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The Trend Is Your Friend
The USD has weakened significantly over the past few months as the tone of the U.S. economy has turned extremely negative. The official ruling on whether the U.S. is in recession will be made by our government's National Bureau of Economic Research (NBER), but this decision may not known for some time. The NBER defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months." They will base their findings on the assessment of important data on employment, personal income, industrial production, and sales activity in the manufacturing and retail sectors. But many economists have already concluded we are either in the midst of a recession, or we will be in one very soon. So, the next logical question: how long will it last? Certainly the Federal Reserve Bank is doing what it thinks is right to help the economy rebound. Interest rates in the U.S. continue to fall. In fact, we could see overnight Fed funds rates approach 2.5 percent by year-end. However, it's not just lower U.S. interest rates that are affecting USD weakness. Recent EUR strength has its own dynamics, in part because, last week, the European Central Bank (ECB) decided to leave its key rates unchanged at 4 percent.
In contrast to the United States, the ECB is signaling that due to inflation risks interest rate cuts are not on the agenda any time soon. ECB President Jean-Claude Trichet and board member Stark confirmed that growth in the euro zone is basically fine. Some recent economic data support this view. Neither the European business climate nor the consumer climate showed any sign of weakening further. This was reinforced by last week's German ZEW institutional investor sentiment, which reported a number higher than most anticipated. The ECB also emphasized "that maintaining price stability in the medium term is the main objective in accordance with the ECB's mandate." Governing President Trichet also said that the ECB believes that "the current monetary policy stance will contribute to achieving this objective" and that the ECB "remains strongly committed to preventing second-round effects and the materialization of upside risks to price stability over the medium term."
The fact that these statements reinforced the focus on price stability sounds like a justification as well as a clarification of the ECB's monetary policy, where slowing growth does not necessarily mean rate cuts. At the same time, the ECB feels that current rates are appropriate to maintain price stability confirms that they are in neutral gear. The ECB admits that the global slowdown will have an impact, but still expects both domestic and foreign demand to support ongoing real gross domestic product growth this year, albeit at lower rates than previously. In addition, investment growth is expected to remain strong and consumption is expected to contribute to growth, in line with rising employment.
Turning to inflation, the ECB acknowledged that February inflation remained at 3.2 percent, a 14 year high, noting that "[we] confirm the strong upward pressure on inflation in the short term [stems] mainly from the increases in energy and food prices in recent months." Mr. Trichet also said that the ECB expects "a more protracted period of relatively high rates of inflation" than it did a few months ago. Inflation is now expected to remain significantly above the 2 percent target level in the coming months and moderate gradually later in the year." Given this data under normal circumstances, ECB would probably more inclined to raise rates. However, current global uncertainties have led to a more cautious approach.
Since monetary intervention is on hold, European officials have resorted to verbal intervention. French President Sarkozy and German Finance Minister Steinbrueck, two of the more vocal critics, have repeated the EUR's gain is a shock to their economies, which makes exports more expensive to consumers outside Europe. Even Trichet has voiced concerns that he would prefer a less volatile currency market. However, these official calls are falling on deaf ears, and their expressed concern about the EUR's strength is unlikely to succeed in today's environment. With the interest rate differential being a primary driver of currency fluctuations, the inability of the ECB to lower interest rates combined with continued U.S. economic weakness, I expect volatility — and the EUR's strength — to continue.
