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Article-A LIBORious Recovery 0811 PDF Print E-mail
 

A LIBOR-ious Recovery

My Dinner with Craig


"We came THIS close," says Craig Alexander, TD Bank's Deputy Chief Economist, pinching his thumb and finger almost tight, "to a Depression scenario." He is referring to the US Congress' initial rejection of injection of $700 Billion of capital into the US banking system. Without that, he believes as do many, the US credit system would have ground to a halt, taking the global financial markets and soon, the global economy with it.

Lost in his rambling discourse, he is oblivious to his own second course (as well as a heapin' helping of irony) of the sumptuous meal as we sit, a smallish group attended by a silent, well-ordered, well-rehearsed cadre of wait staff, listening like the robber barons of old in tux and tails (All except me of course, dressed as I am more like train robber than train magnate.) to a Tale of Depression Averted.

Mr. Alexander expanded on his point, explaining how history has viewed governments' inaction during the crash of 1929-1930 as one of the key triggers of the Great Depression. In his view, despite some deserved criticism, the global governments have acted wisely in irrigating the spreading credit drought before it's effect had a chance to become a dustbowl.

That does NOT mean of course that the next few months will be coming up roses. TD's economic story foretells a recession in the last quarter of 2008 and the first quarter of 2009, a stabilization period through 2009's second quarter and a weak recovery happening in the last half of 2009 with no real strong growth, especially in the US, til 2010.

Further to this, TD expects that commodity prices, especially for the high fliers like oil, uranium, potash, etc, had peaked out last year and the drop seen since has been reflection of the long-expected recession settling around the world. Thus, they see prices stabilizing then recovering but not to 2007 price levels. He reminded us that during the nineties oil traded between $10-$30 a barrel and companies managed to make money. (As an aside, it is easy to forget that it was only in 2002 that oil was $16!) Looking forward, he believes that ‘peak oil' is not just a theory and that as scarcity increases there will be a higher "price equilibrium" of $50-60 without factoring in some sort of speculation or fear premium.

Looking domestically, Craig spoke extensively about the tightening lending standards for both consumers and businesses. This of course has not happened to the same extent as the Americans but then it had never loosened as much either. He feels TD can be smug about this because they had never had a big interest in trading much securitized debt and they had shut it down well before this year.

He also addressed the seeming disconnect between current mortgage rates and Bank of Canada rate cuts. He explained this by reminding us that a large chunk of the assets the banks use for mortgage lending comes from inter-bank lending. Since this lending is "set" somewhat exclusive of federal bank rates, the banks are currently losing money on current mortgages since the rates they offer to lend are less than what they have to borrow at. This is not an event that can continue and has triggered an increase in the variable rates and new mortgages being offered. However, the banks believe this situation will ease and Alexander advises watching the LIBOR more than the Bank of Canada rates. The LIBOR is the London Interbank Offered Rate and is the rate that banks charge each other for overnight lending. It tends to track the US Fed Reserve rate but has broken away over the last couple of months to spike much higher. This trend seems to have reversed itself over the last month and has fallen to half the rate it was a month ago.

More importantly, Craig believes that, given that the current crisis is driven primarily by companies being reluctant to lend to each other, watching the LIBOR rate is much more useful than watching the stock market on a daily basis since it is a averaged-out reflection of what banks believe to be the future borrowing rates. It is therefore a concrete indicator of the banks' optimism/pessimism. (As a note, there are actually 150 LIBORs generated daily for 15 different loan durations in 10 different currencies.[1])

It was also directly connected to and directly affects the price of the once loved and now reviled various interest rate swaps or credit default swaps (CDS) that are worth in the hundred of trillions. As the credit crisis deepened, fewer and fewer banks were willing to trade with each other at all meaning less and less transactions happened with the LIBOR. As credit begins to flow again, the LIBOR will both increase in volume and decrease it's rate.

The spiking of the LIBOR was what hammered AIG, the big American insurance company. They were doing a lot of credit default faults swap insurance, their initial reasoning being that not all of the CDSs would get hammered at the same time, which of course turned out NOT to be the case.  These credit defaults swaps, which are unregulated, were used heavily by the European banks since they weren't allowed to directly invest in the subprime type notes by their country regulators. These credit default swaps are now, of course, on the radar of the governments.

The local mortgage rates are fluctuating at a time when the housing markets, especially in the West, are tipping from being sellers markets to buyer's markets for the first time in over 7 years. From a 20% house increase the West experienced in 2006, TD is projecting a drop in prices in both 2008 and 2009.

Looking out he sees a couple of key trends for investors to focus on. His number one asset class opportunity is in corporate bonds where the spreads between some of the bonds vs government bonds as reached 1600 bps (basis points-pronounced "beeps" which is hundredths of a percent so 1600 bps is the same as saying 16%) This spread means that if current 10 yr government bonds are yielding 4% then some corporate bonds are yielding 20% (a yield is the interest rate on the payment) He did not mention that since the interest payment on the bond is fixed the only way yields can increase is that the market price of the bond has dropped. So investors in corporate bonds need to be confident that the issuer company is going to be around to make the future payment of both interest and principle.

The connected down side to this is that any companies trying to issue new debt will have to offer higher yields to attract investors. This higher yield increases the companies cost and means that either the company profit is reduced OR the company needs to go borrow from the bank (or issue more stock, not the best time for that.) and if the LIBOR is too high then companies are more likely not to borrow at all and sim[ply reduce their economic activity which of course contributes to the recession and thus the wheel continues to turn.

So, his other great theme is that going forward is that capital-intensive companies (ie. companies needing to borrow heavily for development or financing) are going to be having a rough time in the near future. (The obvious, though tactfully unstated, example to us Calgarians would be resource companies. Luckily the companies can offset rising interest rates and the tougher borrowing climate with high commodity prices...oh, wait... never mind.)

He sees the globe going through a period of not only increased scrutiny and regulation of the financial services industry but further, to a greater trend of nationalization either openly and obviously like the Europeans are doing or quietly and less blatantly like the US government is doing -acquiring shares of various banks and insurance companies.

While accepting the coming (or arrived) cyclical recession as fact, he believes that the chances of us tipping deeper into some more permanent Depression scenario being highly unlikely. He believes that the worst case we may see is where the US government is forced to nationalize its banking industry on a more full-scale basis. This would be a relatively drastic and dramatic event but Sweden's actions and experience in the early nineties, also dealing with a real estate-triggered banking collapse of their own shows that this action can be very effective in fending off more serious economic problems.

Having swiped his desert while he was busy answering a question about currencies, I slipped off into the night, filled with cat-sized chicken morsels, tempered optimism and thoughts of LIBOR and Gordon Brown.


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[1] "Whats in a number?" http://www.lrb.co.uk/v30/n18/mack01_.html