A view - The new normal & impact on Retail over the next 12 months

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:

• 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 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.

Need for a balanced and practical approach - Regulating the OTC Derivatives market

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 regualting 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!

Do we have a sustainable economic recovery yet?

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 May Jun Jul Aug Sep

Personal consumption expenditure (USD trillion) 9.18 9.19 9.20 9.22 9.31
Unemployment rate (%) 8.90 9.40 9.50 9.40 9.70 9.80
ISM index 40.10 42.80 44.80 48.90 52.90 52.60
Bank lending (USD btrillion) 9.25 9.34 9.33 9.26 9.20 9.11
New home sales (annualized in '000s) 352 346 384 429 426

(sorry for the mess up on the table - could not get it in neatly!)

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, assuming continued Fed and government support, I would rather bet on a slow, but volatile climb of the DJIA to 11,000 levels by Q3 2010 as against a move to 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

Market movements and direction of key economic indicators over the last 2-3 months clearly points to a tempering of the current down-turn and possibly a quick uptick in activity across most sectors. THough the market's overexuberance is not supported by any facts pointing to a drastic return to growth and profits, there are many economists who support this view. Last week, James Glassman at JP Morgan opined that 'Whenever we have plunged off a cliff and fallen into a deep hole in the past, for a while the economy has a tendency to bounce back very quickly' - a view supported by some others including Lauirence Meyer, formal Fed governor. And contradicted by several others who predict a slower, uptick, and that too to a 'new normal' where we would see higher savings rates, reduced consumer spending and tempered growth. I would sincerely hope the latter is true, despite all the immediate benefits and gains from the former trajectory!

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?

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!

PPIP moves in to execution mode...

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!

Government intervention - do we really have alternatives at this point?

My last post on the PPIP drew strong opinions - on the government's strategy behind the plan.

The key reasons for the opposition are:
1) How can the government 'waste' tax payer money on helping unfreeze MBS/ABS/CMO and other securities and asset markets, and hence proppping up the same set of institutions that has caused the market crash in the first place?
2) How will the government ensure its not taken for a ride - through participants in the plan colluding and creating flawed price discovery?
3) It's a better long-term option to let the situation play out i.e. let weaker banks fall, let asset prices find their true values etc - isn't that a more balanced long-term strategy?

Let's take the points in the inverse order above - first looking at the option of letting the crisis play out in its 'normal course'. Apart from the agony associated with prolonged recession and persistently high unemployment, i would question the very premise between this argument.

Take a look at the Japanese economic crisis of the 90's - Bank of Japan took 7-9 years to meaningfully relax interest rates, and close to 8 years to meaningfully inject public money to help banks; while there were changes in rules and regulations in the interim. Thus, BoJ basically played 'prudent and waited/allowed the crisis to play its course. Though many observers quote the Japanese and US crisis to show case the evils of deregulation, the parallels hopefully stop there. Because apart from what's commonly known as 'the lost decade', we didn't see any medium term gains from BoJ's wait-and-watch plan. On the other hand, if we can have a counter-balancing force of strong regulatory supervision and revival of corporate governance and risk monitoring, a government-facilitated resuscitation can help the economy revive short-term while laying the foundation for more meaningful growth longer-term.

In a different kind of comparison, some including Roubini have been advocating a repeat of the bank nationalization that happenned in Sweden in the early 90's. However, the size of the Swedish economy (less than 3% of the US economy) and the relative size of the banking institutions clearly means we are not comparing apples to apples. As an example, our mortgage debt book size itself is 12 trillion plus - as compared to the Treasury balance sheet of USD 9 trillion. This is only a part (if not tip) of the iceberg - if we add notionals on derivative instruments, it reaches gargantuan proportions. To presume that the US government has the appetite to nationalize and turn around at such scale is being naive.

As for flawed price discovery and the government being taken for a ride, i don't think there is more at stake compared to what has been already done - or forced to be done rather.

