My Diary 388 --- To Save Last Fund; What is the Next Move; China is Below 4000; Hong Kong is Softening

March 13, 2008

The excitement is definitely over as the biggest bounce in equities since Mar2003 only last one day……Overnight, rumors of Drake hedge fund defaulting, renewed rumblings about BSC, plus USD/EUR dropped to record low on speculation on the Fed’s plan won't work hammered our regional market today…MSCI AP fell 2.2%, the biggest drop since 07Mar (-13%Ytd), while Nikkei fell 3.3%, the lowest since Aug31, 2005. Hang Seng Index slumped 4.8% percent, the most in 5 weeks, after an “SARS-reminding” influenza outbreak…So unless you still believe in decoupling, new lows lie ahead…

In addition, with UST yields plummeting (2yr=1.53, -21bp; 10yr=3.43, -17bp), a more disturbing explanation is that such a move is more like a pending disaster than recovery. In spread markets, despite their massive spread tightening yesterday, the agency or GSE's paper was actually 2-3bp wider on spread…Adding to that, realized Vols (Daily Chg of 10yrUSSR) remain at historically elevated levels (MTD 10bp vs Feb 10.6bp)…a bad number for long MBS due to -ve convexity, plus the much fatter tails of distribution will remain that way, suggesting bets on normal-distribution price moves are wrong…..Else where, market move remain extreme. The US Dollar fell to the lowest since 1995 against YEN (100.19now), breaking 100 intraday, and 1MWTI hit another new high at $109.92/bbl, up >$10 over the past 2 weeks…

Well, well, well…it looks we are standing near the Bears as market sentiment points to that direction. According to BBG Professional Global Confidence Survey, only investors in Brazil predicted their market will rise…In fact, S&P500 is down 16% from 09Oct2007 peak, 4% lower than the 20% tumble of a typical bear market. According to Bespoke Investment, the benchmark has declined an average 30% in bear markets……First thing first, let us start from the Fed's ”Term Securities Lending Facility”……

To Save Last Fund (TSLF)

Fed is the market savor? Not really…the stories of failed hedge funds dominated the street as Carlye says its creditors will promptly take over all of the company’s remaining assets, plus Drake may shut its largest Global Opportunities Fund ($3bn), while GO Capital blocked clients from withdrawing money out of its $880mn Global Opportunities Fund.....I believe hedge fund managers will avoid using Global Opportunities Fund for the next marketing tours going forward…Just kidding, the Fed’s plan is to save the last Global Opportunities Fund…

Back to the Fed's latest move to introduce TSLF, which is viewed as an important step in relieving forced-selling of high-quality MBS and Agencies, and in reducing the shortage of bank liquidity. The mechanism is simple through allowing dealers to swap high-quality MBS and Agencies for USTs, it should stop credit spreads from widening further, since dealers now can sell USTs to meet liquidity needs, rather than agencies and MBS.

However, I have at least three reasons to doubt on whether TSLF is a innovative cure for current credit market woes, including 1) the underlying problems in housing market is still in place, witnessed by the falling house prices and soaring foreclosures that have undermined collateral values and confidence in the banking system; 2) perhaps more importantly, the TSLF does nothing to address the downward spiral of price/ratings declines in MBS securities which remains a most serious problem; 3) the $200bn size is too small to make a big difference. The total size of MBS market of $6tn, comprised of $4.1tn in agency-MBS and $1.9tn in non-agency MBS, according to Fed.

In reality, the Fed will only be accepting high-quality MBS (AAA or Aaa-rated debt).Thus, the TSLF will encourage some spread tightening in HG securities, but yesterday's announcement is unlikely to mark the end of the credit crisis or a peak in LG spreads (especially Subprime and Alt-A mortgage debt)…As a result, my best guess is traders may take the bounce t as an opportunity to clear their decks for the next attack…For that saying, the market will wait to see further action to help the bad debts or the struggling Subprime homeowners……

What is the Next Move?

Looking back, indeed TSLF program does provide the market with a short breath time when global sentiment was dropping like a rock. But, in essence, the Fed's latest action is just another attempt to inject liquidity (although helpful) and does not suddenly convince real money investors that banks/brokers are a buy since the problems that initially created risk aversion, including asset write-downs, delinquencies and deteriorating economic data stay……Certainly, we should not blame Mr. Bernanke as the Fed only has limited ability to address the credit concerns that have disrupted the capital flows of to some markets…So far what Fed have done (cutting interest rates, injecting liquidity and now taking over HG ABS) are like helping a woman-in-labor --- a does of anesthesia only makes the pain subsidized but may lengthen the birth process. This is not a case too hard to digest because if it took us more than 20yrs to build up leverage, then it should take more than 8 months to fix the pain of debt unwinding. If we have longer time to go, then it is logical to ask a question, what is the next move?

