Global Economy: Credit Crisis and Interest Rates

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Dear Property Buyer.com.sg, what is your view of the current credit crunch and Share market crisis? How Long will it last?

Nobody can accurately predict the market as there are too many factors involved in current day economic analysis.

However I do know that Warren Buffet has started taking bigger stakes of his favourite companies. He has also struck a very favourable deal (to Berkshire shareholders) to buy a stake in General Electric (GE). For those who is not familiar with Warren Buffet, he is known as the world’s richest man and an astute investor who buys great companies at dirt cheap valuations. Some of these companies that Warren Buffet were looking at were fair-valued to begin with, trading at low Price/Earnings (P/E) ratio with moderate growth of above 10% and trading close to book value. And the quality of their book value assets are generally considered "high quality assets". With the market falling due to massive selling pressures, many good companies are trading at ridiculously good prices and are very "Under-valued" and Warren Buffet is starting to take bigger bites of such good bargains while everyone is afraid of entering the market. (With the credit crunch, many hedge funds, corporations, banks, etc, those who have over-extended themselves are facing serious problems when the assets they hold are now worth less than the value of their borrowings. Technically, they are bankrupted on paper. Once their debtors start to realise that these companies are basically insolvent, they started to recall the loans setting off a chain reaction of asset selling. All assets, no matter good or bad are being sold into a market with very little buyers. The chain ripples on.)

So generally when Warren Buffet buys, the market views it as a positive indication. However a note of caution, he has holding horizon of 3 to 10 years, do you have the same investment time horizon?

Will the USA’s government US$700 billion rescue fund stop the stock market from falling? Will the stock market continue to fall?

Again, I do think that the major economies are slowing down. The market should have a bit more to fall before stabilising. The US Government US$700 billion rescue fund to buy up toxic assets will not immediately prop up the economy at large. Companies that were over-leveraged (borrowed too much) will continue to go under. More assets from such companies will be sold for liquidation. Even companies that survive are selling their assets to raise capital to reduce indebtedness. A cycle of de-leveraging has already begun and will continue for the near term. De-leveraging typically means a reduction of liquidity and hence reduction in prices.

So what will the US$700 billion do if it isn’t going to stop the market from dropping?

The US Government’s US$700 billion rescue fund will buy up toxic assets (such as Collaterised Debt Obligations of Sub-prime housing debt, general bad debts, some bankrupt or insolvent derivative contracts, etc). After the government buys up all these toxic assets from the banks and financial institutions, the banks and financial institutions will start from a fresh chapter. Currently the banks are even afraid of lending to other banks, not knowing which bank will fall next. The bank’s reluctance to lend even to other banks is leading to huge spikes in over-night and short term interest rates. If even bank’s cannot get access to capital, you can imagine that many corporations and enterprises will be squeezed even harder, leading to bankruptcies and retrenchments. The effect cannot be under-estimated. The main effect is to allow banks to have the confidence to lend to each other thereby loosening credit to enterprises and corporation.

How will the US government use this US$700 billion of funds? Will they use it fairly?

I don’t know if they will use it fairly. However, the US Democrats have pushed for greater over-sights into how public funds should be used. For example, the US government may take stakes in the banks in the form of outright equity stakes, or convertible bonds (similar to a loan to the bank)  or preferential shares with voting rights and coupon payments. In the extreme case, some banks will be re-nationalised.

What is the effect on interest rates market?

The effect is that, many banks will see increased governmental involvements. Some banks may be nationalised. The US public (including other countries) are angry at US for messy up financially. It is likely that the Federal reserve will lend to these banks and financial institutions with terms and conditions that could include coupon payments similar to bonds and equities. If such terms are exercised to protect the public funds, this effectively created an alternative interest rate market in which the FED lends directly to the banks. This could potentially diminish the FED’s ability to control and set interest rates in the future. For example, market A lends at 9% while the Fed Money market (Market B) lends to each other at 3%. In this case, market A is humongous at US$700 billion, so Fed money market interest rates (Market B) may rise. It may make it harder for FED to set interest rates for the benefit of accelerating or restarting economic growth at a time when the economy is slowing down.

