Archive for 2008

A year ago, the house of cards on which the US mortgage industry was built on began to collapse with the demise of New Century Financial, the second largest mortgage originator in the US. Today as we look across the financial landscape in the global financial market, we find some of the top names in the banking industry have already become patrons of the corporate graveyard. Northern Rock (UK), IndyMac (US), the Lehman Brothers, a century old US investment banking tradition has all but crumbled into oblivion as the magnitude of the subprime leading crisis unfolds. Even the largest savings and loans bank, Washington Mutual, was not spared from the fallout. On 25 September 2008, the Federal Office of Thrift Supervision seized and placed WaMu under receivership in an effort to bring some semblances of sanity to the US financial market.

The US government, urged by some of the major developed countries in the world at the United Nation meeting in New York, proposed a $700 billion bailout plan for the troubled financial market. Due to its huge price tag, members of the US Congress have balked at giving their seal of approval. Even now as the members of congress debate over the nitty gritty details of the bailout plan, the world’s financial markets watched and wait in anxieties. No one really knows whether the bailout plan will work but the atmosphere around Washington DC is that of a somber nature. Everyone agrees that something needs to be done and that the plan was “too big to fail“.

Though we are at the opposite end of the globe, the Australian Stock Exchange (ASX) took a serious pounding as the banking industry shares resume their decline wiping out any gains made earlier in the week. The S&P/ASX index dropped nearly 130 points as a result of doubts whether the US bailout plan will work. The scene at the ASX was like a drama of epic proportion unfolding. At 00.57 GMT on September 24, shares of the mining giants’ BHP and Rio Tinto declined at an average of 0.85%. By 04.56 GMT, the banking sector was hit next by worries of the bailout plan. The Macquarie group shares and Westpac Banking Corp by dropped by 5.6% and 2.8% respectively. The National Australia Bank (NAB) was not spared either as worries of the bank’s exposure to the collateralised debts (CDO) resurfaced again. Shares of NAB declined 2.6%. According to the analysts at MM&E Capital, the deterioration in the shares prices has nothing to do with short selling but rather everything to do with bad debts.

A week ago, Kevin Rudd, our esteemed Prime Minister, assured the Australian people on The 7.30 report that Australia is very much protected from the cascading effects of the subprime leading crisis in the US. If that was true, the Australian economy would be the only developed economy in the world which could survive on international trade in isolation. The truth is that our Prime Minister is as in touch with the Australian economy as the US Republican presidential nominee John McCain, who made the comment that the US economy is “fundamentally sound”.

Experts are warning that as the process of “deleveraging” continues further, the impact of the crisis will get worse especially for those on ‘Main street” and not just Wall street. The reality is clear and brutal. Already there are signs of how we will be affected. The layoffs by Ford, and Mitsubishi are the initial ominous signs of what’s to come.

To make mattersworse, the credit crunch had made it next to impossible to get a mortgage nowadays. The irony is that while banks are lending less, their profits are still soaring! As the income from loans declined due to the credit squeeze, banks in order to make up for the loss of revenue from the lending sector, have to seek alternate means to improve their balance sheets. To do this, they have adjusted their fees upwards. Unless you own substantial holdings in Westpac or the Commonwealth Bank, there is no cause for rejoicing.

The Governor of the RAB, Glen Stevens, reaffirmed this situation by saying that due to higher costs in funding; the Australian financial intermediaries are passing on the added costs to the customers. In this respect, the market is working efficiently. For any financial market to perform efficiently, it must also be informational efficient. The subprime lending crisis is a perfect example of what happened when the market becomes informational inefficient. The lack of transparency resulted in investors making ill informed investment decisions when the exotic financial instruments like the CDOs, MBS were rated triple “A” by the rating agencies. In other words, the investors didn’t know what they were buying. The same goes for all of us at Main Street. It is so typical of us to follow whatever the financial planners or mortgage broker tells us because they are the so called experts. And today, in lieu of properties, financial planners are telling us to invest in shares. 

This is where people like Warren Buffett and George Soros distinguish themselves when it comes to investing. The truly successful investors think along very different lines from the rest of the pack. They follow a definitive plan when it comes to investments. While everybody was loading up with CDOs and MBS, Buffett’s Berkshire Hathaway Inc was regarding them as “financial weapon of mass destructions” and a “time bomb” waiting to go off. Investors like George Soros who invest in the currencies markets hedge his bets when making investments decisions. This way regardless of whether the market is going or down, he makes a profit. By using a system of statistical arbitrage, the investor is able to capitalize on price differentials of an asset in different markets.

The mechanism to go about this is very clearly explained in a book by a former London city trader, Rajeev Shah. (To know more read, Sports-Arbitrage – How To Place Riskless Bets & Create Tax-Free Investments). This system of “fail safe” trading was pioneered by Morgan Stanley’s Equity trading division during the 1980s as a method to avoid losses due to price differentials. Since then, the system of trading has advanced tremendously to using softwares like the ArbAlarm to locate price differentials in the market. The fact of the matter is that, the successful investors do not let “control” out of their hands. Using different forms of investment vehicles, they are able to capitalize on any situations when everyone else is running for cover.

For some of us, the best years of our lives is supposed to be our retirement. But with the current financial crisis, this situation is becoming next to impossible. The slide in superannuation returns has forced some of our seniors to be on the aged pension. One can hardly call living near the poverty line an enjoyable situation. Even those who had a “nest” tucked away are starting to feel the pinch which shares prices drops and with it the dividends. The market might recover but you would hardly call yourself recovering when the majority of your assets are down the tube because all your investments are linked directly or indirectly to the globalised economy. Perhaps it’s time to rethink one’s investment strategy before time runs out like many of the retirees in the US now.

