Archive for April, 2009

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Small loan losses can wipe out banks

Thursday, April 30th, 2009

This week, Australian banks are confessing to profit downgrades. One of the chief reasons for reduced profit is the rise of bad debts. Also, banks are setting aside greater provisions for bad debts. That is, as we wrote before in Is a bank safe if it makes good profits?,

… banks will guess how much of its loans will default or be delinquent and apportion a small fraction of them as an expense. But until debt defaults really happen, a guess is just a guess.

Now, as you read the mainstream media, you may see positive spin being painted for the bad debt provisions by comparing their ‘miniscule’ size with the size of the entire loan portfolio. For example: “$1 billion of provisions for bad debt is only 1% of the entire loan portfolio.”

Well, small size (of bad debt provisions) can be very deceiving! Why?

Remember the concept of capital ratio that we introduced in Introduction to banking corporate accounting? Let’s say a bank is leveraged 25 times, it means they have a capital ratio of 4%. In this case, if 1% of their loans go bad, 25% of their equity are wiped out. If 4% of their loans go bad, the bank is completely wiped out and is insolvent.

Australian banks are more leveraged than their overseas peers, according to Brain Johnson, the former bank analyst of JP Morgan (see How safe are Australian banks?). So, a small proportion of loans going bad can have a more than proportionate impact on the bank’s balance sheet due to leverage.

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Posted in Analysis - Business | 10 Comments »

How well will stocks do in times of high inflation?

Tuesday, April 28th, 2009

As we all know, governments all over the world are engaging in expensive and wasteful bailouts, stimulus and printing of money. Naturally, this resulted in many investors being worried about the long-run impact on price inflation. Already, contrarians like Marc Faber, Warren Buffett and Jimmy Rogers are making the high inflation call.

Investors are scrambling for ways to hedge against high inflation. One of the asset class being considered to do that job is stocks. Indeed, Zimbabwe is a great example of the world’s ‘best performing’ stock market in the midst of hyperinflation (see Zimbabwe: Best Performing Stock Market in 2007?). In a hyper-inflationary economy, earnings can soar in nominal terms through the sheer force of price inflation. Therefore, stock prices will definitely rise in nominal terms.

So, should you rush out to buy any stocks if you are worried about hyperinflation in the future? Before you do so, take note of these points:

  1. A hyper-inflationary economy is in deep trouble. Unemployment can be very high (e.g. the stagflation of the 1970s, 90% unemployment rate in Zimbabwe), many businesses will fail and there will be social problems. You will likely witness depleted store shelves as there will be shortages of goods. Therefore, in such economic environment, not all businesses will survive. This means that many stock prices are going to be zero. You will not want to buy into one of them.
  2. Our theory is that in hyper-inflationary times, while stock prices can go up tremendously in nominal terms, their price-earning (PE) ratios will decline. The reason is not so much due to earnings growth expectation. Instead, it will be due to higher discount rate applied by the market. Remember back in Quantitaive demonstration of the effects of price inflation on your investment, we showed you how high inflation can easily make a mockery of your investment returns if you apply a discount rate that turns out to be far below the inflation rate. Historically, the rate of inflation for hyper-inflations increases exponentially. This may translate to higher and higher inflation expectations, which result in higher and higher discount rates, which in turn imply lower and lower PE ratios.

Zimbabwe’s experience shows that in nominal terms, stocks are great investments. But in real terms, their performances are very restrained.

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Posted in Investor Education, Looking Forward, Market Observations | No Comments »

Hunger for natural resources in Tibet

Sunday, April 26th, 2009

Last month, in Nations will rise against nations, we mentioned that

Therefore, outwardly, the world may be at peace. But inwardly, we believe there will be jostling for power, influence and resources between the major nation blocs. Bigger nations will use smaller nations as pawns, international armed non-state groups will intensify their activities and inter-ethnic conflicts will arise.

Tibet is a political hot potato issue for China. Passions are hot on both side of the political divide. Tibetan-independence activists are present in many countries, with numerous accusations of human rights violation and holding demonstrations all over the world. The common Chinese people on the other hand, cannot see what the fuss is all about. In fact, many of them are genuinely surprised at the anti-Chinese passion regarding the Tibetan issue.