— Joe O'Leary, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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P2P Goes Legit
Peer-to-peer technology, once known for pirating music online, is increasingly being adopted by businesses as an inexpensive way to get video content to customers. Pando Networks, for example, is providing the means for NBC to provide DVD-quality downloads of its shows. However, 90 percent of P2P downloads are still of illegally copied content, with 12 million to 15 million people file-sharing across the world at any one time, according to SafeNet Inc. Media companies can also hire content delivery networks, or CDNs, to deliver video over the Internet and cut the cost of delivery by 50 to 90 percent. But P2P technology can offload much of the work of the CDNs by having subscribers who have downloaded the data already send it to subscribers who haven't. (AP)
Government Connections
IT security companies are looking to the U.S. government not only for funding, but for inroads to sell their products to a variety of government agencies. Government agencies are more likely to buy from companies that have already been vetted by another agency. Because many entrepreneurs are not familiar with the way the funding system works in Washington, start-ups often partner with larger companies who know how to handle government contracts. Companies can receive funding through a process known as a "broad agency announcement" that has specific funding criteria for each particular agency, a research grant with required deliverables. (VentureWire)
Solar Cost Savings
To cut the cost of solar panels, start-up company Solaria intends to decrease the amount of expensive silicon required. Its cells generate about 90 percent of a conventional solar panel's power, while using half as much silicon. Ordinarily, silicon covers the surface of solar panels to collect light from as much area as possible. But Solaria slices the silicon into thin strips and spaces them apart then covers the panel with a clear molded plastic cover to collect light from the entire surface and funnel it to the silicon strips. The company also cuts the cost of customized equipment by using existing semiconductor manufacturing equipment. (MIT Technology Review)
Net Neutrality
Congress is considering amending antitrust laws to keep broadband providers from blocking competing Web-based content and applications. The concern is that without laws requiring net neutrality, Internet users might not get a chance to see Web content unaffiliated with the broadband providers, including independent music videos. On the other hand, some lawmakers are opposed to new Internet regulation, warning that some net neutrality laws could prevent broadband providers from deploying filtering technologies to block the unauthorized upload and download of music files. (PC World)
Pharma Slowdown
According to the latest annual pharma sales report by IMS Health, pharmaceutical revenue grew by a mere 3.8 percent to $286.5 billion in 2007, the slowest pace of expansion since 1961. However, there were a few standouts including cancer meds which grew by 14 percent. Biotech product sales expanded by 9 percent and specialist-driven therapies increased by 10 percent. The offsetting decrease came from cholesterol meds which dropped 15.4 percent. Reasons for the slowing growth included increasing competition from generics, the $17 billion worth of branded drugs that lost exclusivity in 2007, fewer product launches, slower adoption of the new products and safety issues that cut into sales of products that account for 10 percent of the market. (Fierce Biotech)
Development for a Mobile Future
As phones morph into multimedia devices with sophisticated messaging, music, and video services, carriers are realizing that developers hold the key to industry innovation. Corporations are now wooing small developer firms with cash prizes and promises of distributing their programs. Apple recently released its software development kit (SDK) and venture partner Kleiner, Perkins, Caufield & Byers set up a $100 million venture fund to bolster developers' efforts to build applications for the iPhone. For its part, Google has created a $10 million fund to support developers that build applications with its "Android" tools. At the upcoming Las Vegas industry trade show, AT&T will host its "Fast-Pitch Platinum Awards," a contest for developers. (Forbes)
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March 17, 2008
Uncle Bob's Swap Meet
There is something fundamentally wrong in the credit markets. We wish we could get paid for such electrifying insights. We keep staring at the screens, watching the indexes jump and dance as treasuries climb ever higher, and then, looking out the window, we see our neighbor Joe's house. Reading the news and watching venerable investment banks vaporize before our eyes, it's easy to forget that underneath all this activity are physical assets made of wood and brick and stucco that, absent abject fraud, are not valued at zero. As we watch the mortgage credit default swaps market gyrate each day, we can't help but wonder if Joe's mortgage is buried somewhere in there.
The credit default swap (CDS) market provides insurance against a borrower defaulting on a loan. You pay the counterparty a premium every year, and if the loan defaults, you sign over the loan document and they will pay you the outstanding principal. Initially it started out with banks issuing small customized swaps to help manage and better diversify their loan portfolios. Gradually it got more efficient as documentation standardized and more capital entered the market. Eventually the credit default swap became the preferred way to speculate on the health of an issuer's credit. For example, if I wanted to protect a GM bond from default, I could simply enter into a swap that would pay if they did default. In the event of default, with physical settlement, I would deliver the GM bonds in exchange for cash from the counterparty equal to the amount of the bonds outstanding.
The volume in the market jumped when participants decided that physical settlement was no longer required. In fact, today, the notional principal amount of the credit default swaps market is two or three times the actual debt outstanding — reaching a stupendous $45 trillion. This is about equal to all the bank deposits on planet earth. Of course, with no physical settlement required, one can buy default insurance, essentially shorting someone's credit prospects without worrying about delivering the bonds to the insurance writer. In the stock market, this would be called a naked short, and it's against the rules.