Compared to a year ago, the corporate bankruptcy rates in the US have raised by 42%.
(Source: BankruptcyData.com).

Firms are also finding it extremely difficult get credit to starve off bankruptcy due to the credit crunch crisis. A notable example is the auto parts maker Delphi Corp now fighting for survival from corporate insolvency. In addition, job losses, foreclosures, and stock market depreciations are engulfing the US economy. Never in the history of modern economics, have we ever seen bankruptcy the size of that of the Lehman Brothers case. The scale of government bailouts like the case of Fannie Mae and Freddie Mac are rewriting the rules of corporate survival as we plough through “uncharted waters”. No sector of the US economy is being spared as the financial market continues its deleveraging process. The domino effect of the crisis have spill over to the Retail sector, Home builders, Financial firms , Airlines and the Energy sector.

As the US economy is reeling in aftershocks, the FBI has launched investigations into firms which had triggered the US government involvement into bailouts for Wall Street. Some of the firms that have been under the inquiries of the FBI for possibilities of fraud are IndyMac Bancorp Inc, Countrywide Financial Corp, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. The Federal Reserve and the US Treasury department both agreed that the only way to resolve this crisis and bring stability to the financial market is to rid the books of these financials companies of their “Toxic Assets”. The bailout plan proposed by Treasury Secretary Paulson, requires a $700 billion injection into the market to soak up all the toxic assets. This is in order to unlock the credit squeeze the market is currently facing.

Even as the members of Congress debate over the bailout plan proposed by the Bush administration, leaders from developed countries are urging the US to quickly enacted the plan in order to stabilise the global financial market. The Canadian Prime Minister, Stephen Harper, have expressed worries about the fundamentals of the US economy. He acknowledges that the US economy had impacted Canada’s growth. At the United Nation meeting in New York, France and Australia joined in the chorus to call on the US government to quickly find a solution to the crisis. Australian Prime Minister Kevin Rudd said that it is time for the US government to act decisively to restore order in the chaotic financial market. Although the bailout plan may help to give the financial market a dose of confidence and help unlock the credit squeeze, no one had answered the question of what to do with the surplus homes in the real estate market. Furthermore, the positions of those mortgage holders on “Main Street” who are in a precarious situation have also not been addressed.

Many are demanding answers as to how the situation could have gone so bad. The hardest hit in Australia will most probably be the retirees. After the dot com bubble burst, many have shifted their investment focus towards Real Estate Investment Trust (REIT). Today, the REITs are also vulnerable to the credit crunch crisis. Centro, one of the largest property groups in Australia had announced a loss of A$3 billion for the year 2007/2008. Over a period of a year, up to 40% in values have been wiped off the Australian REITs. Another casualty of the crisis is the Superannuation funds. AMP, reported earlier in the year a 22 % drop in profits for the first half of this year alone. Voluntary contributions have also fallen considerably by as much as 33% since last year. In fact many retirees are turning to the aged pension for survival as the superannuation returns slide further. This number had increased by 40% since the last financial year.

Financial planners have advised that when it comes to investment, we should diversify. Another common advice we hear is that bricks and mortars are a safe bet. Many of those who took these investments from so called “experts” have ended suffering when they see their life savings disappeared into thin air. As early as last year, Australians had lost an aggregate of a billion to dubious investment schemes. The collapse of WestPoint, Fincorp and the Australian Capital Reserve (ACR), are all stark reminders that we need to really rethink our investment strategy. Today, in a globalised economy, none of our investments are insulated from any fallout from any major crisis in the world.

Successful investors like Warren Buffett do not follow what the rest of the pack do when it comes to investing. As early as 2002, he had warned of a “time bomb” that was waiting to go off in the US financial market. He had viewed the credit default swaps market as “financial weapons of mass destructions”. And true to his words, today, we are now reeling from the effects of that “time bomb”. The thing is that if we wish to be successful like Warren Buffett or George Soros, we have to adopt their mindset. There is no way to get rich quick. Everyone needs a plan, patience, and an investment vehicle to start with. Things like risk level and tax liability need to be considered and not just the returns. George Soros, uses statistical arbitrage, to hedge his bets whenever he invested in any assets. This way, he reaps a positive return regardless of the direction the market is going. In layman term, this is called riskless investment and it’s not just restricted to financial markets. (To know more read, Sports-Arbitrage – How To Place Riskless Bets & Create Tax-Free Investments). This system of investing was developed by Morgan Stanley Equity trading division during the 1980s. Today, statistical arbitrages have progressed to encompass technological improvements. With the use of software like the ArbAlarm, it is possible for one to execute a trade within mere seconds from the desktop computer.

Apart from the risk level which we have to consider, there is another aspect most of us tend to overlook, that is the tax liability of the returns. Incomes derived from Real estate are subjected to Capital Gain Tax (CGT). Likewise too are the dividends we get from the superannuation funds. Until the superannuation has become your retirement pension, all the returns are subjected to 15 % CGT unlike capital gains made from statistical arbitrages which are tax free. (For more insight, see ATO Tax Ruling TR2004/D17). At the end of the day, we ourselves have to decide how we will live out our retirement years. Many seniors are finding it extremely difficult to survive on the aged pension as many do not have any savings. Even those who have a retirement nest tied in the stock market are finding their returns shrinking day by day as the credit crisis get worse.