The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Richmond Fed Economic Brief, “Where Are Households in the Deleveraging Cycle?,” by R. Andrew Bauer and Betty Joyce Nash. PDF

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Where Are Households in the Deleveraging Cycle?

Manal Mehta is a Banking & Finance analyst with Branch Hill Capital; contact him at manal@branchhillcapital.com.

Why I Wouldn’t Invest in Banks: The Return of Exposure to Off balance Sheet Securitizations

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Why I Wouldn’t Invest in Banks by Manal Mehta

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Source:
States Negotiate $26 Billion Agreement for Homeowners
NELSON D. SCHWARTZ and SHAILA DEWAN
NYT, February 8, 2012
http://www.nytimes.com/2012/02/09/business/states-negotiate-25-billion-deal-for-homeowners.html

Click to enlarge:

The Wall Street Journal – Rate Probe Keys On Traders

Investigators in a world-wide probe of how crucial interest rates are set are focusing on a small number of traders suspected of trying to influence other bank employees to manipulate the rates, according to people familiar with the situation. The move is part of investigations by regulators and law-enforcement officials in Europe, Japan and the U.S. that began more than a year ago. Officials are trying to determine if major banks colluded to manipulate benchmark interest rates such as the London interbank offered rate, commonly known as Libor, and the Tokyo interbank offered rate, or Tibor. There is no indication that the alleged actions by the traders resulted in bank employees acting improperly in setting rates or that there has been any collusion among banks, say people familiar with the situation…People familiar with the ongoing probe said investigators in Japan have found dozens of emails and online chat messages from traders who appeared to be trying to influence other bank employees who submitted Libor or Tibor quotes involved in the interest-rate-setting process. None of the traders has been charged with wrongdoing. Japanese authorities have taken civil actions against two banks. Several banks have disclosed they are under investigation in Europe and the U.S., but this doesn’t indicate that any charges will result. In the wider investigation, officials are trying to determine whether some banks deliberately tried to skew Libor by submitting inaccurate data during the financial crisis. One possibility being looked at is whether any banks held down their rates, so as to try not to appear in riskier financial condition than their rivals.

Comment

For years we have argued that the LIBOR market essentially does not exist. Federal Reserve intervention and banks lying about their levels have strained the credibility of this measure.  As the chart above shows, the difference between the highest and lowest reported 3-month LIBOR bank rates is at its widest spread since May 2009.

We have linked stories proclaiming “LIBOR fails to paint a true picture” and that extraordinary government intervention in this market has distorted the rate so much that banks are reducing their use of LIBOR as a reference rate for new unsecured lending. It still remains the reference rate for trillions of existing loans, securities, derivatives and bank deposits. Currently there is no good alternative to LIBOR, although the Overnight Index Swap (OIS) and “LIBOR floors” are trying to replace it with limited success. So, the marketplace is searching for an alternative with many banks attempting to devise their own measures to varying degrees of success. The British Bankers Association has noticed this, which is why they are trying to rework this measure.

Source: Bianco Research

The RBA, unexpectedly, kept interest rates on hold at 4.25%. The decision was even more surprising, given the accompanying statement – namely a weaker Europe, slowing China etc, etc, though (in defence of their decision) they highlighted the better US economic data and high commodity prices. Personally, I believe this is merely a pause before further easing, quite possibly as early as next month. The surprise decision resulted in Australian equity markets declining, though the A$ rose above US$1.08. Still believe its crazy. Fortunately, I did not act on my view to short the A$, but it’s getting to be one of my top prospective plays in the near future – hopefully the A$ will rise to closer to US$1.10;

Japan’s Coincident Composite Index (which reflects current conditions) rose by +2.9 points to 93.2 in December (forecast was for a rise of +2.4 points). The CCI dropped by -1.1 points in November. The leading Composite Index (reflecting expectations 3 months ahead) rose by +0.6 points to 94.3 MoM. Better numbers and Japanese authorities are talking of a turnaround. Hmmmm;

The Chinese Ministry of Industry reports that industrial output is expected to decline this Q. Output is expected to rise by +11.0% this year, below last years +13.9%.

Whilst analysts still write about China’s financial strength, the IMF warns that China has already pushed debt levels (which have increased by 200% in 5 years – a larger rise than in the US during the sub prime crisis) above safe levels. The IMF is proposing that the Chinese authorities introduce stimulus measures.

