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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 ´┐Żeven 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 Numbers survey. 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.

Questions? Comments? [email protected]


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