NEWS FLASH: The United States is not the only country suffering from significant financial imbalances. Neither is it the only country where underwriting standards were thrown overboard as a result of many years of rising collateral values. Even if these factors were not at play it would be debatable whether world economies could emerge unscathed from a U.S. consumer slowdown. With the attitude towards aggressive lending changing markedly, some of the heretofore benignly neglected bubbles could pop.
Now that I have your attention, let's go country by country (through both developed and emerging markets) and catalog some of the problem issues.....my bet is that there are many more cases than I have overturned in the rather cursory (yes, I'm admitting it myself folks) investigation I have done for this article. Why are there all these imbalances? Easy money. Those of you who have attended the asset cycle 101 class already know that money hates a vacuum and that investors will leverage up appreciating assets until the asset prices start to fall or someone raises the price of leverage. Usually both of these happen at the same time. The rest of the story ain't pretty. Here is the list of problematic issues worldwide, that could be made worse by a wholesale change in sentiment towards aggressive lending. I'm not predicting that they will, I'm just letting you know they are out there and you may hear more about them in the future.
British Consumer Debt Crisis & London Commercial Real Estate Debacle
With regard to how a worldwide slowdown would impact the country, The Observer notes: "Since Britons are some of the most indebted people in the world, that puts us in a particularly vulnerable position. Per capita, Britons borrow more than twice as much as other Europeans. The average family pays 18 per cent of disposable income servicing debt. If the world economy slumps, the bailiffs will knock at British doors first."
As we have chronicled here before, there has been a run on British REIT's by investors seeking to pull their money out of the investment partnerships. While it is reflective of somewhat indiscriminate risk aversion, according to The Guradian, "Commercial property has proved one of the most popular investments of recent years, with billions of pounds pouring into the sector. Investors, keen to enjoy double-digit returns, maintained their attachment to the sector last year despite many analysts arguing it was already hugely overvalued. Warnings that commercial property was an asset bubble ready to burst went unheeded."
With regard to London in particular, which has possibly benefited in a business sense even more than New York City from Wall Street's credit derivatives and related hedge fund trading, The Evening Standard notes, "The faltering economy has left the City of London office market braced for its worst crisis since the recession of the early 1990s. Demand for office space is falling as firms slash thousands of jobs and stop hiring new staff. But supply levels are rising dramatically - not just from space freed up by redundancies but also from a wave of new offices being built with completion dates this year and next. Around five million square feet of office space yet to be let is due to open in the City this year and next - room for some 40,000 people."
Spain - Residential Property Bubble Extraordinaire
According to a quote by David Owen of investment bank Dresdner Kleinwort, cited in the blog Seeking Alpha, "Spain could face serious difficulties this year as the excesses of a decade-long boom finally catch up with the country. The size of the Spanish corporate sector's financial sector is truly really scary. It rose to 14.5% of GDP in the third quarter of 2007 from 10% in the first quarter. This must be a record for a relatively large economy. Clearly this is not sustainable. Cost imbalances have a nasty habit of unwinding quickly and very painfully." The article goes on to note that Spanish direct investment in residential construction (ex mortgages and other related businesses) is 18% of the economy versus 6% in the U.S. Diana Choyleva, an economist at Lombard Street Research in London, is quoted as saying "Spain is like the U.S, on speed when it comes to the housing market. It is highly likely there will be falls in nominal prices." It also cites Moody's as saying that Spanish loan delinquencies may rise 15 fold by the end of 2008 due to increasing interest rates.
China Potential Stock Market Unwind + Corporate Bad Debt Bomb:
Zhong Wei, an economist with Beijing Normal University, was recently quoted regarding the U.S. sub prime crisis in the central bank's newspaper saying "The non-performing loan ratio in the banking industry and risks of volatility in the capital market are both rising". Why should the central bank be worried about this? It's not just the $7.9 billion of U.S. sub prime exposure the Bank of China has admitted to. According to aMay 2006 Ernst & Young report, the country had $911 billion of domestic bad debt. This is the $1 trillion of bad debt number you may recall hearing about now and again. At the time this was equal to nearly 40% of China's gross domestic product. Ernst & Young also believed there were $225 billion of additional pending low quality loans that would eventually go non-performing. However, Ernst & Young reportedly "corrected" their report a short while later to be more in keeping with the government's official tally of $133 Billion in non-performing loans for the four largest banks. When these figures were reported, worries about China being vulnerable to a liquidity shock were well publicized. While not much has been written since then, these bad debts didn't just disappear in 18 months. The Chinese government has reportedly been transferring bad loans to "special asset management companies" at least in part, with the use of $500B of government funds, over the past decade. Last Friday, China's banking regulator put out a report on its priorities for the country's banks; it didn't mention bad loans, but focused on improving innovation and strategic planning. The silence was somewhat deafening. In fact, the agency's chairman, Liu Mingkang, was quoted as saying: "Five years ago, the state banks were technically on the verge of bankruptcy, but now they are large commercial banks with international recognition." The economy was booming for 15 years and the banks were nearly bankrupt, it's still booming and now everything is fine? Somehow I am not sure that underwriting standards have done a 180 degree turn in the last 18 months. Interestingly, about 21% of loans are to exporters, who are reportedly already seeing their U.S. customers become slow in paying their bills. This may be why Yu Yongding, director of the Chinese Academy of Social Sciences and a former adviser to the central bank, was recently quoted as saying: ``If there is weakness in the world economy, the impact on the Chinese economy will be very serious.'' The Shanghai Composite Index was up over 125% last year and 132% in 2006, individuals; corporations and, yes, banks have all been making significant profits in the stock market, which has now fallen 30% or so from the peak.
