Finding Opportunities In The Current Financial Crisis

September 30th, 2008 | Posted in Investment

A flurry of activities continues in the financial sector, with the US financial index tanking about 14% over the past two weeks (in USD terms, as at 17 September). We saw the US government placing Freddie Mac and Fannie Mae under conservatorship, Lehman Brothers (Lehman) filing for bankruptcy, Merrill Lynch (Merrill) being bought over by Bank of America (BoA) and the near collapse of American International Group (AIG). What can investors possibly make out of the recent financial turmoil? Can any opportunities be found amidst this crisis?

The article reviews the happenings over the past two weeks and provides an update on the price to book (PB) ratio of these financials.

8 September

US Government takes over Fannie Mae and Freddie Mac

Increased mortgage defaults threatened the solvency of these two institutions as Fannie Mae and Freddie Mac were operating with capital ratios (capital divided by risk adjusted assets) that were much lower than the banks. The US government decided to intervene with a four-part plan to prevent the failure of the two Government-Sponsored Enterprises (GSEs) because both GSEs are so large and so interwoven into the US financial system that a failure of either would cause great turmoil in US and other global financial markets.

The US Treasury has placed Fannie Mae and Freddie Mac under conservatorship. The Federal Housing Finance Agency (FHFA) will take control of the two GSEs until the necessary conditions for solvency have been met. The shares of Fannie and Freddie will continue to trade during conservatorship; however, the powers of shareholders will be suspended until the conservatorship is terminated.

A new secured lending credit facility will be available to Fannie Mae, Freddie Mac and Federal Home loan Banks and this credit facility is currently available till December 2009.

The Treasury may purchase up to US$100 billion in preferred stock in each of the GSEs to maintain positive net worth in the entities required by the regulator, the FHFA. This preferred stock will have priority over the existing common and preferred shares, but will be subordinate to other outstanding debt. This provides clarity to both local and foreign debt holders, as well as private and sovereign investors.

The Treasury will start to purchase Mortgage Backed Securities (MBS) of Fannie Mae and Freddie Mac in the open market later this month. This authority to purchase expires at the end of the year, but the Treasury can hold these securities to maturity, so investors should not be unduly concerned that the Treasury would start offloading these securities after December 2008.

The four-part plan seeks to satisfy three critical objectives: provide stability to financial markets, support the availability of mortgage finance, and protect taxpayers – both by minimising the near term costs to taxpayers and by setting policymakers on course to resolve the systemic risk created by the inherent conflict in the GSE structure (i.e. the problems that comes with GSEs having the implicit guarantee from the US government that they would not fail).

Impact of Government Actions: Mortgage rates would likely come down

During the ongoing housing crisis, the GSEs were not able to expand their portfolio because of capital constraints. Foreclosure rates have also been increasing so banks are willing to lend only at higher interest rates. The spreads between mortgage rates and Treasuries have widened, making mortgages less affordable for homebuyers. However, as part of the four-part plan, the US Treasury will be buying into the MBS of these GSEs and the GSEs will increase their portfolio sizes by buying more mortgages from financial institutions over the next 15 months. These actions would help lower the spreads, translating into lower mortgage rates. Chart 2 shows the spreads narrowing sharply, following the actions taken by the US Treasury.

We think that the steps taken could have only limited impact on the demand for housing. Current concerns over economic conditions might override the lower mortgage rates in influencing the demand for housing. Weak employment data is one of the main factors weighing down on the optimism of investors and consumers.

The total decline in payrolls for this year has reached 605 000 as at August, wiping out half of the 1.1 million jobs created in 2007. The unemployment rate of 6.1% in August is also at a five-year high. Rising unemployment also makes it harder for Americans to keep paying their mortgages, suggesting that the housing prices might not bottom yet. This means that the rescue of the two GSEs is not likely to stem the decline in housing prices anytime soon.

After Freddie and Fannie were placed under conservatorship, there has been more news of other financials facing difficulties.