Here, we do not have any opinion regarding Tibet because we do not understand the issues enough to comment about them. But we have this to say: China is most likely to hang on to Tibet at all cost. The reason is simple- Tibet holds a vast reserve of natural resources that have yet to be exploited. Given that Tibet is one of the world’s least habitated, remotest and most untouched area in the world, it is one of the few ‘virgin’ areas on earth that can still yield massive rewards for nations who can tap into its vast natural resources. Since China is clearly going to need vast amount of natural resources in the decades to come, it will defy international opinion and hang on to Tibet.

As this article says,

In 1999, the Chinese embarked on a secret, seven-year geological survey that found 16 major deposits of copper, iron, lead, zinc and other minerals. Tibet is believed to hold as much as 30m-40m tons of copper, 40m tons of lead and zinc and more than a billion tons of high-grade iron ore.

What is the catch for China?

The commodities are there, under the ground, but to dig them up in this vast inhospitable region is not going to be easy. As we mentioned in Real economy suffers while financial markets stuff around with prices, producing metals is a highly capital-intensive activity, which include

Construction of nearby infrastructure (e.g. roads, railways, power stations, development of water supplies and townships) due to the remoteness of mining projects.

These developments will take many years. The Chinese may even need foreign expertise and investments to do so. Therefore, there is little wonder that China is developing Tibet (including the engineering feat of constructing a rail link to Tibet). Whether that’s good for Tibetans or not is not for us to say.

For us in Australia, if Tibetan natural resources are fully exploited by China, there will be less demand for our iron ore.

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Posted in Commodities, Geopolitics & Politics, Looking Forward, Market Observations | No Comments »

Fixed vs variable mortgage rates?

Friday, April 24th, 2009

One of our readers have this question to ask in the forum:

Hi, I am looking at buying a property in the next 6-12 months and was wondering what everyone’s thoughts were regarding fixed vs variable rate mortgages. With interest rates quite low at the moment do you think I would be better off locking in a fixed rate for the first year (or five), particularly with the chance of inflation rising in the near future?

I understand that any comments posted here are not to be considered financial advice but hope that this can generate a little bit of discussion.

Cheers

Everyone is welcome to discuss this question at the forum.

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How are governments driving up fixed mortgage rates?

Thursday, April 23rd, 2009

Newton’s Third Law of Motion says that for every action, there is an equal and opposite reaction. Likewise, in the field of economics and finance, for every government intervention in the financial market, there is always a side-effect (some of them will be unintended).

As Marc Faber reckoned, the bull market for long-term government bonds, which started in the 1980s, has come to an end in late 2008, with a tentative rising trend of long-term government bond yields. With the private sectors all over the world de-leveraging (unwinding of debt) in an unprecedented scale from an unprecedented credit bubble, governments will be forced to fill the slack via bailouts and stimulus. As our of our concerned readers pointed out the government’s “spend, spend, spend” slogan in Can government create jobs?, government budget deficit will be a rising trend all over the world.

Consequently, government borrowings will have to increase (or taxes raised and/or money being printed). In a world where credit is scarce, government demand for credit will make it even scarcer. If the government resort to ‘printing’ money (issuing government bonds from thin air to be sold to central banks who created money from thin air to buy them), concerns about rising long-term government inflation will force long-term government bond yields to go up. As a result, this will result in a trend of rising long-term interest rates.

As fixed rate mortgages tend to follow long-term interest rates, banks will be raising their fixed mortgage rates too.

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Posted in Looking Forward, Market Observations | 8 Comments »

Rumours of China diversifying their US dollars

Tuesday, April 21st, 2009

Back in January 2008 (15 months ago), we wrote in Why did the foreigners bail out cash-starved financial institutions?,

China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.

