Credit crunch is far from over

Credit crunch is far from over
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First Published: Mon, Jun 23 2008. 11 45 PM IST

Updated: Mon, Jun 23 2008. 11 45 PM IST
With inflation taking centre stage, attention has shifted away somewhat from the US mortgage crisis and the credit crunch. That’s not surprising, because credit default swap (CDS) spreads, which measure a company’s ability to repay debt, have narrowed substantially since March, indicating an improvement in credit markets.
(TWIST IN THE TALE) CDS spreads on the iTRAXX Europe index have narrowed to around 85 basis points from 110 in March, while those on the North American CDX index have also improved from around 185 basis points in March to 118 or so at present.
That should be good news, not just for financial stocks in the US and Europe, but also for other asset classes, because the big banks have been one of the main providers of liquidity to the markets. Loans from banks have enabled players such as hedge funds to funnel liquidity to their preferred markets. Shouldn’t the improvement in the credit markets, as seen from the narrowing spreads on CDS, mean a resurgence of liquidity?
There is, however, a twist in the tale. The S&P 500 Financials index, which tracks financial stocks in the US market, closed at 296.36 last Friday, well below the intra-day low of 302.8 reached on 17 March, at a time when panic about the Bear Stearns collapse was at its height.
The reason is simple: the big banks have big holes in their balance sheets and they’ve been busy diluting equity to raise capital, which is hardly something the equity markets should celebrate.
In spite of the improvement in the credit markets, the outlook for the big international banks is still murky.
What about the future? The underlying reason for the banks’ troubles is the collapse of the housing market. That’s why the US Federal Reserve has slashed its policy rates, in an effort to buoy the housing market. Unfortunately, it hasn’t had the desired effect.
US 30-year mortgage rates are currently at 6.2%, the same level that they were a year ago, although the Fed funds rate has been hacked by 325 basis points starting last September.
The fact that mortgage rates aren’t coming down will mean more losses for the financial sector, which in turn will increase risk aversion. That will be negative for emerging markets.
Parsvnath Developers: risks outweigh rewards
Real estate firm Parsvnath Developers Ltd reported an 18% drop in net profit for the fourth quarter ended March, after which its shares have fallen by more than 11%. The company’s shares have now fallen by a whopping 75% from its highs in January this year. Net profit fell largely because the tax provision reverted to the norm of about 30% of profit before tax from an unusually low level a year ago.
But even if one were to ignore this, profit rose by just 7.6% over the year-ago March quarter and fell by 10.4% compared with the December quarter. Revenues rose by 31% on a year-on-year basis, so the smaller profit rise shows that margins were under pressure. True, it’s premature to make judgements on real estate companies based on quarterly results, especially because revenue recognition can be lumpy in nature.
But an analyst from a foreign brokerage, who did not wish to be named, says that Parsvnath’s results show that there is a slowdown in execution as well as a slowdown in demand. He says a lot of projects were launched in the year-ago March quarter, which has not been repeated this time around—hence the slowdown in profit growth.
Importantly, March quarter results of some other real estate developers such as Omaxe Ltd and Brigade Enterprises Ltd also showed a drop in profit margins compared with the December quarter. The lacklustre results posted by these firms are making things worse for real estate stocks, which have been battered because rising interest rates have hurt demand on the one hand, and cost inflation has hit profitability, on the other.
Things are only likely to get worse as far as the profit and loss statements of these companies go.
The realizations reflected in the current accounts are an average of rates over roughly the last two years, says the analyst. With rates softening and costs rising, margins are likely to be hit more.
For some developers, including Parsvnath, where the focus for future growth is on tier II and tier III cities in the country, the risks are higher. Much of the demand in these locations came from “investors”, many of who have withdrawn from the market, and analysts say there’s a dearth of genuine buyers in these areas as employment has not grown at the same pace as the number of real estate projects.
For these reasons, developers are likely to go slow on execution of some project plans, which in turn will affect the valuation estimates of these firms. Parsvnath’s heavy dependence on residential projects, too, is a risk because it can pose liquidity problems.
At current levels, Parsvnath trades at a 55% discount to its net asset value of Rs320, estimated by Citigroup. But the fact that its shares continue to drop, signals a perception that the risks still outweigh possible rewards.
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First Published: Mon, Jun 23 2008. 11 45 PM IST