A realistic assessment would tell us that the worst case downside is probably USD 200-250 bn (asset and securitiy prices falling a further 50% from current levels, and the government losing its equity investments apart from losses on guarantees/debt). The amount is not trivial; but not as large if we compare current stake that the government has already assumed, the impact that the lack of a forceful plan would have on (continued) depletion in asset prices, further bank delinguencies (and hence FDIC money-on-the-table), continued slump in the economy and a long period of depleted tax revenues.

Taking a look at the dynamics of price collusion and flawed price discovery, there are enough reasons why this should/would not happen in a rampant fashion. To presume that institutions which have already taken a severe jolt would further collude to take more risk is basically assuming there's a total lack of regulatory oversight, share holder vigilance and corporate governance. More over, if the treasury can get the right financial expertise (we are already seeing increased recruitment of such kind from all govt agencies including the SEC), its common sense to assume that it can have a fairer estimate of the valuation to prevent participants from playing foul!

Lastly, on the point that tax payer money is lost, the counter argument is - who else bears the brunt of the crisis if it is prolonged? Are we saying we can live with a 5-year recessionary cycle, 10%+ unemployment and every thing else that comes with it? I hope not - unless there's a meaningful (&practical) alternate option where frozen markets can be resuscitated without heavy government intervention. Also, to look at it from another angle, the government has majority equity stakes in AIG, Freddie & Fannie, a significant stake (with inbuilt clauses for expanded stake) in institutions like Citi and several such. So, tax payers are assured of a similar share in the upside. Going back to the Swedish example, this is similar to what the Swedish governmant did too - resulting in a net total (tax payer) cost of less than 1-2% of GDP at steady state.

Having said the above, I cannot agree more with the opinion that any revival not built on a stronger strategic/long-term foundation of risk monitoring, regulatory oversight and fiscal prudence is unsustainable. Though we haven't seen a lot of details on this front yet from the government, we did see an outline of upcoming changes - strong monitoring of systemic risk, stronger liquidity monitoring for bigger banks, increased capital cushions for the bigger banks, mandatory stress tests for bailout package recipient banks, increased regulatory oversight and reporting norms for alternative investments etc.

There might be some who say we need the above first and every thing else later i.e. effect stronger regulations, let the market play out its course and then think about fiscally-prudent long-term growth. But considering the impact that the crisis had on institions like AIG and Citi, and hence the larger US and global economy, this approach is very text-book by nature. Nor are other stakeholders (EU, Japan, China) going to abide by such a long-drawn out plan.

To put it in simple terms, unless we have key large participants in the system functioning normally, we cannot either talk about revival or sustainable growth. Because we need to first stand up before we can run or even walk!

Making sense of the Public-Private Investment Program

Tim Geithner unveiled a good amount of detail on the much-awaited financial sector resuscitation package over the last week. Apart from addressing the core issue of unfreezing the credit market and hence imrpoving liquidity, the Treasury also clearly articulated the broad guidelines of new financial sector regulation.

Let's try to make sense of the PPIP - the plan basically envisages the government putting its skin-in-the-game to push/incentivize private sector participants (read money managers) to take that elusive step forward - buy distressed assets and securities. The government's share of risk is through a mix of FDIC guarantees, direct Fed loans and Equity participation. To make sense of the program, let's look at the Legacy Assets and Legacy Securities program separately.