The US is ‘printing’ their dollars into existence from thin air to fund their stimulus and bailouts at a time when the credit-worthiness of their financial system flounders in a deteriorating economy. Needless to say, the Chinese must have doubted that their hoard of US dollar reserves will function as a reliable store of value in the days to come. So what can they do? As we wrote twelve months ago, in What if the US fall into hyperinflation?, we wrote,

Since a collapsing US dollar means terrible unimaginable consequences, we expect countries like Europe, China, Middle East and Russia to be doing something quietly in the background. But it is not easy because if they do so in a hurry, there will be severe disruption in the financial markets, turning a US dollar rout into a self-fulfilling prophecy. What can these countries do? We see two major courses of actions:

  1. Slowly and quietly diversify away their US dollar reserves.  Obviously, none of these countries will be doing so while talking about it with their megaphones- the US dollar will crash straight away if they act so foolishly.

Today, we are hearing of rumours among mainstream economic commentators that the Chinese are buying up commodities (notably copper) as a means to diversify away from their US dollars. Not only that, there is a recent trend of the Chinese buying up stakes in resource companies (Rio Tinto, Oz Minerals) and spending money on resource investments all over the world (including Africa and South America).

Not only that, the Chinese are setting up currency swap agreements with their trading partners so that their yuan could be directly used for trade instead of using the US dollar as an intermediary. Some commentators are speculating that this is a Chinese scheme to set up their yuan as a world reserve currency.

In the months and years to come, the Chinese’s intention will become clearer. This will not be good for the US dollar. But if other countries are also inflating their currencies in order to fund their budget deficits, bailouts and stimulus, then the devaluation of the US dollar will not be apparent. Instead, it will show up as rising gold and commodity prices and the return of price inflation.

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Posted in Looking Forward, Market Observations | 6 Comments »

Is a bank safe if it makes good profits?

Sunday, April 19th, 2009

The masses dislike the banks immensely. In Australia, we read news report that the banks’ profits were higher today compared to last year. The masses surmised that since their profits have increased, they must be doing well. In addition, some of those who are very optimistic about Australia’s banking sector will cite the increased profits as the basis to support their optimism.

So, just because a bank is making good (and rising) profits, does it mean it is safe? The short answer is “No!”

Remember what we said in Banking for dummies, we said that

At its very core, a bank borrows money at lower interest rates and lends them out at higher interest rates. Its borrowings are its liabilities while its lendings are its assets. When you deposit your money into the bank, your money is the bank?s liability but your asset. In accounting technicalities, your money goes into the bank?s balance sheet as an asset with a corresponding liability.

…

As we said earlier, a bank profits by taking a cut between its borrowing and lending interest rates. If it keeps too much deposit money in the ?vault,? it is money that is not put in productive use and thus, have a negative impact on its profits. On the other hand, lending money out entails risks of debt default.

Basically, all a bank has to do to increase its profits is to lend more money! This increase in profits is highly visible in the profit and loss statements. But what is much less visible is the increase in debt default risks of its loans. Typically, banks will guess how much of its loans will default or be delinquent and apportion a small fraction of them as an expense. But until debt defaults really happen, a guess is just a guess. If their guesses are wrong by a long shot, the result will be asset write-downs, which will result in unexpected losses.

Assuming that Australia is going to face a serious bout of debt deflation soon, we can imagine many of the banks’ guesses will be revealed as laughable underestimates. Even if the banks realise today that their guesses are way off from reality, we can imagine that they will be loathed to confess because that will imply huge profit downgrades.

The Australian government better warm up their monetary printing press to be ready for the activation of their bank deposit guarantees, just in case.

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Posted in Analysis - Business | 12 Comments »

Central banks helping to increase your insurance premium

Wednesday, April 15th, 2009

Insurance is one of the easiest businesses to understand. Basically, it earns money this way:

  1. Collect insurance premiums
  2. Invest the collected premiums (in insurance jargon, this invested money is known as floats)
  3. Pay out insurance claims

Where are the areas that can go wrong with this kind of business?

