Now we’ll find out if the 20% rally in global stocks was simply short covering and misplaced optimism, or the tentative first steps to a world-wide recovery. You know our thoughts on the matter. But the trouble with inflation is that it distorts choices and causes a man to believe that he can have more than is really possible.
It’s tempting to think you can have a recovery in bank stocks based on one single quarter in which bank earnings were boosted by fixed income trading (front running the Fed in the bond market). But based on the action on Wall Street today (the Dow down 3.5%), investors are having second thoughts about whether the bank’s have returned to profitability for good or just for a quarter.
By the way, before we go further, we should correct a mistake we made yesterday regarding Citibank’s accounting. We wrote, “Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up.” That is incorrect. Instead, we should have said that Citi boosted revenues by $2.7 billion using an accounting adjustment to the market value of its debt.
Our main point was that Citi’s profitability didn’t fundamentally increase in the first quarter. But the accounting rule which allowed the company to present investors with a profit has been around since 2007. Heidi Moore at the Wall Street Journal’s Deal Journal explains in plain English, “The rule is part of the Financial Accounting Standards Board’s FAS 159, which governs the rules under which banks value their debt, including everything from short-term lending to credit-default swaps.”
“Essentially, the rule is a counterintuitive and confusing one. It requires banks to take a gain when the price of their debt falls. The reasoning behind it is this: When the debt declines in value, the banks have to assume at the end of the quarter that they bought the debt back and retired it. The banks would ‘buy it back’ at a lower price, so they get to make a profit. Here’s an example: Imagine that a bank has a bond that was once worth 100 cents on the dollar and is now trading at 60 cents on the dollar. At the end of the quarter, the bank has to assume it would buy that debt back at 60 cents – which is essentially a profit of 40 cents. ”
“That’s what happened to Citigroup in the first quarter. Citigroup had a rough quarter in which investors showed little faith in the bank’s future by widening the spreads on the bank’s credit-default swaps. As those spreads widened, they sent the message that investors believed Citigroup would be less profitable. In a nice twist, the widening spreads also triggered an accounting rule that allowed Citigroup to record a profit. ”
Got that? While we were incorrect to say that Citigroup profited from a bet based on its declining creditworthiness, the whole explanation shows you just how bizarre the accounting rules are, where mark-to-market accounting is used when its beneficial, but fair value accounting is used for assets that are ‘impaired.’ If you’re keen to read more on the subject, try this. And our apologies for yesterday’s error. We’ll be more careful in our accounting discussions from now on.
Meanwhile, back in the world of tangible things, the National Australia Bank is worried about a fire sale in commercial property in Australia. NAB told a Senate inquiry that the Big Four Aussie banks would not be able to refinance $190 billion in commercial property debt without government help. You can find a complete list of submissions to the Senate inquiry here. Or you can just read a few highlights below.
NAB’s submission concluded that, “The four major Australian banks cannot solve the problem, due to industry concentration limits, and increasing capital requirements from credit-quality downgrades…A solution for the liquidity/funding issues emerging in the commercial property industry as a result of the global economic crisis is needed promptly.”
This is a far cry from the old saw that Aussie banks are well capitalised and safe enough to meet the credit needs of the Aussie economy on their own. And on that score, one paragraph that caught our eye was this one from the submission by the Treasury: “While the major domestic banks are well capitalised, they face constraints in terms of the extent to which they could offset a significant and sudden withdrawal of finance from other financiers.”
“The possible shortage of finance for financially viable commercial property assets could have adverse consequences for the ongoing operations of these assets, as well as broader macroeconomic consequences. If borrowers believe there are risks they will not be able to refinance assets, they may de-leverage by selling property, which can then sharpen price falls, and trigger further sales.”
Ah yes. This is the dreaded “fire sale” of deleveraging and forced asset sales in commercial property that everyone wants to avoid. After all, we’ve seen what deleveraging and fire sale pricing did to the stock market. It is no wonder that the submission by the Property Council of Australia is so shrill in this regard. This particular submission says that the, “property sector has a huge exposure to foreign financiers.”
That’s certainly true. Of the commercial property sector’s $165 billion in bank debt outstanding, $30 billion (18%) is sourced from foreign lenders. But for Australian Real Estate Investment Trusts (AREITS) nearly 70% ($16 billion) of $23 billion in debt outstanding comes from foreign lenders. As we’ve been saying all along, Australia’s property boom was bought with foreign money. And now, in a credit depression, there’s a real fear that once the money’s gone, prices will collapse as developers are forced to deleverage and sell.
Or, in the Property Council’s own words, “The Australian commercial property market is significantly exposed to foreign banking finance…foreign banks are already exiting the Australian commercial property market…there is a high risk that foreign banks will continue to withdraw or scale back their exposure to the commercial property sector.”
The submission concludes that the withdrawal of foreign finance from the Aussie commercial property market will have will impact on, “jobs, superannuation benefits, small businesses, housing and social investments, and mum and dad investors.”
They didn’t leave anyone out did they?
The Property Council submission concedes that real estate values are going to fall as the flow of credit to Australia is choked off by the credit depression. But it insists that RuddBank will make sure the adjustment in prices is normal and not exaggerated by forced de-leveraging. It also insists this is not an effort to use the Federal government’s Triple A credit rating to funnel money directly into the property industry and the Big Four Banks. Hmmn.
It’s going to sound like a broken record, but we reckon there’s going to be deleveraging in the Australian property sector one way or another. One by one, the arguments about why it’s different here will fade away. The property market, like the share market, benefitted tremendously from the credit boom. Now everyone wants to preserve those gains with more inflation.
And make no mistake, that’s what all alphabet soup programs across the world are all about: propping up credit bubble asset valuations with the creation of new debt obligations. It takes ever greater amounts of credit to sustain the illusion that these values are, well, sustainable.
But as several readers have begun to note, there’s a diminishing marginal return on each new dollar of debt added to the economy. When you sink this new borrowed money into old financial assets, it doesn’t create anything new or productive. You don’t get any boost to GDP from the new debt. You just get a wobbly old property market that needs ever greater amounts of credit (or a permanent first home buyer’s grant) to keep the bubble from losing air. You might as well burn the money. It would at least create some heat, light, and warmth.
That’s about where we are in the property market right now. In the share market, investors are trying to sort out who wins and who loses when the banks and the government cooperate to inflate. The answer: the banks and the politicians win; the rest of us lose.
The one note of interest this week is how active China’s sovereign wealth fund has been in ignoring the implosion of financial asset bubbles and instead trading paper money for tangible assets. China’s loan-for-oil programme was in evidence this week when it agreed to a US$10 billion loan package to Kazakhstan in exchange for a stake in a Kazakh oil producer. Chinese companies have already concluded similar deals with Brazilian, Russian, and Venezuelan companies.
An article in last week’s London Telegraph speculated that Chinese buyers are using the massive commodities correction to build up large stockpiles of raw materials at discount prices. This kills the proverbial two birds with one stone. First, Chinese companies scoop up commodities at dirt cheap prices. Second, they get rid of their dollars without circulating them back into the U.S. bond market. More on what this means for Australia in tomorrow’s edition of the Markets and Money.
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