A substantial volume of capital has been raised by various asset managers to capitalize on the imminent or eventual fire sale of distressed assets by European banks and financial institutions. Its going to be a long wait.

Mark Scott writes in the NY Times that the likes of Carlyle, Oaktree, Apollo, Cerberus, Avenue et al are raising billions of dollars in funds seeking to buy loans, bonds and other assets from European financial institutions, but that the great European fire sale has not begun. Here is why.

The European regulators definitively do not want a fire sale by their banks precisely because to do so would burn more bank capital and require further recapitalizations. Absent the risk of total and catastrophic failure, no bank would sell its distressed assets at distressed prices. From a capital perspective, it is more rational to sell performing assets at non-distressed market prices. This is typical in any liquidity crisis, one sells the higher quality assets, because they can be sold more easily and at better prices, and is left holding the poorer quality assets. It exacerbates the situation later down the road but in the immediate time frame, is the easiest, most intuitive, and emotionally inexpensive thing to do.

There was a bit of a fire sale in late 2010 early 2011 as the European sovereign crisis threatened bank failures. The ECB, however, stepped in to provide long term funding to the European banking system in December of last year, both to avert a collapse of the banking system as well as to provide capital to refinance maturing sovereign debt. The effect of this was to remove the near term stress that would necessitate the fire selling of assets. Put simply, fire sales are like amputations; you don’t do it unless there is no choice. And now there is a choice. Sit and wait and hope.

As a result of the above, on a risk and quality adjusted basis, one could say that higher quality assets are underpriced relative to poorer quality assets. The resolution to the European bank’s issues is not clear. Ideally, assets would have been placed into segregated ‘bad banks’ which would require discrete capitalization and would then wind down the problem portfolios. The pain would be shared between taxpayers who would almost certainly be called to capitalize the bad banks, and the bank shareholders would also take a hit from the valuations at which the bad assets were contributed to the ‘bad banks’. Alas, public finances are sufficiently impaired that this route is not viable.

The ECB’s LTROs but postpone a problem for which no solution has been put forward. Neither does it appear that anyone is seeking a long term resolution. Instead we have a stand off between buyer and seller of distressed assets with bid offers of 20% and wider.

It would arguably be better if the ‘bad banks’ were created and allowed to access the LTROs than the current situation where the LTROs support balance sheets with an unknown mixture of good and bad assets, with the uncertainty over the proportion of bad assets and the loss severities overhanging sentiment and thus bank’s access to subsequent capital or liquidity.

In such an environment where there is no segregation of assets by quality, there is an opportunity for privately negotiated bilateral solutions which help provide capital solutions to banks, and maintain the opacity that these banks desire. Such structured solutions typically involve the provision of first loss capital against a pre-identified pool of assets, in return for a hefty coupon usually structured as a senior claim and priced in such a way as to dominate the capital on a net present value basis. The bank then seeks from the regulator capital relief on the defined pool of assets.

Both the LTRO and such capital relief solutions buy time for the banks to either recapitalize directly or structure profitable and capital efficient carry trades to bolster capital.

All of the above discussions still do not present a solution to the debt crisis once the current LTROs mature. The macro economic issues are not the scope of this blog post.

Diversification hides a multitude of sins. The idea of diversification is to ensure that no single investment or risk factor causes a catastrophic and irrecoverable loss. Too little diversification and you become vulnerable to being taken out by a single factor or event.

Too much and you lose control and understanding of your portfolio. If you cannot recall all the line items in your portfolio and the rationale for each position then likely you are over-diversified. Over-diversification can introduce all sorts of unforeseen risks as well since the behaviour of a large collection of instruments can result in complex interdependencies which were not envisaged before. 

Complexity is a double edged sword that is super sharp, has serrated edges and often has no scabbard. In a complicated world the ability to deal with complexity and the willingness to assume complex risks can and does pay handsomely. However, taking on complex risks with poor or no understanding of them almost always results in you paying handsomely. Complexity for complexity’s sake is irrational. Arbitrage and other trades offering asymmetric risk reward characteristics require complex analysis and complex trade construction. However, complex trade construction does not imply attractive risk reward characteristics. In fact, when offered complexity prior to the risk reward proposition, the beneficiary of the complexity is likely your counterparty and not you.

