14 November 2007

Hi John,

NOVEMBER 2007 NEWSLETTER

Looks like the sub-prime hangover isn’t over yet. It may be several months before U.S. and European banks have revealed all the losses they have made and what they intend to do to finance the obligations that have resulted from them.

While there are a number of schemes being put forward – Citigroup, J P Morgan Chase and Bank of America are one group that have set up a fund to mop up the illiquid securitised loans – the figures are large and are likely to affect most international banks’ balance sheets.

Citigroup wrote off US$65 billion three weeks’ ago and is now revealing an expected US$8 – $11 billion more. Swiss bank UBS has lost $3.4 billion with another $8 billion expected. Ex Fed Chairman, Alan Greenspan, is quoted as saying about US$900 billion of sub-prime mortgages had been securitised into collateral debt obligations and the like, which have been sold off to banks all over the world.

To see an excellent article on the “credit storm” by Dr Neville Bennett on www.interest.co.nz  CTRL click here http://www.interest.co.nz/bennett-9Nov2007.asp He points out that mortgage backed securities are not the only looming problem.

Securitised credit card obligations in the U.S. total US$915 billion, and the levels of other sophisticated securities like leveraged buy-out bridge loans, asset backed commercial paper and Credit Default swaps – all of which are almost impossible to value - are unknown. All these could be exposed, placing international banks and credit markets under enormous pressure.  

The worry is that much of this debt will come back on to the banks’ balance sheets and restrict their ability to lend.  Hence the so called “credit crunch”.

The interesting thing about all this is it was the abundance of cheap money and lax credit processes in residential mortgage lending in the U.S. that caused the problem in the first place. And all the signs are that the U.S. housing market will get considerably worse before it gets better.

The U.S. Federal Reserve reacted to the credit crunch in the way that was expected by reducing official interest rates by 0.50% in September and a further on 0.25% on 1st November.  The Fed Funds rate is now 4.5%.

The U.S. Fed’s reaction to the credit crunch does not necessarily mean interest rates in other economies will be reduced. Wholesale interest rates in New Zealand have risen yet again. The 2 year swap rate – at which banks borrow to lend fixed for 2 year periods – is up on a fortnight ago and up around 2.3% on the 6.5% April 2006 figure. There has been a steady rise in the swap rate since that time.

Global inflationary pressures are still there. Here and in Australia they are being largely driven by labour shortages. The latest unemployment rate in New Zealand is 3.5% - a 21 year low – and in Australia it’s 4.3%.

Last month the Reserve Bank of New Zealand kept the Official Cash Rate at 8.25% and blamed a tight labour market, expanding domestic income growth on high commodity prices, and core inflationary pressure as the causes. But they also said “While the turbulence in global financial markets has eased somewhat, considerable uncertainty remains”. Current opinion is a rise in the OCR in December is unlikely.

Last week the Australian Reserve Bank increased its cash rate to 6.75%. This is the 6th increase since the 2004 election and the first time the RBA has raised rates during an election campaign. And the expectation is there will be two more raises in February and May 2008 to 7.25% - the highest cash rate since June 1996. They too said “In reaching its decision, the Board continued to look carefully at developments in the financial markets. Conditions have improved over the past couple of months, but confidence remains fragile”.

The People’s Bank of China has increased the bank’s Reserve Requirement Rate which is the 9th increase this year. This requires commercial banks to keep more money on hand to attempt to rein in the rapid lending that is fuelling China’s extraordinary economic growth.

The Bank of Japan, the Bank of England and the European Central Bank kept their rates on hold at 0.50%, 5.75% and 4.00% respectively. But in their statements all mentioned inflationary pressures and the uncertainty in the global financial markets.

So what’s all this mean to us?

• The New Zealand and Australian economies are on a roll driven by a commodity boom. Our currencies remain high against the depreciating USD, but volatile as global uncertainties make risk aversion a dominant factor. The prospect of a further carry trade unwind – the reason for the sharp drop in out currency in August – remains.
• We are not yet free of the danger that the credit crunch is spreading globally and large international bank’s balance sheets are under threat. The U.S. housing market’s recent negative performance is predicted to continue and there is a view that a housing downturn has started in the U.K. Expect the “danger” and “threat” to remain.
• A week ago the New Zealand Reserve Bank released figures that show deposit taking finance companies – which largely rely on retail investors for their funding – are the ones that are at “confidence” risk. This is the group which suffered the recent failures. Those failures however represent only about 14% of the total assets of deposit taking finance companies. The Reserve Bank’s saying “Despite the substantial impact of recent events on non-bank depositors, the failures are unlikely to have broader negative effects on the financial system and the economy”.
• The Reserve Bank’s efforts to cool the housing market appear to be working. There has been a downturn in mortgage approvals and residential sales. 
• Residential mortgage interest rates are on the rise. Fixed rate increases are driven by the rising cost of finance in the international wholesale markets as the risk premium rises after the credit crunch. Increased floating rates are showing there’s still a view the Reserve Bank may have to increase the Official Cash Rate to curb inflation here.
• Commercial, industrial and retail property continues to provide good returns for investors. The Property Council of New Zealand figures show the retail sector was the best, producing an annual return of 28.69% for the year ended June 2007. This was made up from 7.89% income yield and 21.61% capital gain.
• However the previous surplus of cheap money that reduced the risk premium on commercial and industrial property has ceased. Expect rising interest rates and increased aversion to risk to increase income yields sought by buyers. Sub 8% cap rates may well be a thing of the past.

Whatever people are saying, obtaining finance for property is harder. Here the residential non-bank lenders have continued to promote lo-doc and highly leveraged loans and appear not to have been directly affected by the events in the U.S. The problem they face would be one of wholesale money supply - which comes principally from large multinational banks - and the ability to sell down the securities in the rated debt markets. Expect higher cost of funds and tighter credit in this sector.

In the commercial property finance markets funds for property developments with capitalised interest or without resource consent and pre-sales, have virtually dried up. As have funds for investment properties without strong leases.

The focus has changed. No longer are simply low loan to valuation ratios enough to attract finance. Now far more lenders are saying no to proposals that cannot show how the borrower can service the debt and how it will be repaid. And don’t expect your existing financier to automatically roll over loans that are due for repayment – they may not.

If finance of any kind is required, albeit commercial, industrial, rural, business, or development finance don’t leave it until the last moment and expect it to just happen – it won’t. If it is outside the restrictive criteria of the mainstream banks then the correct planning, packaging, documentation, and presentation with a sufficient lead time, is vital.

Cheers

JP

John Paine
Global Pacific Corporation Limited
112 Gladstone Road, Parnell,
P O Box 3229, Auckland, New Zealand
Phone 64 9 303 3700, Fax 64 9 303 3031
Mobile 64 21 902 004
Email john.paine@globalpacific.co.nz
Web site www.globalpacific.co.nz

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