Just 1 piece of anecdotal evidence – some 3 years ago, when I first started to question the validity of the Chinese “economic miracle”, I received numerous comments from Chinese “experts” telling me that I was NUTS. At present, I get few, if any, such comments. Just saying;

The Indian Government has reduced its forecast for the year to March this year to +6.9%, sharply down from the +8.4% recorded last year – the lowest growth since 2009. The RBI is expected to reduce interest rates further, though inflation at +7.47% in December remains high;

Russian inflation declined to +4.2% last month, well below December’s +6.1%, reports the Federal Statistical Service (“FSS”) – by the way, the FSS is controlled by the Russian Ministry of Economy. Presidential elections are due in a few months.

A very clued up friend of mine, based in Moscow, advises me that I should treat comments by Mr Gideon Rachman’s of the FT re Russia with a pinch of salt – apparently Mr Rachman’s views does not reflect the actual situation in Russia. Let me say, my friend is particularly well plugged in and, as a result, I take his views seriously;

The British retail consortium reported that UK January retail sales (for shops open for at least 1 year) declined by -0.3%. Times are tough, but other recent economic data has been positive;

EPFR reports that inflows into EM has risen significantly since the start of the year – by +US$3.5bn for the week ended 1st February and a total of US$11.5bn since the beginning of the year. Fund flows into EM bonds rose by US$1.2bn last week, the highest since March last year. EM’s have been the star performers in 2012 – too much, too soon in my humble opinion – still believe they may well be a shorting opportunity shortly;

Euro seems to have picked up on hopes of a resolution re Greece – currently US$1.3145. Well, I suppose the Euro will recover if the Greek’s agree to the Euro Zone demands, but I for one, am not buying into it – indeed, look to raise my short (against the US$).

Glencore is paying a 15% premium to buy out the rest of Xstrata – does not seem to be too generous. Call me a cynic, but I’ve always believed you invest in the company where the main guy(s) own shares – wow, that’s Glencore – up nearly 2.0%, though Xstrata is down over 2.0%. I would guess that Xstrata shareholders are likely to object to the proposed terms.

European markets flat – I must admit, I’d thought that they would be higher. US futures indicate a flat open, but way, way too early. Brent still around US$115.50.

Was preparing this for tomorrow, but too much alredy so I thought I’d send it out.

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There is a absurd yet fascinating article in the Sunday Times by Gretchen Morgenson, titled A Mortgage Tornado Warning, Unheeded. It is is stirring and emotional.

What makes it fascinating is yet another story told about prescient warnings in advance not heeded about the coming mortgage crisis.

What makes it absurd is its complete lack of recognition of how large companies operate, how businesses interact with the public, how humans behave.

Consider the reality of how businesses operate in the world. No (bizarrely according to this column) huge corporations do not sift through an enormous volume of incoming communications, including emails, letters, and phone calls to pull out that one important warning from non-clients, and make major shifts in their business models and operations. This is not how firms whose goals are to profit maximize on behalf of their shareholders operate.

I speak from experience. I spent the better part of 2005-06 discussing the imminent housing collapse, warning about valuations, showing how the collapse would play out into the broader economy. These were with clients I had an existing relationship with, a good track record and an established degree of trust.

How did that work out? I ended up getting the following Hugh McLeod line printed on the back of my business card: “I can’t take this shit anymore, he said, mistakenly.” Its now a print hanging in my office.

They had their models, they thanked me for the color, but there was simply too much money to be made.

The thing to blame companies for is not that they ignored some outsider’s warnings; Rather, it is  that they themselves failed to recognize the many warning signs of the coming housing collapse. This is the true failure of the Mortgage Lenders, Wall Street Secritizers, GSEs, Real Estate Agents, Appraisers, and of course, Central Bankers. Their expertise should have alerted them to the obvious coming tornado. Or worse — and IMO criminally — they saw it all coming and went about running up risky exposure regardless. The massive smash and grab, break the bank, snatch huge IBGYBG bonuses, and split before anyone noticed was the order of the day.

It is not that they ignored the public warnings.  If the economy is dependent upon large companies recognizing broad warnings of economic danger coming from the public, we are all doomed. Rather, it is that they should have known better on their own. That was their massive failure.