Legacy Assets PPIP program - This envisages private parties (meeting certain eligibility criteria) to bid for defined pools of troubled assets as made available by banks. Once the best bidder is decided for each pool, the government would match equity contribution. But the bigger piece of the puzzle here is the FDIC guarantee - FDIC would employ consultants to value each pool and provide debt guarantees up to 85% of the total bid value of the pool. The actual guarantee percentage for each pool (85% or lesser) would eventually determine total credit risk assumed by the government. Assume a USD 100 million RMBS pool with a bid value of USD 80 million (to account for potential losses in the portfolio), if the FDIC provides a debt guarantee up to 85% of bid value, it basically means the government is taking a risk of USD 6.0 mn in Equity + additional losses if the actual realizable value of the asset pool is lesser than 68 million. This is fine in case the overall PPIP plan does turn back the market to normalcy; but its a significant risk to the Treasury's balance sheet otherwise...another 12 million (15%) value drop on the portfolio is not beyond practicality! In a nut shell, there is enough risk sharing from the government to bring in private investment - but on the same note, an ineffective execution can expose the treasury balance sheet signficantly. Considering the vary nature of the base asset (loans as against negotiable securities), initial participation is bound to be tepid, unless the securties PPIP program picks up speed and loosens the secondary market.

Legacy Securities PPIP program - The basic premise of the plan is similar to the assets program described above, but the modus operandi is a bit different. It starts with the treasury inviting bids from large assets managers (again, defined eligibility criteria) to select up to 5 asset managers to run the program. These managers would form distressed securities funds with disclosure on fund amount, investor mix, asset selection strategy, asset management strategy, fees etc. The treasury would commit an equal share of equity and on top of that, provide a matching share or in some cases (based on analysis of target investment pool, strategy etc) even twice the matching share in the form of senior debt. Assuming the maximum share of senior debt from the treasury/FDIC, this basically means, there's an open risk beyond a value depletion of 25% on the base assesses value of the securities pool. Given the fact that several large global funds have already raised significant money targeted at distressed securities, this plan should drive active participation and free up liquidity in the market.

From the above, its clear that its a well-thought out plan from the Treasury, but its no magic wand. As in any other solution, it does assume rational markets (and market participants) and hence does imply significant balance sheet risks to the treasury - up to 800+ billion, a large number considering the 9 trillion + balance sheet size. But, given the already-distressed value of the base assets and latent investor appetite for such assets, i would bet my money on the plan gradually unleashing liquidity over the next few quarters. The dark horse here is the impact that freshly unveiled regulatory changes (read registration, increased disclosures and hence constariend investment strategies) will have on the existence and volumes associated with critical participants like hedge funds, venture capital funds and private equity funds.

Why are we wasting our energy - and getting so pseudo-moralistic?

Last week saw an unprecendented amount of corporate CXO-bashing from politicians, public and the media in general. A sudden surge of moral anger seem to have been generated by the AIG bonus news. I don't personally support the AIG bonuses, but none the less, i cannot fathom the logic behind doing a witch hunt for the bonus recipients. We are living in a capitalistic economy and hence there's little merit in arguing on the lines of rich-getting-richer/ poor-getting- poorer.

Let's try to look at it from another angle. The past few decades saw unprecendented growth and as a result, an accumulation of personal wealth and a consistent increase in personal spending across most classes in society. This unfortunately came at the cost of lax supervisory oversight and poor market discipline. Every one shared the gains, but leaders in the financial services space which drove or at least facilitated most of the economic expansion reaped the largest gains through windfall corporate profits and hence astronomical bonuses. We are seeing a drastic correction, which is forcing us to look at the value of fiscal prudence, savings and long-term sustainability. So, all of a sudden the same media and public voices which ga-ga-ed at Bill Clinton's talk of 'we do it large because we can afford it' turns around and moves to a position of extreme fiscal prudence and conservatism.

I am not saying the correction's not warranted - but whole heartedly agree with the 'back-to-the-basics' move towards increased savings, financial prudence and controlled markets. However, it has to stop being a witch hunt - if we go over board with governmental oversight and regulations, we would be committing a big mistake. What gain will come out of revealing the names of individual bonus recipients at Merril Lynch or for that matter AIG? Even worser, you have state AGs investigating why tax payer money went to honor counter-party obligations of AIG related to its CDS portfolios!! The government can and should use more subtle means to discipline firms who received tax payer funds - but stop at being moralistic. Do we REALLY expect businesses to stop honoring legal commitments, contractual norms and focus on reviving the economy and ensuring money flow? I hope not...there's a lot else that's left to be done before we spend our collective energies on discussions around economic philosophy.

