Monday, December 29, 2008

Oil: Canada's version of the US housing boom

Canada’s version of the US housing boom has been the Alberta oil sands boom. This has resulted in various investors and oil companies flocking to Alberta, and along with them, thousands of migrant labourers looking to secure one of the lucrative jobs the boom created. Now, the floor has collapsed under the great oil sands bonanza.

Project after future project has been shelved or slowed down until, according to the companies, plunging oil prices stabilize and financing starts to loosen up.

For at least another two years, and probably more, Fort Mac will no longer be the dream factory for ambitious young men and women from elsewhere in North America. It won't be the escape valve for frustrated workers in areas short of jobs and long on shuttered factories – places like northern Nova Scotia and central Ontario.

Just as the global economic boom was driven by China, the Canadian economic expansion of the past decade was fired by northern Alberta. Now China is talking about 8 per cent growth, not the 11 per cent-plus of past years, and Fort McMurray is talking about more “normal” growth built on operations, not massive capital spending.

This may not be so bad for the “core” oil sands workers, but this will have serious repercussions to the rest of the Canadian economy going forward.

The oil sands will no longer be the strong shoulders that carry the economy. With the price of oil below $40 (U.S.) a barrel, as current construction projects finish up there will be no immediate plunge into Phase 2 expansions….. and that will cool activity in and around Edmonton, including in the hectic oil sands manufacturing centre of Nisku south of the city. And with the cancellation or delay of future capital projects, what once amounted to 24,000 mobile workers' jobs in the oil sands are now in jeopardy.

The shadow work force is in danger. ….if the downturn is not catastrophic for Fort Mac, it is devastating for many communities that have been exporting their young men and women to the oil sands – places like Marystown, Nfld.; Donkin, N.S.; Prince Albert, Sask.; and Wainwright, Alta.

In fact, the end of the oil sands boom could most seriously hurt the rest of Alberta, which, according to the Oil Sands Developers Group, an industry association, typically generates 52 per cent of the mobile work force in northern Alberta.

In the past, rural communities could export their labourers, but they would not lose all the purchasing power. The normal routine for mobile workers is to spend 20 days in Fort McMurray and go home for 10 days, which means they can still buy new ATVs, pickups, and widescreen TVs in their home communities.

A lot of that income will dry up now, as will the wealth transfer to the rest of Canada. Assume the average mobile worker might bring home $25,000 in surplus cash to spend at home in Fredericton or New Glasgow, N.S. Those 24,000 jobs could potentially channel more than $600-million a year from Fort McMurray to the rest of Canada – or to Latin America and China, which contribute a small percentage of oil sands labourers. And that's not counting the vast oil sands supply chain of equipment and materials.

It is one of the best equalization mechanisms outside government transfers. But now the workers will be coming home and putting pressure on their home economies. Young men and women had put education on hold while grabbing six-figure incomes in the sands. Now, there will be increased demand for schooling and retraining.

What a difference seven months makes. Back then, I thought Alberta’s growth offset, and probably contributed to, the manufacturing downturn in the rest of Canada. Now, demand destruction has spread the economic downturn to a much broader area of the economy. This seriously undermines the government’s capability to finance a broad-based stimulus.

Will asset sales, such as of these oil properties, to those still left holding some money (Sovereign wealth funds from China/Asia?) finance the stimulus?

Friday, December 26, 2008

Will quantitative easing lead to more bank lending?

Aggressive monetary policy, such as quantitative easing, were meant to make banks lend. The Fed is supposed to put so much currency into the system that holding onto cash becomes uneconomic.

But banks do not merely look at yields when deciding whether to lend. They look at a borrower’s credit.

This unraveling recession is changing a lot of business assumptions, many made only a few months ago. What just a few months ago seemed to feasible now no longer are. What just a few months ago are financeable now no longer are.

As long as businesses stand to lose more customers, as more customers stand to lose jobs, and as more goods stand to go unsold, borrowers’ credit are going to deteriorate.

Banks will not lend if businesses are no longer feasible. The solution to the lack of bank lending has to be increasing aggregate demand. Quantitative easing may only debase the currency, which will make financing fiscal deficits more difficult.

Similar-themed post here.

Monday, December 22, 2008

Can there be a private sector solution to creating demand in a crisis?

The capitalist system is very attuned to the needs of the market. It is an efficient system in reaching the goals of 1) providing the most number of goods possible for those willing and able to pay, and 2) providing the goods and services at the lowest possible price.

In an economic downturn, these two goals are still relevant, and in fact, become even more important to attain. A downturn, however, can make it more difficult, if not impossible, to achieve a third goal – provide a viable livelihood for the greatest number.

Hence, in an economic downturn, where there are less people willing and able to pay for goods and services, and willing to do so only at much lowered prices than usual, market stability may settle at a level that sustains employment for a fewer lucky people. This is a group who, by their current demand levels, can only support economic activities to sustain this same smaller group.

The capitalist system also favors those who already have capital. During uncertain times, money can be hoarded by those who already have it, thereby creating a destabilizing halt to economic activity. Those whose livelihoods depend on the continued investment of capitalists (i.e. all salaried workers) are left at the mercy of ever-increasing economic hardship. This leads to even less able consumers, and more uncertainty to businesses in general.

This is where Keynesian policy prescription usually comes in. Keynes advised that government investment come in and take the place of the lowered private investment, and that government spending should increase to take the place of decreased private spending. In this way, you increase over-all income to once again jumpstart private consumption and investment.

But is there a private sector solution to the crisis?