India Potential Stock Market Structural Issues & Real Estate Valuation Problems
According to an article in the blog Seeking Alpha, 2 bedroom condos in New Delhi, are now selling for $200,000, or about $200 per square foot, this compares with $400 per square foot for a similar condo in Chicago. The only problem is, per capita income in Chicago is 50 times that of New Delhi. Additionally, New Delhi has room to grow geographically in 4 directions so there is no reason for a scarcity premium versus Chicago which can only grow in two directions. Additionally, while it is true that India's overall population density is much higher than the U.S., it is reportedly less densely populated than your run of the mill northeastern U.S. state like New Jersey.
In 2007, India's stock market rose a record 47.1%. Recently, sentiment has shifted markedly regarding the future market outlook. Much attention has been paid to the cooling of a smoking IPO market, particularly after Monday's 17% drop and flop of the biggest ever Indian IPO, Reliance Power.
According to Jigar Shah, head of research in India for Kim Eng Securities, as quoted in the Wall Street Journal, "As I see it, we are likely to go down further, primarily because investor sentiment has declined quite significantly." One analyst's opinion, but if it reflects public sentiment in this retail driven market; it may not be a good omen. Alok Vajpeyi, a VP and MD with Dawnay Day AV Financial, told the Economic Times of India, "The stock market reacted with great speed to redress the short-term valuation imbalances that had arisen as a result of exceptional liquidity — both domestic and overseas, by reversing perhaps 20% of the index gains from the peak. It hurt! It does not matter to most how much you made in the past. Even those, who earlier made a multiple of the money that they lost in recent weeks, have temporarily receded into their shells. For the time being investment sentiment is changed from the secularly bullish outlook on the market that shares will only go up, and that IPOs will list at massive premiums." Note that according to a recent Business Week article, due to an under-developed bond market - where new issues are less than 1% of GDP vs. 112% in the U.S. and 10% in China, the equity market is more critical to funding businesses' day-to-day funding needs. Another structural issue that has already been a problem during periods of frenetic trading is that, according to the Wall Street Journal, the stock exchange does not allow electronic funds transfer and relies on payments made by check. Retail investors have trouble acting quickly on changes in the stock market because they often mail checks to brokers and the checks then have to clear. This has reportedly caused some clients with margin accounts to be "bought in" before they could deliver funds against margin calls.
On the plus side. I am hopeful that this may be one of the last articles we have to write about risks in the financial system that people aren't talking enough about yet. I really hope so, because the sooner we can qualify and quantify all the things that could go wrong, the sooner the markets will discount these factors and governments and central banks can start working to offset their corrosive effects on money creation.
From the Blogosphere:
Is Europe's Housing Market Next
Will That Great Bubble Be Full of Hot Air
Spanish Economy Dominates Eelection
Decade of The Dragon
Timing the Chinese Bubble
PHOTO SOURCE: Answers.com
A: This is the most direct way to explain to you that credit markets are still under distress. With all the stimulus we have had; 175 bps of rate cuts, $150 Billion of fed term auctions, project hope + lifeline, rate freeze plans, co-ordinated bail out talks for bond insurers, Buffet's security offer for muni market...corporate credit spreads are STILL widening. San Francisco Fed President Janet Yellen acknowledges this reality, and admitted that this problem was one of the targeted solutions hoped for by fed rate cuts. And is anyone else seeing these muni auction's failing? Umm, this is not so good.