So, an investment product that involves you getting this payoff unless that happens, until this date whereupon you get that, until this other thing happens unless something else happens first in which case you get the worst of the following, until the product is called, is a nice little distraction which should be analysed in the context of ‘what do I think will happen and how do I think the markets will unfold’ and ‘given my view of the world, what is the right trade expression.’ Also, it is amusing and illuminating to ask, ‘well if someone took the opposite side of this trade, what are they trying to achieve?’

Even apparently simple products like, ‘we will pay you so much per day as long as something stays within a certain range, otherwise we pay you nothing, and we may call the deal at par at anytime after such and such a date’ are made up of more basic things like a floating rate note, a swap, receivers, payers, caps or floors, and all sorts of wonderful financial novelty items like that.

If your financial advisor is recommending these cool products, don’t just buy them, ask them what these products are made up of, and what the components are, how each component is priced, how it is all put together, and priced, and who are the counterparties for each leg, how is the counterparty risk managed, how is collateral managed. If any of the answers is ‘I don’t know’ then the appropriate response is to let the great and glaring opportunity pass. Damage is multiple times more difficult to undo than it is to do.

Oh, don’t forget to ask your discretionary portfolio manager the same questions before you give them the discretion to buy these products. Nothing is good or bad, its just how you use them. 

The Euro is a chronic disease. But you can bet on the good days and bad days in Europe as the governments and the ECB sequentially crash and revive the patient.

Spain is a case in point. Its government is financially unviable, its real estate market is terminal, its banks are, with the exception of the international ones, skint, its factor prices are all wrong and its fiscal strategy is misguided.

Fortunately, the ECB will co-opt the banking system to refinance maturing Spanish government debt thus prolonging Spain’s Euro membership and liquidity even while its solvency is indeterminate.

What does this mean?

Well, it means that every so often you can buy a levered structured product called Santander, which does the majority of its business in Lat Am, in Brazil to be precise (its Argentinian exposure is tiny), which basically borrows at cheap rates and lends them either to good private credits abroad, or dodgy sovereign ones at home.

It means you can buy Telefonica, whose bonds still yield close to AAA, but whose equity is a levered cash flow pass through of telephony contracts both in Lat Am and Spain.

It means you can periodically get good assets on the cheap just when fearful investors are dumping, and you can sell it back to them again when markets stabilize and these same investors have their bouts of confidence.

Apply the above to Italy and France as appropriate.

The Euro will be an incredibly rich investment opportunity as long as we recognize a couple of things.

1. As a unified currency, it doesn’t work. Or at least it is destabilizing of domestic prices, and it encourages imbalances to accumulate.

2. European governments are wedded to the idea of the Euro and have equated it with social and indeed martial and strategic cohesiveness.

3. Imbalances will therefore accumulate until they need to be addressed. This will occur cyclically and provide the necessary directional volatility and relative value dislocations.

Don’t let it go to waste.

If anyone believed that the proceeds of the LTRO were meant to be spent buying bonds in the secondary market, they have misunderstood the raison d’etre of the LTRO. The ECB has made available this 1 trillion EUR so that banks may purchase new issues of their respective sovereign debt. They will not be making SME loans, or buying sovereign debt in the secondary market, or other sovereign’s debt within the Eurozone. The ECB is not refinancing the banks; it is refinancing the sovereigns. Once this is understood the high cash balances of the banks with the ECB generating negative cash flow is explained.

The risk of sovereign default is therefore low, at least in the next 12 months. If the risk should rise, the ECB will find some way of helping these countries refinance themselves, either through direct bond purchases at auction or further LTROs. The foregoing is therefore academic but it may be amusing to look at the refinancing risk in the next 12 months anyway.

All eyes are on Spain and Italy. Spain’s 5 year CDS spread is now 510bps, an all time high, rising from 350 bps in early February. Italy’s 5 year CDS is 470bps, from 350 bps in mid March. This year, Spain will need to refinance 46 billion EUR of debt, and plans to issue 87 billion EUR of new debt. Italy on the other hand has 193 billion EUR to retire in 2012 and a planned issuance of 245 billion EUR. Which country would you worry about more?

Well don’t worry. The ECB has been and will be the lender of last resort, directly or indirectly, to the European sovereigns. In many ways, this takes central banking to its roots. The world’s second oldest central bank, the Bank of England was established to fund William III’s military expenditure in rebuilding the Royal Navy.

Singaporeans are obsessive about real estate, much like Americans and Britons were before 2008 burst their bubble. However, while other countries’ housing markets have failed to recover fully, the housing markets of the emerging markets have rebounded and surged past old highs.

