The Sun God And Other False Deities
I present some "theological" musings compliments of JP Morgan.
The Sun God
Ancient sun worshippers were mostly unaware of the astronomical forces at work guaranteeing that the sun would rise every day, whether they offered a sacrifice or not. It reminds me of part of the fanfare being given to recent economic data. There's no doubt the news is improving: U.S. regional manufacturing surveys picked up sharply (particularly new orders and even ISM employment); profit declines are mitigated by a record-low 2.1% growth in employment costs; and consumer goods purchases are running ahead of production enough to lead to a production bounce later this year. The best way to visualize the healing: a global measure of manufacturing orders-to-inventory is almost back to normal, as is a measure of inter-bank counterparty credit spreads.
But after $2.7 trillion of asset purchases, guarantees, DIP financing, swap lines, municipal transfers, direct aid to industries and other stimulus injections in the US alone, what did the sun worshippers expect? The world had BETTER start seeing positive payback. To put the rescue mission in context, here's the March 30th EOTM chart which compares the current recession response to prior ones. The Sun deities show the current policy response, and where it's headed for 2010. Even "bad" recessions in '57, '73 and '81 never saw anything like this. Markets may one day have to deal with the costs of this response as well as the immediate benefits.
On Commercial vs Residential Real Estate Markets: Are We There yet?
Some ask whether it's too early to invest in commercial real estate debt via CMBS: "hasn't the commercial real estate crisis just begun?" Residential mortgage markets went through stages of denial, anger and frustration before finally pricing in a catastrophic deterioration in delinquencies and salvage value. As seen below, there were several false dawns for subprime before it reached its current resting place at 30-35 cents on the dollar (2006-vintage AAA subprime paper). What about CMBS? Last summer, it was pricing in a more optimistic outcome. But the Lehman bankruptcy exposed the frailties of the real estate markets when their $40 billion portfolio of industrial, office and multi-family loans was subjected to price discovery. CMBS markets promptly collapsed in October, as shown by the convergence below. So while some banks, insurance companies and REITs may still cling to outdated valuations on commercial property, the same cannot be said for CMBS markets.
Here's another way to compare these two securities at 35 cents on the dollar. Let's use our best guess of Fed Stress Test loss assumptions, and the specific credit enhancement and structural loss-sharing rules for each (too detailed to summarize here). In both cases, the loss-adjusted price is around 50% on the dollar. The timing of repayment is uncertain, which is why they trade at steep discounts. For the record, our managers prefer the risk-return of securities much higher up in the capital structure than the examples in the chart, whose prices have rallied a bit from their March lows. The exhibit is simply meant to convey that similar levels of bad news are
priced into both markets.
hat tip Mike