Here is a very brief explanation of corporate bonds. Corporate bonds can offer a high yield compared to other investments. Investors of these bonds take on interest rate risk + credit risk, the risk that the issuer will default on its debt obligations (there is also event risk, but for sake of this discussion lets keep it simple and ignore this for now). The payoff to the investor for assuming these risks is a higher yield. The difference between the yield on a corporate bond & government bond, is known as the credit spread!
The credit spread, whether narrow or wide, reflects the premium that the investor gets for assuming higher credit risk! When credit spreads widen, it is a signal of the demanded premium by investors (via a higher yield) to take on an increased credit risk. This is exactly what is going on right now. The chart below will illustrate to you what is going on.
WIDENING CREDIT SPREAD BETWEEN WACHOVIA HIGH YIELD CORPORATE BOND INDEX vs iSHARES LEHMAN 7-10 YR TREASURY BOND FUND
CHART LINK VIA BLOOMBERG: Simply add "IEF:US" symbol to this chart to compare credit spreads.
Ok, so now you have a general idea of what the widening corporate credit spreads means (higher risk) and a visual showing you that this is actually occurring right now. Now, lets see what fed president Janet Yellen said on February 7th. According to Bloomberg:
"The increase in credit spreads has sort of worked against our policy," San Francisco Fed President Janet Yellen told reporters at her bank yesterday. "The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address."
Lets take another angle and try to bear with me here. Check out this TheStreet.com article which discusses, "
Soaring Default Spreads Sock A Swap Seller"; which goes into derivatives trader Tom Jasper's trades:
Primus Guaranty -- which reported a $404 million loss in the fourth quarter, its largest ever -- remains a relatively unknown company that is nonetheless a major player in the credit default swap market. Primus essentially does only one thing: sell credit default swaps on single-name corporate bonds.
From 2005 to the summer of 2007, the U.S. CDX investment grade index -- a basket of corporate credits -- generally traded at spreads of below 50 basis points...
During this timeframe of relatively low risk, Primus was a big seller of credit default protection. But in the summer of 2007, spreads on the CDX investment grade index widened to 100 basis points, as fears of the brewing credit crunch drove up the cost of protection. Spreads dipped in the fall, but rose to a record 143 basis points on Tuesday, according to Markit.
Below is the
MARKIT CDX.NA.IG Series 9 Index which shows the widening of spreads referred to in the above article which is at a record right now:
KEY:
Left Axis = Index Spread
Right Axis = Index Price
Red Line = Index Spread Widening
Black Line = Index Price Falling
WHAT CDX.NA.IG SERIES 9 MEANS (as I understand it from contacts I know in these markets): NA stands for North American. IG stands for Investment Grade. Every 6 months dealers are polled. They vote names into the new index. We're now up to series 9. To be eligible for a vote you must have contributed end of day marks for X% of days in the last 6 months on the names in the old index; X being a lot. There are a bunch of indices, but the two big ones are HY - high yield, and IG - investment grade. 100 names are in each. You take the 100 names and average the credit spreads to get the CDS spread on the overall index. Bigger spreads = worse credit in the index as a whole. If HY (high yield index) goes from 500bps to 1500bps and IG (investment grade index) goes from 50 to 70bps you know the HY index is getting a lot worse a lot faster than IG in terms of credit quality. Those numbers are just arbitrary to demonstrate a point.
This chart shows us that investment grade credit spreads had risen about 63 basis points in the past 12 days alone! Did I lose anyone? Hopefully not, and maybe it makes a bit more sense now. Here are some quick takes on the failing muni auctions and related articles to these topics. The markets are ignoring these events or consider it priced in already:
Auction-Bond Failures Roil Munis, Pushing Rates Up (Bloomberg)
Bonds sold by U.S. municipal borrowers with rates set through periodic auctions failed to attract enough buyers as banks including Goldman Sachs Group Inc. and Citigroup Inc. that run the bidding won't commit their own capital to the debt. The auction failures provide new indication of Wall Street's unwillingness to commit capital amid $133 billion in credit losses and asset writedowns.
"It's the beginning of the end for the auction-rate market," said Matt Fabian, a senior analyst with Concord, Massachusetts-based Municipal Market Advisors. "Banks have stopped supporting the market."
Multiple Muni Issuers See Notes Fail At Auction (Forbes)
U.S. municipal bond issuers were hit with "multiple" failures of auctions of their paper on Tuesday, industry sources said, as investors fretted about the safety of the bond insurers backing the debt.
As a result, states, counties, cities and towns around the nation now are being forced to pay sharply higher short-term interest rates, in some cases as much as 15 percent.