When you consider that in today's illiquid mortgage market the actual accounting for the loans and bonds sometimes uses the swaps market, it's not hard to see why all this is great sport for hedge funds and other speculators. In fact, their share of this market has grown to 30 percent of total volume in the last 18 months. Imagine the fun of piling into the swap market, driving up the price of credit insurance knowing that whoever has the underlying loans would need to write them down. In fact, the write-offs might rise to a level that would impair the capital of the owners, and the stock prices might collapse or the firm might liquidate in a fire sale at $2 a share, thus, bringing even greater riches to our friendly speculators.
So how crazy has all this become? The credit default swap index for AAA-rated mortgage pool ABX-HE-AAA-07-01 is trading at 56.1. When it was first issued, this pool was of such high quality that the insurance premium was only nine basis points per year or $9,000 for a policy on $10 million of bonds. To buy that same policy today would cost $4,390,000 plus the annual coupon. Hedge funds engaged in the CDS arena are beginning to complain that they are getting roughed up by banks and brokers. Since no one in the CDS market is subjected to any type of reserve requirement against these contracts and the hedge funds have no obligation to account for their activities in any serious manner, it is difficult for counterparties to assess the risk they are taking. With their own losses hidden from view, hedge funds need to go the extra mile to build confidence with their trading parties. The trash talking and elbow throwing in the CDS game comes in the form of requests for more collateral to cover the counterparty risk. Conservative bankers and brokers are obliging their "prime broker" clients to pony up more cash to cover the exposure. It's about time.
So, what about Uncle Bob? Suppose life insurance policies traded like the credit default swaps market. With the rapid rise of securities based on viatical settlements (death benefits), this conjecture is actually not so outlandish. First, we would need to acknowledge that if there are 300 million people in the U.S., this insurance market would boast some 600 to 900 million policies. Now, suppose a group of 28-year-old bond traders from Goldman Sachs quit their jobs and organized a series of tradable indexes to help people hedge these insurance policies. The indexes would delineate prices for different demographic cohorts. As prices rise for a particular index, the clear implication that death is near for that cohort is well understood. Then one day you read in the newspaper that the price of Uncle Bob's life insurance index jumped. Suddenly, it cost four hundred times as much to buy that index, implying that Uncle Bob's death is imminent. What action would you take? Do you organize a funeral? Do you call Aunt Edna and offer condolences? Or, perhaps, you might just call up Uncle Bob and ask after his health. We think the problem in the credit markets today is that no one is talking to Uncle Bob.
Twigs in the Wind
We warned many months ago that the losses piling up on the balance sheets of public financial institutions would eventually be reflected in the mysterious and obscure world of hedge funds. According to the Financial Times, the closure of six funds last week prompted a leading private equity executive, who declined to be named, to say that such funds were "snapping like twigs," with one failing every day. Last year, when credit became tight, stock market punters ran to technology as the least leveraged sector. We saw precious few stories about the effect on firms whose very life blood is leverage despite the fact that over 700 hedge funds shut their doors. Odd that large banks and investment banks must now choose between cutting off their best prime broker clients or preserving liquidity for themselves. Market observers expect hedge fund failures to triple this year.
Elsewhere, in the real economy, continuing jobless claims edged up to 2.8 million, still well below the peak level (3.8 million) of 2001, but the direction is disconcerting. Retail sales declined as did mortgage applications. The big news was the Fed's new discount facility totaling $200 billion and open to previously unacceptable collateral. The market rallied immediately, closing up 416 points, as the Fed began buying mortgage-backed paper for the first time. The emergency rescue of Bear Stearns ("we had to kill the patient to save it") drove more lemmings into treasuries as short yield plummeted to new lows. The 2-year yields dropped to 1.332 percent this morning. Economists betting on the FOMC meeting next week average at a 50 bps cut, but, to be fair, many of the estimates were made before last week's turmoil. The Fed Funds futures are showing a 100 percent probability of a 100 bps easing tomorrow. Over to you, Mr. Chairman.
End Note
We bankers take a certain pride in our role of protecting America from terrorists, drug dealers, and money launderers. This chore is detailed in the Patriot Act, and we all participate in annual anti-money laundering training where we learn to spot nefarious activities and fill out "Suspicious Activity Reports" or SARs. Now, it appears that Wall Street crusader Eliot Spitzer, who resigned as governor of New York last week, was brought down by one lowly SAR filled out by a small regional bank. (There was no word yet as to whether he would also resign his membership in the Emperor's Club V.I.P.) We will now add "protectors of public decency" to our already long list of community service duties.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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