- By now, we know that no stimulus/bail out package can succeed unless flow of money is restored in the larger economy - but we haven't YET seen anything substantial/serious from Tim Geithner and team to revive the financial services sector. While we saw individual firms like Citi forming 'bad money' banks and trying to separate out the wheat from the chaff, we still haven't seen any further light on the ambiguously termed larger 'public-private' partnership that was announced many weeks back. This is imperative to re-energize bank balance sheets and enable them to work 'normally'and do what they are supposed to do - lend money and facilitate money flow.
- We haven't seen any details on revised accounting norms for mark-to-market valuation.
- Nor have we seen any serious/informed discussion on the nature and form of regulations for the Securities and Investments industry that can prevent what happenned.

As a result, we have a financial services sector that's still stuck in a quagmire, with out either the ability or the willigness to circulate government and tax-payer funded money that's flowing in! While the government, media and many others have litle time but to debate whether CXOs deserve to earn their million dollar bonuses!

Devil lies in the details - the importance of financial sector resuscitation

Despite the House passing the Recovery and Reinvestment act over the past week, there's been a persistent sense of doom and gloom in the US and global markets. Though it is a fallacy to predict the effectiveness of such an initiative using a short-term stock market reaction, we cannot ignore the natue of the stick market reaction and the sector which bore all the brunt - financials. Let's take a quick look at the numbers.

The recovery and reinvestment act, in terms of size, looks quite dwarfed in context of overall macro economic numbers (all numbers as of end Q3 2008):
Domestic financial sector debt: USD 16.9 trillion
Domestic home mortgage debt: USD 10.5 trillion
Domestic consumer credit: USD 2.6 trillion
Domestic Federal debt: USD 5.8 trillion
In comparison, the act would add to budgetary deficits by USD 185 billion in 2009, USD 399 billion in 2010 and USD 787 billion cumulatively over the next few years. So, despite all the hoopla over the size of the package and the fiscal profligacy tag imposed by fiscal conservatives (if there is such a class at all!), the size of the package is quite moderate! Let's look at it another way: Federal debt increased by over USD 770 billion over Q3 2007 to Q3 2008 (15.2% increase). In comparison, the stimulus act would add over USD 584 billion (9.9% increase) over 2009-'10.

From the above, its clear that the stimulus act by itself does not pose a fatal threat to the fiscal state of the US economy. As long as there's a foundation of fiscal discipline (read avoidance of unfettered tax cuts and freebies), the economy will be able to absorb the fiscal bump to reach a mangeable steady state.

However, as can be easily seen from the above macro-economic numbers, there's little that the stimulus act can achieve unless there is a very focused and directed effort to 'unfreeze' the money flow in the financial sector, with special emphasis on 'directed' mortgage lending.

TARP Phase 1 obviously didn't achieve it, neither did any efforts from the Federal Reserve for driving additional liquidity. During the past few months, while Federal Reserve lending to banks increased by over USD 800 billion, deposits from banks with the Fed increased by almost the same amount - what a sheer fallacy! The basic problem with the above efforts was the same - as long as the mortgage freeze persists and banks continue to face the risk of further write-offs on newer assets, no amount of additional money in the system wil help ensure free flow of credit!

Phase 2 of the financial and mortgage sector revitalization act has to do all of the below to be effective (as highlighted in some of my write-ups earlier too):

1) Until the credit market freeze is significantly overcome, its difficult to ensure free credit flow without altering the rules of the game. In some form or fashion, there need to be a dilution of the mark-to-market rule - i hate to advocate a core principle behind conservative/realistic accounting, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms. This has to be complimented by a mechanism to rid the bank balance sheets of existing written down/troubled assets, through some federal participation, as has been already discussed.

2) Even if the above is done, money flow to sectors deserving the highest priority cannot be ensured without a new dose of targeted/priority lending norms. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors (including obviously residential and commercial mortgage)!

