Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Market Musings 25/5/11

with 4 comments

I didn’t expect to have any time to blog on my travels through North and South America but with an hour to spare I thought I should scribble down a few observations.  From a broad markets perspective, I wasn’t surprised to see that most of the leading share indices have declined in line with the prediction given in my last update, but I have to admit that I would have thought that the declines would have been more pronounced than they have been. We’ve seen a good bit of volatility in currency markets too. The “flight to safety” theme is well and truly in the ascendancy here with the Swiss franc rising to an all-time high against the euro. Concerns about peripheral Europe remain to the fore, but the EU elite appear hell-bent on pursuing measures that will worsen and prolong the crisis instead of doing the sensible thing and imposing haircuts on the unsustainable debts that Ireland, Portugal and Greece have.

One of the worst offenders when it comes to advocating policies to address the peripheral countries’ problems that make absolutely no sense is the French government. My heart sank when I saw that Christine Lagarde is the leading candidate to take over the IMF. Christine believes that Ireland should be raising taxes on business (translation: jobs) at a time of deep recession, which of course will serve only to heap further pain onto the Irish economy. It was staggering to see several Irish politicians enthusiastically support her candidacy, given her views about our economy. Something to remember for the next time a canvasser calls to your door.

Speaking of bad policy decisions, I note Tullow Oil’s subtle dig at the UK government in its announcement accompanying its acquisition of Nuon in the Dutch part of the North Sea. At a time where concerns about energy security are elevated it makes no sense that George Osborne raised taxes on E&P operators in his last budget.

The US debt ceiling talks continue to drag on. The reality that both the Democrats and the Republicans need to face up to is that America’s debt and deficit positions are completely unsustainable. The fiscal jaws need to close sooner rather than later, and I was pleased to see that Grover Norquist, who I’d the pleasure of meeting at a free-market conference in Brussels some years ago, is applying pressure on politicians to do the right thing and cut spending, instead of raising taxes.

Turning to the banks, I see that Moody’s has placed 14 UK banks, including Bank of Ireland’s UK subsidiary, on notice for a possible downgrade. Not a big surprise, but I do think that the UK government is trying to wean them off its support a little too early. I note an interesting suggestion by economist Ronan Lyons for a maximum LTV to be applied to future mortgages by the regulators in Ireland. That’s a sensible suggestion which I endorse, but I would go a step further and say that total borrowings should be taken into account as well – we all know imprudent folk who have built up a “portfolio of debt” that encompasses personal loans, car loans, credit card debt and mortgages. While my more libertarian-minded friends would say that individuals should be allowed do with their finances as they wish, the problem with that logic, as we’ve seen in Ireland, is that the taxpayer usually has to pick up the tab for financial messes created by other people.

Did you know that shale gas formations have the potential to double the world’s gas reserves? Staying on energy, here are some interesting perspectives on US gasoline consumption, via the good people at Morgan Stanley:

  1. Americans spend $500bn on gasoline a year (50% of total US oil demand).
  2. US households spend twice as much on gasoline and motor oil as they do on education.
  3. At $5/gallon (it’s at $3.85 now), assuming constant demand, US households would spend as much on gas & motor oil as they do on healthcare.

Finally,  a commodity price update – Starbucks is raising the price of bagged coffee sold at its US stores by 17%. I like coffee as long-term investment given that the commodity has robust structural drivers – the demand boost that the more than 1bn “emerging middle class” people in Asia will give this over the coming years is going to be staggering to watch.

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Written by Philip O'Sullivan

May 25, 2011 at 9:04 pm

4 Responses

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  1. Using LTV as a regulatory tool is silly in the extreme….and the proposal of such an idea exhibits the basic thinking that got everyone into this mess to begin with as well as demonstrating a complete lack of understanding as to how property markets differ from other asset classes, partucularly as a form of collateral for debt. Household income to support repayments, sufficiently stress tested, should be the only basis for such decisions.

    By restricting the LTV, you are only providing incentive for valuers to inflate valuations in order to get deals through. This was a major problem in the 1980’s crisis in the US, as Fannie and Freddie had severe LTV restrictions before they would pass through securities based upon them. Valuers inflated the values because lenders wanted to write more business and banks placed pressure on valuers to make deals work (and because property valuation is basically an educated guess and subject to serious manipulation, with the valuer being approved by the lender….this happens often, but that is another issue)

    There is a very old maxim in real estate finance that when the bank lends based upon the property rather than the quality of the borrower, both will be in trouble. Every property crash throughout the world over the past 50 years provides clear evidence for this.

    James

    May 26, 2011 at 10:26 pm

    • James, if you look back over what I wrote you’ll see that what you’re addressing isn’t quite what I said. I argued that a max LTV coupled with rules to take total borrowings into account (I am aware of several cases in Ireland during the bubble where banks ignored other borrowings and extended 5x salary mortgages to people) is a good step.

      I firmly believe that the advantage of having a cap on the max LTV for mortgages is that it gets people used to the idea of living comfortably within their means and by extension this improves the quality of loan book and takes some of the froth out of the housing market that might otherwise exist at times of low interest rates.

      Philip O'Sullivan

      May 29, 2011 at 2:30 pm

    • @James
      Thanks for the comment but, even aside from it throwing away the lessons of global property markets over the past few decades, there is a fundamental paradox at the heart of your logic. Your argument against maximum LTVs essentially rests on regulators not being able spot inflated valuations… but somehow being able to resist the extremely pro-cyclical tendencies of leverage. Of the two, it is an order of magnitude easier to spot inflated values (using rent-to-price ratios, for example).

      The problem with floating credit standards is that due to the thin nature of the property market and their extreme pro-cyclicality, they create bubbles. You can see the flesh of the argument here:
      http://www.ronanlyons.com/2011/05/31/ideas-for-building-property-market-3-0/

      There is an older maxim in economics that you would do well to remember: no matter how smart they are or how much information they have, in an uncertain world, ultimately lenders cannot tell the exact quality of the borrower. That is why the credit is secured. Anyone who tries to tell you that there are no informational imperfections in the mortgage market is having you on. Regulation needs to reflect this inefficiency, not pretend it’s not there.

      Ronan L

      May 31, 2011 at 8:21 am

  2. […] of the oil sector, you might recall that some months ago I criticised Chancellor of the Exchequer George Osborne for raising taxes on North Sea oil […]


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