Back from Holiday and Initial Thoughts on Recent Events

I sure picked a nice time to go away didn't I? Well, in any case I am now back and ready to resume my work here at Alpha.Sources and elsewhere. My trip to France was excellent although I did not get to read as much as I had expected which means that I cannot yet give any reviews to the novels I had marked for reading. This meant however that I had plenty of time to do other things.

Moving on to more pertinent issues regarding my work it is of course impossible for me not to dwell a bit by the ongoing debacle in financial markets. I won't go into any kind of specifics here since but merely note the three main things which have caught my attention in the overall perspective.

First of all I think it is pretty certain now that the focus on subprime mortgage and general risky market conditions in the latter part of 2006 was real and not just another example of crying wolf. August's events which follow inferior but noticeable wobbles in the early Spring seem to finally support the views of those who stood tall in the face of strong criticism. What matters at this point is the handling of the issues at hand and as is readily clearly the blame game is well under away with the rating agencies currently bearing the brunt of the burden. After all, the money managers and wizards in the banks' exotic mortgage credit departments are paying with their jobs. However, behind this unravelling and subsequent recurring debate over market transparency as well as the need to instigate tougher regulation to reign in the financial hotheads looms a much more important issue.

This brings us in my opinion to the second issue which also somewhat situates the rating agencies right smack in the middle of the turmoil. In order to frame the issue it serves us well to take a look at one of Edward's recent posts on Latvia in which he comments on Fitch' latest downward adjustment of both Latvia's currency issuer default rating (IDR) and Latvia's currency IDR. On the face of it there is nothing controversial about this. In fact, as I have been at pains to note lately several of the CEE economies are in danger of rather severe overheating and as such it is not exactly unwarranted for Fitch to move on Latvia. Yet, if we think for a moment about the general situation and how the rating agencies, perhaps indeed with good cause, are up for graps as part scapegoats; what this will mean for debt ratings? Of course, the debt/credit instruments themselves (i.e. CLOs, CDOs etc) are up for a major revision. At least it seems as if there is going to be an institutional and regulative aftermath on this front but at this point it is difficult to say what this will look like. The problem is the derivative effect on sovereign debt ratings (if any?) and what this will mean for economies faced with deteriorating economic fundamentals as well as the risk for a general institutional and perhaps even real economic retrenchment of credit. Here of course we get into the lion's den since as I have shown in the case of the CEE economies these countries structural issues which are not easily addressed even in relative benign economic conditions. In short, for this reason especially the CEE economies need special watching since they might up being on the forefront of all this both as a result of general market wobbles but specifically because they represent a potential way for the rating agencies to hammer down on credit conditions to show institutional actors and political interests that they are serious. And don't forget that given the recent meager growth performance in the Eurozone this has the very real potential to shore up in Italy as well. In fact, as we learn from Bloomberg today the games have already begun ...

Italy won't increase state borrowing to ease an economic slowdown that may be caused by the U.S. credit crunch, Finance Minister Tommaso Padoa-Schioppa said in a letter published in la Repubblica newspaper.

``We cannot take on debt in order to boost investment,'' Padoa-Schioppa wrote in the Rome-based daily. ``We've already indebted ourselves, and we wasted and spent our credit.''

Italy has the highest debt among the countries sharing the euro, amounting to 106.8 percent of gross domestic product last year. Prime Minister Romano Prodi has already said Italy is going to slow its deficit-reduction, and pledged not to make any extraordinary deficit cuts in next year's budget.

Turning to another of the world's debt laden economies another Bloomberg note also alerts us of similar issues in Japan. As such, the lines are drawn up here too and although it is not explicit mentioned the tug-of-war is very real at this point since if indeed economic growth is faltering in Japan in the latter part of 2007 and if indeed Fukui decides to end his term on a hiking note then there will be plenty of reasons for the rating agencies to pounce on Japan.

Whether this hypothesis of a derivative effect of sovereign debt ratings is plausible is of course debatable. However, given the fact that the rating agencies are likely to review credit standards all across the board also sovereign debt ratings will come under scrutiny. In this light I will be watching the CEE economies as well as Japan and Italy with great interest.

The third and last point I want to note is the recent economic figures from Japan and the Eurozone which largely conforms with my predictions as of late which is to say that they are somewhat below the consensus market forecasts. I will have much more to say on this in my next notes but clearly and coupled with the recent market turmoil the future course of monetary policy in Japan and the Eurozone (i.e. the economies I tend to follow) is not at all set firmly on a course of more tightening at least not if you look at economic fundamentals.

Ok, this was it for a short return. I will have more later this week.