3) A thorough revamp of the regulatory and compliance scenario. Tim Geithner already referred to mandatory stress testing for banks receiving (above a certain threshold limit of) TARP funds, but we probably need to go much deeper and broader beyond that. The US has been unfortunately lagging in implementation of Basel II as compared to Europe and Asia - some would question the efficacy of these norms by pointing out the failure of several banks in Europe, but as in many other cases, the mode and manner of implementing such norms/guidelines is even more important that the risk/regulatory oversight that it mandates. Even if banks compute capital norms per Basel II norms and practice market disclosure, true risk assessment often lies in some areas where rules are not as explicit - risk aggregation, stress testing and scenario analysis. Also, goal alignment between business groups and risk management groups through risk-aligned performance measurements and the like is equally critical.

More over, central and regulatory oversight would not be complete without a fresh complementary dose of self-regulatory guidelines, principles and institutions focusing on oversight of equity and credit rating agencies, enhanced market disclosures and fostering market discipline.

A lot depends of the finer print of the financial sector package that Tim Geithner would hopefully announce over this week and next - what it addresses and how! I am personally sure there would be enough meat in the proposal, given how the current administration has conducted itself so far.

Stimulus package - ensuring efficiency and sustainability

The Senate is closer to signing of the stimulus bill, after a short hiatus of introspection and wrangling. Though one does feel that the package is spread out a bit too thin - in terms of areas it tries to cover - it never the less provides a much-need lever for trying to stem the current economic decline. Sceptics would question the relevance of another 850-odd billion 'stimulus package' when the earlier 700 billion kitty (TARP) did little to either ease money supply or contain fincnail sector turmoil! This could very well be true unless administration and execution of the package is done in a business-like fashion. Adding the money remaining from the TARP package, the government has a ~USD 1 trillion pool now to spark economic activity.

Despite all the goodwill and long term benefits that green energy spending and healthcare spending would bring, we probably cannot pull ourselves out of the rut unless there is targeted efforts at improving money supply. Government spending in infrastructure would drive some downstream activity in construction and ancilliary sectors; but this cannot result in sustainable business acticity unless the core issue of liquidity and money supply is addressed. We need to address the root problem for this - ongoing mark-to-market impairment on the balance sheets of fincancial services firms and resulting squeeze for meeting regulatory and economic capital norms. This cannot be achieved without both of the following:
1) I would absolutely hate to advocate scrapping of the mark-to-market rule, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms.
2) There should be explicit provisions for emergency priority lending provisions targeted at residential/commercial mortgage and commercial lending. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors.
With steps like the above, banks can continue to build core-sector assets without undue downside risk, and also beef up interest income since base treasury funding rates would be low enough to provide decent margins even at low lending rates.

None of the above would ensure sutainability unless backed by strong regulatory changes as advocated in some of my earlier notes - oversight on credit rating agencies, enhancement of supervisory oversight on risk management, stronger corporate governance norms...among other things.

Retail spending, bleak statistics - but is it a good forecast for 2009?

Economic statistics have been pointing only one way since the past 3-4 quarters - down! Though the NBER announced a few months back that we 'technically' entered recession some time in Q4 2007, we really didn't feel the intensity of the slow down till Q3 2008, especially after the Lehman-Merrill day in September '08. Almost all indicators are very bleak by now - retail sales fell by 1.8 and 1.2 percent respectively in November and December, with same store sales falling close to 2.2 percent on the average as compared to the same period in 2007. This, along with an exteremly depressing unemployment rate of 7.2%, paints the picture of a deep, gloomy slow down period. The big question in every one's mind is - is this the start of a deeper recession or is the worst behind us?