One possibility is that it may miscalculate the probability of mishaps and mispriced the insurance premiums charged to customers. As a result, claims on the insurance company overwhelms its ability to pay. The Australian government’s guarantee of bank deposits and funding is akin to providing insurance to the Australian financial system. But as we said before in Australian government?s contingent liability to exceed AU$1 trillion, if the mishaps in the financial system are correlated with each other, the Australian government may find that it has burned a big hole in its pocket. For insurance companies, at least they can buy re-insurance to insure itself from such fiascos. The Australian government, on the other hand, have no re-insurance to insure itself other than the monetary printing press.

The other possibility of what can go wrong can occur when it suffer severe losses in its investment endeavours. That can happen when the investment divisions of insurance companies decide to become cowboys and get involved in sexy derivatives, as in the case of AIG. The more prudent ones keep a substantial portion of its investment portfolio in safe bonds and other fixed interest securities. That’s where central bankers are not helping. By cutting interest rates to below price inflation rate, the investment returns of insurance companies get eroded. Along with rising value of claims due to price inflation (e.g. rising health care costs for health insurance), their profit margins get squeezed, sometimes so severely that they can suffer losses.

So, guess what insurance companies will do in that case? They raise the premiums that all of us pay. Cutting interest rates may be good for borrowers, but as everything else in life, there is no such thing as a free lunch.

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Posted in Analysis - Business | 2 Comments »

Answer to quiz: error in long-term gearing

Monday, April 13th, 2009

In Reader quiz: spot the error in long-term gearing logic, we asked our readers to spot the common error in a long-term gearing logic. Today, we will give a full explanation of the answer. Our readers offered many good answers that you will do well to take note of. But for this explanation, we will concentrate on a most frequently made error in logic. For this, we will expand on what one of our readers, Pete, said,

– margin loans act as leverage to increase gains…or potentially increase losses
– David point 2 mentioned margin calls – these hurt a lot.

This is the most important point that any investor who is considering gearing should paste on to his/her forehead. We have seen investors applying this error because they were retiring and were afraid that they wouldn’t have enough to do so. It is precisely that they are retiring that gearing should be avoided.

Assuming that in the long run, asset prices will be higher due to inflation, what can go wrong if an investor used gearing to maximise the effect of long run capital appreciation? The problem is that asset prices do not go up in a straight line. This is especially true if the investor bought the asset at bubble prices (e.g. before the panic of 2008). In the short-run, asset prices can suffer major correction. During bubble prices, when the risk of a major correction is at its highest and investors’ optimism at its peak, applying this logical error on one’s investment can result in devastating losses. When the price correction occurs, losses are magnified and the investor’s equity can get wiped out. Then subsequently, when asset prices recover, the investor will not have the equity to take advantage of the upswing. Even if the investor has the equity to take advantage of the upswing, so much capital had already been lost that the overall return in nominal terms can still be negative. Even if positive nominal return is achieved after many long years of waiting (that can test the patience of most people), the investor can still lose money in real terms.

For those who used geared managed funds (that is the managed fund is internally geared and the loan has no recourse to the investor), wild market swings can result in some of these funds being completely wiped out (i.e. value goes to zero).

Such fallacious thinking is the reason why clients of Storm Financial were wiped out financially. It is criminal that the so-called financial experts who provided such ‘advice’ could not see this. Unfortunately, the financial panic of 2008 had taught this lesson to many investors the hard way. In Australia, there are still some property investors who have yet to wake up.

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Posted in Investor Education | 2 Comments »

Reader quiz: spot the error in long-term gearing logic

Thursday, April 9th, 2009

Today, we will try something a little different. Instead of doing the talking, we will pose a little investment quiz and let our readers do the talking. So, here it is…

Consider this flow of logic:

  1. In the long run, due to inflation, the price of assets (e.g. property, stocks, managed funds) will appreciate.
  2. Gearing (e.g. margin lending, line of credit, investment loans, geared managed share funds), will magnify the returns due to price appreciation.
  3. Therefore, one should use gearing to maximise one’s long term wealth

Long time readers of this publication may have already spotted the error in this flow of logic. But we have come across many people who are close to retirement applying this logic on their retirement funds!

So, our question to our readers are: what is the error with this logic?

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Posted in Investor Education | 26 Comments »

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