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Previously:
Mistakenly (April 7th, 2011)

More Ignored Warnings About Bad Mortgages circa 2003 (October 11th, 2008)

Putting an end to Wall Street’s ‘I’ll be gone, you’ll be gone’ bonuses (March 12, 2011)

Source:
A Mortgage Tornado Warning, Unheeded
Gretchen Morgenson
NYT: February 4, 2012
http://www.nytimes.com/2012/02/05/business/mortgage-tornado-warning-unheeded.html

zombie debtor: n. An indebted consumer who is only able to pay the debt interest each month.

Example Citations:

“There’s a new term being coined for payday borrowers who are able only to pay the interest on their loans — zombie debtors — so that the principal debt just rolls on, and while there’s talk of those institutions having a code of conduct introduced, that’s only in the pipeline at present and we want people to know that there is an alternative in the shape of Scotcash,” he said.

—Joan McFadden, “Loan service launches attack on the zombies,” Herald Scotland, December 30, 2011

It is feared that 3.5m people will turn to payday lenders in the next six months but research shows that nearly two-thirds will regret the decision.Many will be unable to pay off the loan and risk becoming “zombie debtors“, only able to pay off the interest on what they owe.

—Nick Sommerlad, “Church of England ban on payday investments,” Daily Mirror, December 19, 2011

Via Word Spy

The latest trial balloon in the robosigning fraud cases is being pushed by Housing Secretary Shaun Donovan. It is as foolish and reckless as the mortgages underlying the crisis in the first place.

The terms which have been floated look something like this:

• $25 billion “fine”
• Up to another $17 billion used to reduce principal for homeowners facing foreclosure
• Fund for homeowners who were victims of improper foreclosure practices — 750,000 families receiving about $1,800 each.
• Principal reduction of $20,000;
• Halt all investigations into Robo-Signing;
• NO CRIMINAL PROSECUTIONS FOR ILLEGAL BANK ACTIVITIES

This deal manages to do just about everything wrong it possibly could:

1. The management of public companies are using shareholder monies to buy their ways out of criminal prosecution. They are stealing money from shareholders to give to AGs to prevent being sent to jail.

2.We still do not know who ordered the illegal robo-signing, the false notarizations, fraudulent written statements to courts, and perjury. Those persons need to be brought to justice.

3. Home owners who were victims of illegal foreclosures can easily access the courts to sue for damages — some of the more egregious cases have resulted in fast $1 million+ settlements;

4. Incidences of active servicemen on assignment being foreclosed upon in violation of law should generate very significant fines (I would let Special Forces handle it themselves, however they see fit, but I’m a bastard).

5. Principal reduction of $20,000 is meaningless; it solves nothing for the 25% of the homeowners with mortgages who are underwater. And, it rewards people who made an error in judgement when they bought more house than they could afford.

This proposed settlement confirms for me two additional things: First, it shows what happens when we bailout Banks — we see the same recklessness that led to their near denouement continue in other areas. Second, it incentivizes the government that bailed them out in the first place to protect their sunk costs — they tend to go easy on the banks to protect their “investments.”

Sorry , but this deal stinks all around

Government Debt – How Much Is Too Much?
Satyajit Das
January 23, 2012

Economists and policy makers like simple nostrums. Popularised by Economists Carmen Reinhart and Kenneth Rogoff, the unsustainability of a sovereign debt level above 60-90% of a country’s Gross Domestic Product (“GDP”) has become accepted wisdom.

But government or corporate debt rarely ever gets repaid. The real question is whether that debt can be serviced and investor confidence maintained to allow it to be refinanced.

The level of tolerable sovereign debt depends on a multitude of factors.

One factor is the currency of that debt. Where it borrows in its own currency, a sovereign’s capacity to borrow is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.

Where the borrowing currency is also a major reserve currency, used in global trade or favoured as an investment by central banks, the scope for borrowing is commensurately higher. The combination of these factors has enabled the USA to continue to borrow large amounts to finance its budget and trade deficits.

The inability to print money to service debt has been a significant issue in shaping the European debt crisis.

Where a country has a large domestic saving pool, like Japan, the ability of the government to finance its expenditure is significantly enhanced. A country reliant on foreign investors for its funding is far more restricted, limiting its debt levels.

A significant portion of government debt of weaker European states is held by foreign investors –Greece (91%), Ireland (61%), Portugal (53%) and Italy (51%). For some stronger nations, the level of foreign ownership is also high – Belgium (58%), France (50%) and Germany (41%). In contrast, only 28% of Spanish debt is held by foreign investors. Most of this debt is held within the Euro-Zone as the average holding of government debt outside the area is 25%.