Corporate Credit Dislocation Persists, May Worsen (Guardian.uk)
Dislocation reigns supreme in the European corporate credit market, with conventional thinking turned on its head over and over again, threatening to delay the return of confidence. High-yield bond investors are worried about what is happening to triple-A borrowers. Secured debt is trading comparably with unsecured debt. And investment-grade credit indexes have performed worse than their riskier high-yield counterparts. And, despite credit spreads being at their widest level since early 2003, things may get worse before they get better, as sentiment remains extremely fragile.
"There's complete dislocation," said Sean Dawson, executive director for structured finance at Lehman Brothers, at a Fitch Ratings conference on subprime securities late last week.
Commercial Real Estate Follow Up: REIT Indicator (UrbanDigs)
We knew spreads had widened, forcing banks to write down the values of some of these CMBSs, but what really worries me is that the widening has continued even as the fed has slashed rates. Fed cuts rates and borrowing cost goes up, not the math we want to see.
The reason for this is the action of one powerful indicator, which was flashing an all-clear sign in 1998.....but is not doing so today. As a portfolio manager I found this one simple indicator to be the most valuable in establishing a market mind set. Before I share this elementary concept with you, a couple of explanations. First why should you care? As Noah and I have been saying for at least 6 months, while the Manhattan real estate market is a special case versus the rest of the country, it is not immune to a recession, particularly one that is centered in Wall Street. We have cited lots of statistics and information to back up our belief that this is true and I think so far we have had a pretty good track record of being in front of financial market developments that have stunned and amazed many. 
My buddy Stan Weinstein runs a technical forecasting service for institutional investors called Global Trend Alert. His monthly and weekly pieces are found ubiquitously on hedge fund and Wall Street trading desks. Back in the day, Stan literally wrote the book on technical analysis, "Secrets for Profiting in Bull and Bear Markets," and had a widely followed newsletter called "The Professional Tape Reader", which he started back when there was still a ticker tape. I haven't talked to Stan in a long time, but as always he was generous with his time (between grabbing lines from the titans of Wall Street). He sent me his last monthly piece and allowed me to quote him here on UrbanDigs.com. What Stan said went something like this: 
Yes, all this matters. First, lets take a look at what the CMBS indices have been doing over at 
"Following its monthly surveillance review, Fitch Ratings has identified 51 of its U.S. CMBS deals as 'Under Analysis', indicating that Fitch will be issuing a rating action within 30 days."
Via 
First off, here are my past writings on bidding strategy for buyers and all should be must reads for any first time purchaser:
I haven't written about any new developments in a while. In all honesty, they've kind of started to blend together. Once you've seen 50 new developments, you almost feel like you've seen them all. I finally made it to the 
Out of the 50+ new development sales offices I have been to, three of the four best presentations have been at buildings marketed by 
There is something positive I would like to mention. 
"Why would someone build a new co-op instead of a condo," you might ask. 
As the lost group attempts to charter previously unchartered paths, they stumble upon the larger rocks on the ground here and there. Sometimes they fall, sometimes they don't but they always get up and continue on their way; each time a bit more wary than before. The group sub consciously walks slower with each fall as they fear what may lie ahead. Hours go by as slow as months as you try to navigate the herd back home without having to sleep in the woods with no equipment. But you know what, sometimes you have to sleep in the woods with no equipment. 
Credit cards! Hey America, you have a spending and credit card problem! No news here. Did we really think this game would go on forever, honestly? According to 
Here are the datapoints for Existing Home Sales (
I'm sick of the macro-economic pall overshadowing everything! No, I don't think we are out of the woods...I just don't feel like talking about it anymore. So this is the first in a series of pieces I'm going to do on the emerging markets of New York City, where I will check in with local brokers who are active in the market and get some feedback on what they see on the ground today. I have already written on this site that I am bearish on the boroughs and Harlem in the intermediate term, due to new supply trends and my feeling that improving Manhattan values will keep more people in midtown and downtown. I also feel that certain markets like Harlem and Long Island City will offer great long-term appreciation potential to those who take advantage of the expected price correction. But I will not be blind to reality and would be happy to have my forecast proved wrong. So I promise to deliver to you, Mr./Ms. Reader, the unvarnished feedback I am getting from the people on the street doing deals. Remember I myself am not a broker, I currently have no development projects to tout, but yes, I would love to buy income-producing properties at extraordinary values, would that they existed. With that preface taken care of:
My latest adventure was working with a customer who was going through a divorce. I didn't think it was a big deal that he didn't list alimony or child support payments on his financial statement because none had been determined yet. Word to the wise: Going through a divorce? Don't buy a co-op. 