Of course, the next step would be to add MBS to the Fed's balance sheet on a more permanent basis…Well could be more as the FED may allow $200bn to be $500bn, 28 day term to be 3-6months, AAA private MBS to be Munis, Alt-A and CDOs. The concern is that the Fed has shifted the way central banks work in markets, leaving more rooms for moral hazards. However, there are more can the regulators do --- change the game/accounting rule.

According to BBG, the US’ policy makers plan to release today their broadest blueprint yet for avoiding a recurrence of the credit crunch now threatening the economy. Their recommendations extend to nearly every niche in the credit markets -- from mortgage brokers to the Wall Street firms that package home loans into securities, to the credit-rating firms that assess the risk of those securities, to the regulators who police the system. ”Regulation needs to catch up with innovation and help restore investor confidence, but not go so far as to create new problems, and make our markets less efficient or cut off credit to those who need it”…said by Henry Paulson.

I think the key point of all this solutions remains whether the Fed by fixing the financials has fixed the economy. At the end of day, what will inspire real money’s appetite is when US mortgage delinquency growth starts to peak out so that investors start to feel comfort able about the magnitude of loss and how the losses implied by asset prices….. Just be patient as we will soon to find out in coming week on US brokers reporting further provisions for 1Q08. It will remind us that the Fed can help the liability side, but do little to support asset values, if underlying collateral sand cash-flows continue to deteriorate.

China is Below 4000

Chinese stock market (SHCOM=3971) dropped below 4000 today from a peak of above 6000 in October last year. According to Morgan Stanley, the negative impact of a potential market correction could cause personal consumption and GDP to decline by 1.2% and 0.4%, respectively, if the market were to drop by 30% further. I don’t agree with such an scenario because 3000 level will imply that there is basically no economic growth for the past 12 months and forward market PE is only 14-15 times, based on BBG estimates. That seems not like a possible case for a country growing at 10% per year and a continually growing FX reserves.

Having said so, an unofficial report shows that China’s FX reserves have reached US$1,589bn at the end of Jan08, +61.6bn since year-end 2007…We have now1.6 trillion US Dollars… What is going on? Is the export growth softening and RMB appreciating? One possibility is hot money inflows encouraged by the recent pick up in the pace of RMB appreciation. But this may not be true, given the current credit crisis in DMs, still on-going deleveraging process, plus the illiquid CNY trade. A most likely explanation is that much of the outflows from China in Q2 &Q3 2007 are coming back, given the loss of momentum in the HK equity market.

In the other hand, China’s growth momentum is not slow down as recent macro data shows that the average of Jan/Feb retail sales is 10% annualized above the level in 4Q07, and the comparable figures for exports and imports are 33% and 42%. Moreover, broad money M2 growth eased to 17.5% yoy in Feb (vs. 18.9% in Jan), but remain substantially higher than the central bank target of 16%. RMB loan growth trimmed to 15.7% (+16.7% in Jan), but the combined Jan-Feb new lending amounted to RMB1.049tn, about 83% of the quota for 1Q08. Thus, I still do not see the signals of “hard-landing”, given the external weakness and domestic high inflation.

For sure, PBOC will continue to manage liquidity conditions through open market operations and adjustments in RRR, but there is no obvious evidence of continued solid growth in China will prompt accelerated monetary tightening. From the recent speech by Premier Wen, it seems that the senior officers have fully noticed the risks to global growth, while the domestic high inflation is largely due to food prices.

Hong Kong is Softening

Although Hong Kong is anticipating a possible 75bps rate cut next week by FOMC, the city is unlikely to follow as HKMA chief said local lenders have limited room to further cut rates since deposit rate in HK is not very high. Having said so, HK’s recent white-hot property market is also like to cool down due to supply and demand dynamics. According to Sing Tao Daily, supply in the secondary market has increased remarkably with an increasing amount of homeowners and investors releasing their holdings into the market. For example, for sale in the Top 10 benchmark housing estates has risen by 29% MTD vs February, while transaction volume is slowing (from -20% to -50%) and asking prices are softening (range by 3-5%) according property agencies including Midland Realty, Centaline and Ricacorp.

As a result, the street is forecasting Hong Kong GDP growth to slow below 4%, due to softer financial industry (15% GDP) and China’s export growth (from 16% yoy to 8.9% yoy in Feb). Consumption remains be driver, but inflation pressure is rising due to RMB appreciation, rising wage/domestic demand and food & energy inflation. From the angel of domestic influence, China's structural inflation and future path of monetary tightening is the single most important question. If inflation gets out of control and export growth plummets to single-digit level for the whole year, Hong Kong could de-rate to 10-11XPE, as previously seen during the Asian financial crisis, post-telecom-bubble and SARS period...... Oops, HK government today decided to shut down all schools for two weeks to control the further spread of influenza…What is going to be hit, if it turns out to be the real case? Check out that sectors were hit most during SARS, including Retail, Airlines, Hotel and Property… Coincidently, today Hang seng property index dropped 1731ppts (5.96%) and CX also down 4.46%... Mama mia, maybe it is real…Stay tone…

Good night, my dear friends!