WIthout doubt, the slow down has deeply impacted consumer sentiment and thus damaged the trend of the single largest factor which drives over 2/3rd of this nations GDP - consumer spending. However, I would personally argue this is more of a reversal of the exuberant trends seen from '05-'07 rather than point to anything that's inherently unhealthy in this sector. The consumer hasn't stopped spending - just to illustrate this point, let me mention an interesting experience i had when i was at an outlet mall south of Boston recently along with my spouse. We saw a long line of 15+ people waiting outside the door of an Uggs store and was curious as to why - apparently, Uggs was offering some good deals, and there were more than enough people interested...to make the folks who run the store 'control' intake of customers to prevent over crowding! We saw pretty much the same at a nearby Coach outlet...they were offering 50%+ discounts (which still doesn't make the purchase price reasonable for many!) and there were throngs of women pouring over their handbags, clutches and other accessories on sale. I have heard the same from many of my colleagues and friends across the region - which all points to the fact that the consumer is still willing to spend money, provided the deals are 'right'. So, what's happening is more of a change in the way consumers approach spending than any doomsday no-spending behavior as many would expect us to believe. If people prefer buying at Walmart and pay less dollar for exactly the same merchandise as compared to the fancy department store locally, or if they switch from Saks to Gap for a larger percentage of their clothing purchases, it's probably for the good. We saw a long period of (close to) reckless spending, depleted savings rates and bloated same-store retail numbers...a period where 'value' took a backseat and the consumer stretched savings and on-paper home equity values to splurge on not-so-necessities. We are just seeing a 'good' reversal of these trends - this is exactly the same psyche that led consumers to (hopefully) permenently alter their outlook on fuel-related spending when oil touched 147 a barrel in Q3 '08...despite prices crashing down to 40 a barrel levels, consumers have continued to stay more 'conscious' of the money that are spending on running their cars and heating up their homes. As i had said earlier, this was probably one of the best things to happen from the oil price shock in late '08. And probably this retail spending 'pattern change' is a better thing for the consumer in the long run too!

My basic argument is that there is still some 'sentiment' around and consumers are not sitting at their homes and looking out of their windows altogether - which means good for the economy. As i had mentioned in one of my blogs in late '08, the only way to step up from this slow down is to loosen fiscal prudence for a brief while and indulge in drastic government spending. Don't get me wrong - i am not typically a demand-side economics supporter, but the current unprecendented situation warrants unusual strength in fiscal and monetary actions. We don't have much of a leverage in monetary policy, with fed rates already close to zero - thus there's no option but to use the fiscal lever! If Obama does succeed, even moderately in targeting fresh money in to areas like construction, healthcare, green energy and education, the very impact of this in down stream sectors and resulting gains in employment would be more than enough to crank the engine back. From what he's said so far, it looks very much like it's going to be a very common-sensical approach - every one cannot expect taxes to be cut and sops to be given , but still expect the economy to be revived...sops can only be targetd at the right sectors (high-employment industry areas and low-income population). Once we see early signals in the US, there would be downstream impact across global markets and a synchronized global recession can probably be turned around! There are many who opine that history points to a longer period of slow-down, but when we compare this slow down to earlier slowdowns, what we should note is that everything's been played in pretty much fast forward so far - and a pickup in trends would be quite quick too, given the right stimulus. Advances in economic theory and fiscal and monetary tools and policies have just made economic cycles more drastic! But hopefully we should see some thing even better - if policy makers can use this opportunity to drive permanent shifts in trends towards increased savings, tempered leverage and fiscal prudence (long-term), we should see a more stable growth trend once a turn-around happens!

Even by risking the probability of being wrong, i would stick out my neck and say that we should be back to near-sanity conditions by mid-to-late Q3 2009. We shoud see unemployment trends slowly reverting, housing and real estate stabilizing, and manufacturing looking up from it's trough. So, we are still looking at another 2 quarters of bad statistics and sad news on the unemployment and consumer spending fronts, but there's light at the end of the tunnel. That is assuming Obama and his team does not flounder completely - the chances of which look pretty grim. Here's promising and hoping a more cheerful look-back blog for late 2009!