Are there any up-sides? What are the possible up-sides?

It is possible that the economy will start to pick up in a few quarters once confidence start to come back and demand returns.

What are the Risks to me in Singapore?

The USA is a major trading partner of Singapore. In fact, the US GDP is US$14 trillion, roughly more than a quarter of the world’s economic production. The US is a net importer of goods and therefore any slowdown in the US will lead to slowdown in nations exporting to the USA. The USA government is running a trade deficit of about US$500B, and a budget deficit of about US$200 plus billion. The US national debt is now over US$10 trillion (over 70% of their annual GDP) and debt servicing based on 5% would come up to US$500 billion.

All these aside, USA needs funding requirements of: -

Budget Deficit of                                      US$ 200+ billion.

Off budget Iraq cost                                 US$ 100+ billion.

Additioanl Budget (rescue package)       US$ 700 billion.

The additional funding requirements total more than US$1 trillion (US$ 1000 billion)

The concern is, how are they going to raise US$1 trillion in 2009? Bill Gates is worth around US$55 billion just to provide a benchmark.

If they cannot raise this cash through increased taxes, (since both presidential candidates have declared they are not raising taxes), they will have to borrow from sovereign sources such as Japan, China, South Korea, Saudi Arabia who traditionally buys US treasury bonds. But going from an average borrowing of US$200-300 billion a year to US$1 trillion? This is an additional whopping US$ 700 to US$ 800 billion. Who’s buying? Even the sovereign funds do not have that much funds considering that much of their funds are already in US treasury bonds, Euro bonds and other investments.

The US government may make up the short-fall through increasing money supply temporarily. If this increase of money supply is temporary, inflationary pressures may be controllable, if not, such increase in money supply is surely inflationary.

In other words, inflationary pressure tends to force interest rates hike in the USA.

Why can’t the FED set their interest rates?

When the FED sets interest rates, they don’t just say it and then everything falls into place. After the FED announced a target rate, they will use CASH to go into the market to flood the market with funds to lower the rates (to their declared target rate) or to suck up excess funds through issuing of bonds or increase taxes, etc. Increasing money supply without an accompanying increase in goods and services production will lead to inflation. Inflation will lead generally to interest rates hike, to slow down inflation.

Can’t Singapore set and determine our own interest rates?

Sure the Singapore government have some flexibility in setting interest rates. As long as credit crisis do not affect adversely the banks, MAS, GIC and Temasek, there should be enough liquidity in the Singapore interbank market to ensure low interest rates.

Singapore uses does not use interest rates, rather it uses exchange rate mechanism to control inflation. 

Singapore’s Monetary Authority of Singapore (MAS), Government investment Corporation of Singapore (GIC), Temasek and Singapore’s banks are known to be well capitalised. As long as this continue to hold true with no surprise exposure to the credit mess in the US or elsewhere, Singapore government should have ample fiscal flexibility in setting interest rates through the Interbank market.

However, recently banks have started to offer better and better fixed deposit rates to depositors. This effectively raise the cost of funds of the banks. In return, the banks should and would then lend out funds at higher rates.

If banks generally are tightening credit and not lending out much, then why are they aggressively courting depositors?

Could they be using those funds to retire more expensive debt?

Or could they be exposed to some extend by the financial turmoil happening in the USA or elsewhere and is beefing up in preparation? This, we got to keep abreast as more news become available.

So what do propertybuyer.com.sg think interest rates will go?

We cannot predict the market and we do not claim to do so. However, we believe that when the credit crisis dusk settles, given that currently the world’s economic growth has slowed, and inflation risks have abated, therefore interest rates could stay low to spur economic development. But if the credit crisis continues, interest rates will continue to swing wildly.

 

Can the team at PropertyBuyer.com.sg help me to evaluate my current mortgage package?

Yes. That is what we do. We help home owners source for the mortgage that best fit their needs.

 

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We do not charge the individuals at all. The banks pay us a commission on successful mortgage completion.

In some cases, after evaluation, we recommend that clients stay with their existing bank, because this is simply best option, we don’t make any commission. However we trust that the clients will then introduce us to their friends and family.

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