15 September

Lehman Brothers Files for Bankruptcy: On 10 September, Lehman announced a record US$3.9 billion loss for the company’s third fiscal quarter. Moody’s Investors Service said the company must find a ‘stronger financial partner’ or the company could face a downgrade in credit ratings. The implications of a credit downgrade are potentially the posting of additional collateral, increasing short-term and long-term funding costs. Lehman filed for bankruptcy on 15 September after Barclays Plc and BoA abandoned talks to buy over Lehman, in what would be the biggest bankruptcy in corporate history. At about the same time, investors also fretted over the downgrade of Washington Mutual’s credit ratings on 11 September, with no potential buyers stepping into the picture.

Bank of America (BoA) Acquires Merrill Lynch & Co: BoA offered to pay US$29 of a share for each Merrill Lynch share, which was at a 70% premium to the closing price of 12 September, valuing the whole deal at US$50 billion. As the takeover is in the form of BoA shares, Merrill shareholders are going to get less than the initial estimated $29 per share because the share prices for BoA has been falling after the takeover announcement was made.

17 September

Government takes control of American International Group (AIG): The US government takes control of AIG by providing a two year loan to the tune of US$85 billion in return for a 79.9% stake in the company. Moody’s Investors Service downgraded AIG’s credit ratings on 15 September. The downgrade threatened to force AIG to post more than US$13 billion in collateral when the company was already short on cash. To try to raise enough capital by selling shares is an uphill task because its share prices were at a fraction of its all-time high reached last October.

Heightened Level of Fears

Credit markets have tightened significantly as the banks hoard cash, causing the cost of borrowing in dollars to jump the most since 1999. On the other hand, investors fled to the safety of Treasuries, pushing the yield of 3-month Treasury bills to 0.45% (as at 17 September), the lowest since at least 1954. The TED spread measures the difference between what the US government and banks pay to borrow in dollars for three months. It is viewed as a measure of sentiment in the credit market.

Elevated readings of the TED spread indicate an increased level of risk aversion in the market, as investors flock to the short-term risk free Treasury bills. The TED spread on 17 September widened to a level that is even greater than that registered on 20 October 1987, the “Black Monday” when the S&P 500 tanked more than 20%, suggesting that current sentiment is as bad as that experienced on Black Monday. (See Chart 3)

What Has Been Done to Calm the Markets

While more bank failures can be expected, governments around the world are joining hands to fight the crisis. The Federal Reserve is receiving support from its counterparts around the world in pumping $180 billion into global markets. Earlier on, the Federal Reserve widened the range of instruments that it can accept as collateral, by allowing banks to use equity as a form of collateral when borrowing.

At the same time in the private sector, a group of 10 banks have formed a consortium to offer a collateralised borrowing facility of US$70 billion to enhance liquidity. These moves aim to inject more liquidity into the system, so that financial risks in the system can be contained and the number of bank failures minimised. We can expect more efforts by both the public and private sectors to contain the crisis.

Cautious on US equities but Financials Still Attractive

Clearly, markets have priced in the increased risks of more bank failures by selling down financials. However, the TED spread, which hit a record high (3.13%) on 17 September, surpassing the level registered on Black Monday (3.0%), suggests over-pessimism. While current economic conditions do not bode well for US equities in general, the low PB ratios of the financials do seem to show signs of attractive value.

Getting exposure to the US financials via a diversified financials fund would ensure that risks are spread across many financials and when the crisis is over, the surviving banks would thrive and possibly receive a re-rating on their PB ratios. Available financials fund on our platform with exposure to US financials include ABN AMRO Financials Fund, Fidelity Global Financial Services Fund, UOB United Global Capital Fund and Henderson Horizon Global Financials Fund. Do remember, however, that the financials sector is not for the faint-hearted so we recommend that these funds be placed in the supplementary portion (which takes up at most 20%) of an aggressive investor’s portfolio.

By Wong Weiyi