The portion of government debt of other large economies held by foreign investors is lower – US (30%), UK (19%) and Japan (15%).

Significantly, when the net external liabilities of the economy (external liabilities adjustment for foreign assets) is considered, only Japan, Germany and Belgium are owed more by foreigners than they owe externally. All others have a net external liability. Interestingly, Spain’s relatively low level of foreign ownership of government debt is replaced by net external liabilities equivalent to 88% of GDP reflecting high levels of overseas borrowing by Spanish financial institutions and businesses.

The level of interest rates also determines the level of acceptable debt. Higher interest rates and the resultant larger claims on public revenues to service the borrowing limit the level of debt. Extremely low interest rates, such as those in Japan and more recently in the USA and Europe, enable higher level of borrowing.

A further consideration is the maturity structure of the debt. Short term debt increases vulnerability to market disruptions, limiting the level of borrowing. Conversely, longer maturities and low concentration of maturing debt in an individual period can increase debt capacity. The inability to re-finance maturing debts was a crucial catalyst in the European debt problems.

Sustainable debt levels also depend on the size and economic structure of the country. A large, varied economy with a substantial potential tax base can sustain far more debt than a narrowly based and tax revenue poor country. Peripheral European economies, such as Greece, Portugal and Ireland, are heavily dependent on few industries and also a limited tax base.

But perhaps the most important determinant is the level of current and expected economic growth. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attractive investment, can maintain a higher level of debt than one with lower growth prospects.

While not exact, the sustainable level of debt can be approximated by another formulation, which links the existing level of public debt (% of Gross Domestic Product (“GDP”)), the current budget position (% of Gross Domestic Product (“GDP”)), interest rates and growth rates:

Changes In Government Debt = Budget Deficit + [(Interest Rate – GDP Growth) times Debt]

Italy illustrates the relationship between debt levels and GDP growth. Assuming borrowing costs of 4% and a debt to GDP ratio of 120%, Italy needs to grow at 4.8% just to avoid increasing its debt burden where it budget is balanced. At current market borrowing costs of 6%, Italy has to grow at an unlikely 7.2% just to avoid increases in its debt levels.

Like most of Europe, Italy is projected to have anaemic growth of 1-2 %. Its current borrowing costs are elevated (around 6%) although its overall borrowing costs are lower as the bulk of its debt is at lower rates. This means that Italy must reduce its debt levels significantly to avoid the risk of insolvency.

Assuming interest costs of 4% and growth of 2%, Italy would have to run a budget surplus of 5% per annum for 10 years to reduce its debt to 90% of GDP. Alternatively, it must sell state assets to reduce its debt. Such sharp contraction in net government spending would reduce growth significantly in the absence of other helpful circumstances.

The relationship illustrates the problem facing many governments currently. A toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many countries unsustainable. Europe’s beleaguered economies have to run a budget surplus (through spending cuts and tax increases), grow at very high rates, decrease its borrowing costs or combination of these to merely stabilise its debt.

The US is not immune from these problems. Assuming average borrowing costs of 3% and a debt to GDP ratio of around 100%, America needs to grow at 3.0% just to avoid increasing its debt burden where its budget is balanced. To the extent that growth levels are lower than the interest cost, it needs to offset the difference by running equivalent budget surpluses in order to keep its debt from increasing further.

The status of the US dollar as reserve and major trade currency, the ability of the Fed to print dollars and the flight to quality has allowed the US to avoid too much scrutiny of its own debt problems, at least for the moment. But the relationship highlights the vulnerability of heavily indebted economies. A combination of intractable, corrosive budget deficits, low growth rates and increased pressure on borrowing costs, as a result of investor concern of its creditworthiness, can result in a rapid slide into a debt crisis.

Following the global financial crisis, governments expanded their borrowing, replacing the private sector, especially consumer, debt, in a heroic bet to engineer a recovery. The increase in government debt will prove unsustainable if growth does not return quickly to high levels, driving a new phase of the global financial crisis.

Note: A shorter version was published in the FT previously.
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© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)

Huge chart from Steven Rattner’s Sunday NYT Week in Review Op Ed:
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click for ginormous graphic:

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Source:
The Dangerous Notion That Debt Doesn’t Matter
STEVEN RATTNER
NYC, January 20, 2012
http://www.nytimes.com/2012/01/22/opinion/sunday/the-dangerous-notion-that-debt-doesnt-matter.html