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Monday, April 21, 2008

The Race to the Bottom Accelerates

There may have been some confusion over these charts in my last post Citigroup Earnings, Downgrades and LIBOR. Up is down and down is up. The chart is RISING from the bottom left to the top right as rates FALL. To calculate the yield that the front month Eurodollar (XED) contract is implying, you take 100 minus the price. For example, 100 minus Friday's close of 97.09 results in a yield of 2.91%. At the beginning of April, yields were about 2.25%. As you can see the moves late last week have raised yields significantly....

Also notice how the Eurdollar (XED) and LIBOR (LIBOR) track closely. LIBOR is the most important shortest term interest rate and therefore Eurodollar prices heavily off of LIBOR.

Nobody actually expects the Fed to hike rates anytime soon. The fact that short rates have risen quite sharply despite the best efforts of the world's Central Banks is evidence that they have or are losing control...

Depending on where you start, you could argue rates rose by as much as 1% since March. The most important rates in finance use LIBOR as a benchmark, floating and fixed rate mortgages and swaps to name a few.

While still range bound, yields along the entire curve have moved up significantly. The further out on the curve, the more significant the move higher. This is most definitely NOT what Bernanke had in mind when he started cutting. The market is not supposed to take away his rate cuts...

However, in reality it isn't the Fed that sets rates at all but the market. Banks have been unable or unwilling or both to cut their rates on everything from mortgages to car loans and credit cards. Eventually too, traders and investors will demand a higher yield from US Treasuries to compensate for inflation and a declining currency...

So, in yet another desperate attempt to bring LIBOR and all associated short rates back down into their desired ranges:

Bank of England Swaps Bonds to Revive Bank Lending (Update7): “The Bank of England offered to swap government bonds for mortgage securities to kick-start bank lending, with Governor Mervyn King pledging to meet demand even if it exceeds an estimate of 50 billion pounds ($100 billion.)

The measures, backed by Prime Minister Gordon Brown's government, mimic a swap of $200 billion of securities by the U.S. Federal Reserve last month as central banks around the world struggle to prop up financial markets. A surge in borrowing costs prompted U.K. banks to withdraw their best mortgage offers, threatening to exacerbate the worst housing downturn since 1992.”

Well, the TSLF didn’t work. But that obviously isn’t preventing the BOE from employing the same trick. Those of you who watched equities rally over the last week and started toying with the idea that the worst was over, better think again. Would this really be necessary NOW, if the worst was over? Perhaps things have deteriorated further… to the point where the BOE has finally decided to try something, anything else.

The race to the bottom continues…

Stocks `Fire Sale' Burns Investors as Debt Costs Rise (Update1): “A stock market fire sale at the cheapest prices in 13 years is burning investors as companies turn away from the highest credit costs in more than a decade.

Corporations in the U.S. and Europe must repay $1 trillion in debt maturing this year, the most since 2000, data compiled by New York-based Citigroup Inc. show. As the cost of borrowing for investment-grade companies climbed to 2.35 percentage points above government debt in the past year, firms such as Wachovia Corp., Wesfarmers Ltd. and Imperial Energy Plc are selling shares for an average 14.7 times profit, Bloomberg data show. That's the lowest since at least 1995.”

I don’t need to tell you that this CAN’T end well under the current conditions…
So how will the companies of the world deal with these problems? Well, simply put, they will issue shares like you won’t believe…

“Businesses have sacrificed shareholders as the cost of paying dividends decreased to a six-year low versus interest on bonds. The difference between the extra yield investors demand to buy investment-grade bonds from companies tracked by New York-based Merrill and the dividend yield of stocks in the MSCI World Index narrowed to 0.4 percentage point this month, from 1.42 points a year ago.

The last time paying dividends cost the same as bond interest was in December 2000, preceding an increase in new shares issued in the following 12 months, data compiled by Bloomberg show. The same increase now would put almost $800 billion of new equity in global markets in the next 12 months as cash-strapped companies tap investors to repay debt and fund operations.”

Just what struggling longs need eh? Can you say MASSIVE dilution? … and it isn’t gonna be cheap!

“After the worst quarterly decline in the MSCI World Index since 2002, investors are less willing to risk money on corporate earnings than at any time since at least 1995, measured by the gauge's price-earnings ratio. Investors paid an average of $14.71 for every dollar of earnings generated by the 1,940 companies included in the stock benchmark last month. A year earlier, investors paid $17.09 per dollar of profit.

That may force companies to sell larger stakes to make up for financing shortfalls. Banks and brokerages, whose balance sheets have been the hardest hit by credit market losses, have raised or announced plans to seek at least $163 billion in capital since July.”

The equity discount is going to hurt existing shareholders. Major long term shareholders know if their core holdings are likely to have to raise additional capital in the near future. It would therefore make sense for them to reduce their positions now and then just participate in any offering, which would be at below market prices, to quickly and cheaply rebuild their original long positions.

Therefore, expect quite the tsunami of supply as long term equity holders attempt to exit before the companies can attempt to raise additional equity. This does not bode well for equity prices.

Related Posts:
The South Sea Bubble and Today’s Central Banks: FRB, BOE, ECB
Dammit, Why Won’t You Learn?
The TED Spread, LIBOR and EURIBOR = Scary Bad
Mortgage Insurers (Quietly) Downgraded: CDS Spreads Scream Trouble


Ben Bittrolff said...

An interesting post that explains the effects of LIBOR in far more detail than I have time for: Price Fixing, LIBOR and You or Woe be those who are in Debt

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