Right now, no one wants to move first in injecting needed cash to the economy, for fear that nobody else will follow. Could the private sector solution involve local companies engaging in quasi-barter trade with each other? Or paying via in-kind currencies? For example, we can have businesses paying employees via credits that can be used by consumers to buy/pay for services of other local producers. So in essence, in an economic downturn where actual cash flow is scarce, demand is created by empowering cash-starved businesses to pay employees and suppliers in some 'credit principle' that other businesses will then consider acceptable form of payment.

I don’t really know how this type of arrangement can be made to work, but if it can, it will work only if enough businesses participate. The world is now more globalized than ever before, and this solution would again only be possible if an economy has enough industry diversity to be self-sustaining on its own, otherwise the arrangement will need to be global in scope. So could a private sector solution involve a reverse-globalization?

By far, the simpler solution seems to be the government solution. Unfortunately, not a solution for countries low on reserves.

Friday, December 19, 2008

Deutsche tier 2: Is a bond issuer beholden to investors to exercise a call option?

Deutsche Bank’s decision not to exercise a call on its tier 2 bonds is inciting a significant number of negative comments from investors.

FT Alphaville reports: The notes in question are €1bn worth of 3.875 per cent 2004/2014 subordinated bonds. The market had been expecting Deutsche to call these notes, at par, at the first available date - January 16. That’s what banks do with such lower Tier 2 capital notes - redeem and re-issue on a regular basis.

Or at least that’s what banks used to do. On this occasion, Deutsche is allowing the bonds to turn into floating rate notes, paying three month euribor +88bp.

Bloomberg writes: The bank’s choice “will weigh on the markets for months,” said Andreas Fink, a Frankfurt-based spokesman for the BVI German Investment and Asset Management Association, whose 92 members oversee about 1.4 trillion euros of assets. Europe’s biggest investment bank said Dec. 17 it won’t redeem 3.875 percent bonds due 2014 at their first call date next month.

My take on it is that Deutsche Bank’s action arises out of a rational economic decision. Despite a penalty mechanism that will increase its bond premiums starting from initial call date (if uncalled on said date), the increased penalty rate is still significantly lower than what it would have cost the bank to call the bonds and refinance at current market rates.

Deutsche Bank had the option to buy back the notes on Jan. 16 or pay a so-called step-up coupon of 88 basis points more than the euro interbank offered rate, or Euribor, the statement said. Three-month Euribor, a benchmark for borrowing between banks, was 3.082 percent today.

The extra yield investors demand to buy financial company bonds climbed to a record 4.83 percentage points more than government debt, according to Merrill Lynch’s European Financial Corporate Index. That compares with a spread of 1.28 percentage points at the start of the year.

Investors warn that Deutsche’s decision sets a bad precedent, and increases the likelihood that other banks would follow their example in not repaying so-called hybrid-capital bonds.

Investors claim Deutsche Bank’s decision “sets a precedent” for other banks to skip calls, analysts at Societe Generale SA in London wrote in a note to clients.

But in finessing its funding costs, Deutsche has seriously spooked the fixed income market. Is this an invitation to all other banks to avoid redemptions where ever possible? What about Tier 1 notes - are redemption conventions going to be broken there too? Should the whole market be pricing in a new level of “extension risk”?

I have a beef against investors who are questioning Deutsche Bank’s decision not to call the bonds. The bond’s terms clearly indicated that they will mature in 2014, but that the bank had the option to call it in 2009. Clearly, something is amiss if investors did not take into consideration the possibility, however, little at the time of offering, that Deutsche can decide to maintain the bonds until maturity.

Clearly, these same investors would have been perfectly happy had the situation been reversed - if Deutsche had priced the bond just before rates went down. They would have been justified in asserting that Deutsche keep its agreed rate. But now that rates have gone against the investors, meaning keeping the original agreement is now more favourable on Deutsche’s part, they still want Deutsche to exercise its call option. What rational manager would do so? After all, the call is only that, an option on Deutsche’s part.

“This is a setback for the stabilization of banking markets and is likely to increase funding costs for banks generally,” Jonathan French, the London-based spokesman for the Association of British Insurers, said in an e-mailed statement to Bloomberg News.

Not necessarily. The fact that rates are now steep for new issuers should already be indicative of the market’s current sentiment. And this is precisely the reason that Deutsche prefers to maintain its bonds at the originally agreed penalty premium rather than refinance in this market.

Investors should value securities offerings based on their intended maturity, not on their expected call date. Deutsche’s move does not add “extension risk” to the market, it merely removes the investors’ perceived “early liquidity premium”. Now I’m sure this ‘early liquidity premium’ was never considered when the bonds were originally priced, and there is equally no reason for similar instruments with upcoming call dates to now trade with ‘extension risk premiums’. Surely, investors should have seen this coming, when market rates moved significantly above Deutsche’s penalty rate.

FT Alphaville fears that: One more point: if a bank like Deutsche is finding the pain of funding acute enough here, it may only be a matter of time before bank issuers start opting for coupon deferrals to limit their outgoings further.

Now coupon deferral is a different matter. When banks start reneging on agreed-upon coupons, the market will really be in for a major battering.

Tuesday, December 16, 2008

Quantitative easing and asset bubbles

The Fed’s quantitative easing moves are lately getting more attention. Rebecca Wilder gives a good summary description for quantitative easing. Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.

The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%. The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).

Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

More asset bubbles are the likely consequence of this easing. When the economy improves, this new currency will likely move back into commodities, perhaps the equity of commodity companies will also benefit. Increased lending activity (QE's intended result) will perhaps be focused on this narrow area also. Will Bernanke know at what level we are again in a bubble? Will anyone?