Year-End Observations and 2007 Predictions December 12, 2006
Year-End Observations and 2007 Predictions
We
extended holiday greetings to our clients and readers, and wish one and all a very safe, prosperous and happy New Year. Some thoughts on the past year and prognostications on the year ahead.
2007: Credit Risk
& Rising Defaults
The combination of
plentiful liquidity and a mounting shortage of quality assets equates
to declining credit quality for the financial system as a whole, albeit one
masked beneath the high tide of easy credit. One of our favorite
publications, Daily Bankruptcy News, reported a prediction
by vulture investor Wilbur Ross that 7% of junk bonds will be in default by this
time next year. According to S&P, the world wide junk bond default rate in
October was 0.98%. In the U.S., the default rate was 1.27%. Mr. Ross predicts
that defaults will rise �even in the absence of an economic
downturn."
It is interesting to compare
the default rates in junk bonds with the banking sector. Through the third quarter of 2006, the gross
default rate for Citibank NA, the lead unit of Citigroup (NYSE:C), was a mere
96.8bp or about 120bp annualized vs. about 40bp for the peer group (yes, defaults
from Citibank's decidedly sub prime portfolio run 3x peer), according to the IRA Bank
Monitor. The near-term peak in defaults for Citibank NA was 246.4bp in
2002 vs. 145.9bp for the peer group. You have to go back more than
a decade, to 1991, to find a bank loan default rate higher than 2002, 332.6bp
for Citibank NA vs. 251bp for the peers.
Looking at the excesses
visible in the credit marketplace, we wonder: Are US banks set to revisit the
peak in loan defaults illustrated by the data points
above? However, recall that the junk bond default rate was
12% in 1991, thus the prediction made by Mr. Ross regarding junk defaults reaching just 7%
next year is still relatively modest. Good news, even, given
a slowing economy. Applying the same logic to the default rate of
Citibank generates a 2007 default rate around 200bp, still below the near
term peak in 2002 and nowhere near 1991. Is Mr. Ross being too
optimistic?
2007: Interactive Data & Counterparty Risk
Management
After returning from the XBRL conference in Philadelphia last week, our colleagues hosed us down in the decontamination showers and administered
the antidote for electric Kool-Aid overdose. We're doing fine now,
thanks. In the New Year, we will focus some of our efforts on
applying Interactive Data to enhancing the collection and management of
counterparty credit risk. Notice that Interactive Data is spelled with an
"I", not an "X." As IRA CEO Dennis Santiago likes to remind our clients
(as well as our own troops), it's about the business case, not the
technology. Leave the acronyms at the door, please. And
do please contact us
if you wish to
discuss. 2006: Disney + Apple
Reading this week's issue of
Barron's, our friend Mark Veverka still seems to be smarting from the barbs thrown his way by the
bubblistas at CNBC and Sell Side banksters, this after we
suggested in February 27,
2006 Barron's feature that Apple Computer (NYSE:AAPL) and Walt Disney (NYSE:DIS) would eventually get
together. Not only do we still think that this combo makes sense, but we note that
the strong performance of the AAPL PC business in 2006
makes our idea more appealing. While AAPL took a hit along with the other PC makes in Q2 2006, it
rallied to finish the year almost even with DIS in terms of equity market performance -- a tribute to the vision and execution of
Chairman Steve Jobs and his team. Both stocks are currently about even in terms
of market cap, but AAPL boasts twice the P/E -- even though currently it is not timely with the
SEC! And no, we're not worried about AppleDisney alienating the content creators. Remember iTunes? Alone among
the hardware makes, Steve Jobs could make it work. Courage, Mark.
2007:
Market & Liquidity Risk: The Next Regulatory
Priorites
In
a marketplace comprised of less liquid securities, market risk is greater.
As we note in our comment in the latest issue of GARP Risk Review,
regulators are intent upon increasing the capital charge for
market risk for precisely this reason. Look for market risk to supplant
Economic Capital atop of the US regulatory agenda in 2007. To read a copy of the
article in the latest issue of GARP Risk Review,please click here.
With
decimalization and the advent
of electronic trading on the major exchanges, investors and the dealers
which serve them have migrated away from centralized markets and toward
proprietary clearing networks and products. Private equity and OTC
derivatives have several common features, such as less liquidity, wider
bid-offer spreads and greater profits for the most agile
players. Unfortunately, when end-users want or need to liquefy
positions, the bid side is frequently far away from the theoretical "fair value"
used to mark these positions to the notional market. 2006/2007: Basel II/Ia: Delay and More Delay
At the beginning of 2006,
we suggested that the Basel II proposal was in trouble because of bad
political management by the Federal Reserve Board and even less adept handling
of the risk management methodology issues. We regret to say that very
little has changed. With two contradictory proposals out for public
comment -- Basel II and Basel Ia -- we are at a loss to predict just how
this situation will be resolved. The fact that the Democrats now control
both houses of the Congress makes the Basel II proposals and banking issues
generally less of a priority in Washington than in 2006.
We
continue to
believe that the best
path to Basel II adoption is for the US to emulate the processes in motion
around the world and have all US banks adopt the standardized approach of
Basel II, using the publicly available portfolio data from the FDIC
-- the same data that we use for our Basel II by the Numberssurvey. Fact is that the US is ahead of the rest
of the world when it comes to the details of Basel II adoption. Why? Because
of the structured, machine readable financial statement data gathered by
the FDIC. Neither the nations of Europe nor Asia have any standardized, portfolio
level data, public or private, to use for Basel II benchmarking. The good news is that
with the comment period on Basel II extended to
coincide with the Basel Ia process, we have a few months
more to press our case for public data benchmarking.
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