Time to Look at Dividend Swaps?

With 2012 and 2013 dividend swaps priced at the 55-65 levels, let's look at some of the main drivers which are pushing dividend swap levels significantly lower than the current stock markets are:

a) Banks are cutting dividends or are in no position to pay dividend post-full or -partial nationalisation by government bailouts.

b) Concerns over macro-economic conditions that might affect many companies' ability to maintain dividend levels at the pre-crisis levels.

c) De-leveraging and unwinding of such trades by hedge funds and proprietary trading desks due to losses from other asset classes and pressure from investor redemptions.



Why it may look attractive:

a) Markets are pricing in zero dividends from the financial sector and construction, auto sectors and almost 30% cut in all other sectors.

b) Implied levels look extremely low compared to historical averages, although there is a risk of a longdrawn/prolonged recession.

c) Potential macroeconomic recovery by 2010

d) Cash dividends may resume to restore investor confidence



Given that the dividend swap levels for are so low in absolute terms, the long term risk reward looks attractive.

Eric Tan, London

How do you shrink the house of cards? Markets for the week ending 16-Jan-08

The FT economists forum was quite interesting this morning and I thought it was quite a good idea to put that in perspective with what the governments are adopting to deal with the current crisis.

Q: With the US official interest rate at close to zero, is monetary policy running out of ammunition?
People are confusing the 'level of interest rates' with the 'rate of change of the interest rates', hence are focusing on America's inability to lower interest rates further.
But cheap money itself provides a strong incentive to borrow and spend and raise discounted cashflow calculations of asset values
However,
1) There is an imperfect linkage between the official interest rates and the actual range of borrowing rates offered in the market
2) Borrowers further out in the yield curve, which hasn’t fallen as much has less to benefit (10-year US Treasury rates has fallen only 2% compared to the Fed fund rates which has fallen 5%)
3) Banks may not be in a position to lend for various reasons such as shortage of capital, dissapearance of commercial credit market

So, can ZIRP (zero interest rate policy) help ?
- Yes:
A) Central banks can push out as much base money (Issuing bonds) as they want to at close to zero rates.
B) Governments can use the money raised to buy longer dated government paper to push down the yield curve to partially address 2) above
C) The money can buy undervalued assets that are clogging illiquid markets from banks and add much needed capital to their balance sheet, addressing 3)
D) The same money can fund expansionary fiscal policies such as improving infrastructure, providing insurance or guarantees to banks and companies

Comments
But the above does not do much to fix the problems happening in the banking sector. The government wants to maintain a flow of lending to help good companies, but how can they distinguish between the good and toxic assets at the micro level.

The UK government has just announced more help for Royal Bank of Scotland this morning but short of nationalising the banking sector in the UK, the regulators are going to find their hands tied on how to shrink the banking sector to a realistic size while not fully recognising the large amounts of mis(over)-priced illiquid assets still sitting in the banking books of financial institutions that have yet to be marked to market.

Something positive
On hind-side for UK, not being part of the Euro might just turn out to be a blessing this week as the European nations in the EU battle to rescue crumbling credibility of the Euro as the Irish economy worsens and Spain's soverign rating downgrade from AAA to AA+. At the rate this continues, it is not impossible to predict a default of posibly a large European economy. (Other at risks: Greece , Italian Portugal)

Eric Tan, London

The Psychological Profile of a Downturn. Markets for the week ending 9-Jan-09

Economy:
The U.S. Economy Lost 524,000 Jobs in Dec 2008,
Unemployment Jumps to 7.2% Jan 9, 2009
Non Farm Payrolls declined by -524,000 in Dec 2008. Oct and Nov job losses revised up to -584k and -423k.
Unemployment rate rose from 6.8% to 7.2% (15-yr high).
Total 2.6 mn jobs were lost in 2008 (most since World War II).
Households Survey: 806,000 jobs lost in Dec; 3 mn in 2008 (most since 1945)
Continued job losses in manufacturing (-149k), construction (-101k), residential construction (-87k), services (-273k), finance (-14k), retail (-67k), business&professional services (-113k), leisure services (-22k), temporary help (-81k). Job gains in govt. (+7k), education & health (+45k)

Psychological Profile of a Downturn
The massive debt accumulation that drives up prices of assets means, that when the downturn comes, previously optimistic investors are forced to sell assets to raise money. That factor tends to make the downward spiral steeper than the upturn that preceded it. Over the past 60 years, nine of the 10 biggest one-day percentage moves in the S&P 500 were down.


Market participants hoard and protect wealth as they pay down the accumulated debt. This reduces economic transaction velocity, restraining demand for the bubble asset, further increasing the inventory oversupply. And so it goes until the inventories decline near sustainable levels, giving market participants confidence to put their money to work.


Investors look ahead to an improved segment of the economic cycle and begin to adjust asset valuations. More participants enter the fray, seeking higher returns for their cash hoards, and economic activity returns.

2009: Still Underweight Banking? Week ending 02-Jan-09.

Markets

Grim UK economic data drove government bond yields to a fresh low of 0.95 per cent last week.

Ahead of next week's BOE monetary policy committee meeting, the 2-year gilt was affected by an expectation of at least half a percentage point.

a) UK mortgage approvals in Nov hit 27,000 loans, lowest on record

b) Halifax data showed a 2.2 per cent drop in house prices in December 08

c) Bank of England's credit conditions survey showed that banks were cutting the supply of debt to businesses and consumers

Looking back at 2008,

it was easy to claim that the crisis we've tripped ourselves over was largely a crisis of confidence which is unlikely to untangle easily. The spillover into 2009 would most probably be in the form of more business failures (we have seen Zavvi, Woolworth's and Whittards capitulating in the last weeks of 2008) and higher bad debts (credit card loans, mortgages) from recessionary pressures.

Retail banks in the UK and around the world have been used to low levels of bad debt provisions due to a 10-year bull cycle of rising home values and economic growth, but in this new/weaker business environment, banks would have to act fast to raise equity. For those unable to, they will have to resort to balance sheet deleveraging which directly contradicts the UK government's adopted expanionary policy to increase lending.

Many can now claim that investment revenues were actually driven by unsustainable risk taking and dangerous levels of leverage, and with the shift of power from the trading room to corporate and retail banking, we can safely expect less revenues from M&A advisory and proprietary trading. Maybe investment banks can encroach on the business of advising the sale and restructuring of troubled businesses, but that is already a crowded arena with many specialists.

Therefore in 2009, I can safely predict that banking and financial stocks will still underperform the wider "real" economy, but that's something for next week.

Eric Tan, London