leveraged Loan index rising by 1.6%.  An interesting phenomenon is emerging in the distressed echelons of the credit market – it seems that the potential for bankruptcy is being viewed as a positive indicator.  Reuters reported last week that loans in Citadel Broadcasting Corp traded higher by 7 points after the company missed a convertible bond payment.  This is not the first time such an event transpired and is likely occurring because distressed investors are sitting on a stockpile of cash.  This is forcing said investors to jump at any restructuring deal they can find, in the hopes of wringing a few extra dollars out of the coffers. 

On the same day that Bernanke addressed the Brookings Institution, we found out that retail sales for the month of August soared at a 2.7% rate, much higher than the consensus estimate of 1.9%.  The ‘cash-for-clunkers’ program played a large part in that headline figure, but even after we strip out the auto component, retail sales rose at a 1.1% rate, suggesting that end demand is on the mend.  However, as we see below, much of that gain was driven by lower prices.  Consumers are stretching to find bargains at the expense of retailer’s profit margins. 

Source: BCA Research

In addition to improvement on the consumer side of the equation, the predictive power of the capacity utilization rate suggested that the recession may have actually ended in June or July.  Looking at each recession since 1970, a bottom in the economy occurred at a nearly simultaneous time with the capacity utilization bouncing from cycle lows.  Intuitively, there is an obvious corollary between increased demand and an up tick in production.  At the very least, the economy is on track for a technical recovery, as we are building off tremendously abject levels. 

Source: Agora Financial

Bad Assets Sent To ‘Time Out’

While the economy appears headed for serendipitous ground, the decision makers of the world may be subliminally suggesting that all is not yet well. 

Consider if you will, Barclays last week announced that it will send $12 billion in assets (including residential mortgages and other faltering loans) to a newly established Cayman Islands hedge fund.  Subsequently, the Irish government established a ‘bad bank’ plan to buy €54 billion in distressed bank loans from the balance sheets of that country’s largest banks.  

What caught people off guard was the relatively unusual nature of each deal.  Barclays is allowing its former bank executives to take over management of the assets, while also providing a $12 billion 10-year financing agreement at Libor + 275 basis points.  Limited partners in the new fund will be entitled to potential upside, while Barclays seems to be crying ‘Uncle’ by sacrificing the upside in an effort to protect its downside exposures.  Equally confusing, the bank is unable to move the assets off its balance sheet for accounting purposes, and may even have to increase its regulatory capital levels. 

In Ireland’s case, the government is actually willing to pay a premium of €7 billion to purchase the loans.  The original book value was around €77 billion, with the assets now trading at a market value of approximately €44 billion.  As one might expect, providing bankers a premium on securities, merely to bail them out, yet again, was a politically unpopular move.  Bad banks plans in the US and Germany fell flat on their face earlier this year but the Irish government recognizes that customers have completely lost faith in the likes of Allied Irish Bank and Bank of Ireland.  Obviously, the best way to covertly recapitalize banks is to pay a premium on the assets it holds.  The Irish government is stuck in a damned if you do, damned if you don’t situation.  

The reasons behind the sudden trepidation are numerous, but two areas of the market may be driving the concern – option adjustable rate mortgages and the commercial real estate market. 

Option-ARMs are beginning to recast (contrary to popular lexicon, recast represents a change in payment; reset refers to a change in interest rate), with Iowa Attorney General Tom Miller going insofar as to say that payments on option-ARMs will ‘explode’ in the next year to two years.  An acceleration in the recast schedule is expected in 2010 and 2011, although no one is entirely confident of how big of a problem we will face.  Fitch points out that 88% of the $189 billion securitized option ARM market has yet to recast while Barclays argues that with nearly 40% of option ARM borrowers already delinquent or in foreclosure, the natural attrition rate will shrink the market rapidly.  The numbers released from Fitch only address securitized loans, not those tucked away on bank balance sheets – part of what makes Barclays move all the more suspicious.  

Source: Wall Street Journal

The commercial real estate market (CRE) is a stickier wicket.  According to the MIT Center for Real Estate, CRE prices are down 39% from their peak in 2007.  When you consider that nearly half of the outstanding CRE loans are coming due in the next five years, most loans will be upside down and unable to qualify for refinancing.  As has been the case previously, downturns in CRE tend to lag the broader economy, so poor performance in the CRE market is unlikely to send the economy back into a recession.  But, as was recently the case with Corus Bankshares, a Chicago-based lender, the CRE market will likely contribute to a soaring bank failure rate, at the expense of the FDIC. 

It is difficult to say what impact these two markets may have on the broad economy, but the actions of Barclays and the Irish government suggest that there is enough concern to warrant caution.  For the optimistic investor, the distress in residential mortgage-backed securities and CRE will create a ripe investment environment for private-equity and distressed debt investors.  

The Week Ahead

Big headlines will be the theme of this week.  The G20 meeting in Pittsburgh will dominate the major news channels.  Investors are looking for some semblance of what the global regulatory framework for banks will look like as we emerge from this crisis.  Also in the crosshairs will be regulations on bankers’ compensation.  Many ideas have been thrown about, but few officials have been willing to back a definitive proposal – that could be about to change. 

The FOMC meets on Tuesday and Wednesday.  Market participants are hoping for clarity around the future of the agency MBS and agency debt purchase programs.  A cautious but more optimistic outlook is expected from the committee. 

Economic data is light compared to last week, but a focus on housing (existing/new home sales & the FHFA Home Price Index on Tuesday) will lend details to the ever-important housing outlook. 

Lastly, as we mentioned above, the Treasury is coming to market with $112 billion of new supply across the 2-, 5- and 7-year maturities.  The size represents a new weekly record for issuance; one that we are certain will be broken, yet again, in a few short weeks. 

Quotable:         “Men plan, God laughs.”  Yiddish Proverb

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