What makes Singapore housing special? Housing is all about demand and supply. In Singapore, supply is limited by the fact that it is a tiny island. Demand is dependent on the desire and the ability to buy. A booming economy and overcrowding have fuelled both factors.

There is a two segment market in Singapore, both heavily driven by government policy.

Affordable housing is provided by the Housing Development Board (HDB), which offers subsidized apartments for sale under strict conditions of eligibility and restrictions on the secondary market. At last count in 2010, some 82% of households lived in HDB flats. The HDB’s raison d’etre is creating affordable, quality housing and encouraging vibrant towns and cohesive communities.

Private housing accounts for a small minority, therefore, of households, and represents luxury and high status of its households. Some 11% of households live in private apartments while the remaining 6% or so live in landed properties.

Land supply is tightly controlled by the Singapore Land Authority. HDB supply of apartments is tightly controlled as well.

Singapore housing prices have grown steadily since records were kept in 1966. However, the time series exhibits considerable volatility. 1985 – 1989, 1997 – 2000, 2001 – 2002, and 2008 – 2009 being notable bear markets with drawdowns of 25 – 30%.

The long term drivers of Singapore housing prices include 30 yrs of declining interest rates and the impact on an extremely long duration asset, improving demographics in terms of a rapidly increasing population mainly as a result of an open door policy encouraging foreign talent and wealth immigration, rising wealth and wages of incumbents and immigrants alike, low taxation across income, capital gains, inheritance, consumption and property taxes, easy access to mortgage credit, robust economic growth and a fixed, finite and small stock of land.

The risks ahead include, an end to secular declining interest rates (which impact on such long duration assets is potentially serious), the low level of interest rates which effectively lengthen the duration on assets, the absence of fixed rate mortgages and an overdependence on adjustable rate mortgages, a slowdown in global economic growth in general and in the Asian region in particular, political backlash against government immigration policy which has resulted in proactive anti-housing inflation and anti-local labour displacement policies (such as the additional 10% stamp duty on foreigners’ purchases of real estate, and a tightening of work permit approvals), the advanced age of the Father of the Nation and the transition and political risks when the inevitable happens, the high sensitivity of prices to immigration (in either direction) due to the high proportion of foreigners resident in Singapore (in particular Asian buyers who seek safe haven shelter in Singapore and who thus are especially sensitive to political risks), and space and infrastructure limitations to immigration.

Of the above, the most important driver of property prices are low interest rates and continued strong employment; and the greatest risks to property prices come from rising interest rates and political risks.

Non-financial issues:

While the primary residence has been the most significant source and store of wealth for most Singapore households, it is questionable if household welfare is sensitive to housing values. Even as housing prices rise, replacement values rise, negating any mark-to-market gains since monetizing these gains require the household to replace their primary residence. Sentiment, however, is and should not be underestimated as an economic driver.

As Singapore continues to develop, overcrowding becomes an increasingly important issue with profound implications on society if not the economy. It may be possible
to house an ever increasing stock of humans, however, supplying their subsistence and recreational requirements, as well as transporting them from residence to workplace and other locations is another matter. Already the subway system, the vaunted MRT system has come under pressure and system failures have increased in frequency. Even if infrastructural issues can be addressed, intangible but no less material factors have become an issue.

One can argue that apart from rule of law, security, employment, social security and shelter, a maximum level of population density is a basic human need if not right. Below a certain level of population density, humans seek company (an increase in population density), but beyond a certain level, they seek to reduce it. The threshold is evidenced by increased anti-social sentiment, intolerance of other ethnicities, minorities or other social groups, increased stress levels, and elevated incidence of crime. All of which are manifest in Singapore today.

One could argue that to maintain a certain level of cohesiveness in the community, the government, through its immigration, economic and housing policy needs to target a certain level of population density, both locally and at the national level, a level which has been clearly exceeded by now.

Conventional economics recommends growing the economy by unbounded growth of the population, a strategy clearly impracticable for an island state of such acutely limited land area. Such theories were built in lands where space was not a practical constraint. Even there, concentration issues have rendered the metropolises such as New York, London, Hong Kong, barely habitable. For Singapore, this strategy is not viable in the long run. Moreover, density levels are so close to undesirable levels that the long run is here today.

Fortunately, or unfortunately, population density can grow further still, perhaps by some 20%, with increased investment in construction and infrastructure, before the social externalities render Singapore uninhabitable.