Tuesday, January 31, 2012

High beta differentiates stock pickers from index funds

Stock pickers had a rough year in 2011. For example the Fidelity Magellan Fund underperformed the S&P500 by close to 14%. And Fidelity is not alone.
Investor's Business Daily: Most mutual fund managers underperformed the market [in 2011], and many very badly. Morningstar data show less than a third (29%) of the 21,000 mutual funds it tracks beat their benchmarks. By contrast in 2009, when the bull market started, more than half (52%) of all funds did so.
What could be the reason for this trend? The answer is not straight forward. Some suggest that mutual fund fees cause the underperfomance and are the only thing standing between stock pickers and index funds. But if that is the explanation, why would a fund like Magellan underperform by so much - it couldn't just be their fees. The answer comes down to beta of the stocks they pick. Mutual funds know that in order to overcome their high fee hurdle, they need high beta equities that will beat the index in a rally in spite of the high fees. 2011 was a year of extreme uncertainty and investors dumped high beta stocks causing many to underperform.

But what happened to achieving superior performance with stock selection? That has been quite difficult to accomplish these days because of high correlations among stocks. In fact correlations have been close their 30-year maximum of 1986.

S&P100 Correlation (Source: Citigroup)
With correlations this high, the key differentiator among individual stocks is beta. Pick a low beta stock and risk underperforming the index in a rally. With high fees on top of that underperformance any manager will get investors' attention pretty quickly - negative attention that is.  Pick high beta stocks and risk underperforming in a market like we had in 2011. Pick a portfolio of stocks with an average beta of one and get an index-like return because of the high correlation we've had. But with  index-like returns how do you justify the fees? Stock pickers are in a no-win situation. And that is one of the reasons the mutual fund industry has been under considerable pressure these days.

Instead of Baltic Dry, watch iron ore prices

The Baltic Dry Index, which measures dry bulk cargo shipping costs, has been dropping to levels not seen since 2008. This has generated a great deal of excitement as analysts try to determine if this decline is all driven by shipping overcapacity or is there a demand component.
MarketWatch: New super-sized ships ordered up during the era of cheap credit and surging global trade could explain the index’s 57% plunge in the last three weeks, according to Macquarie Research...
Shipping companies appear to have jinxed their own industry by ordering up too many grand ships when conditions looked very favorable before 2008.

Meanwhile, further new capacity, equivalent to 22.7% of the existing fleet, is due to be delivered this year, according to Macquarie calculations.

Baltic Dry Index (Bloomberg)

Is there a corresponding economic slowdown that is manifested at least in part in the Baltic Dry decline? To watch for signs of a global slowdown one should instead pay attention to raw commodity prices, in particular iron ore. Here is what the media has to say about the topic:
Businessweek: Iron ore headed for the worst monthly performance since October amid concern that slowing global economic growth and Europe’s sovereign-debt crisis may curb demand for the raw material used in steelmaking.
But the media tends to manipulate numbers to make their story fit. This Businessweek article was published today - why would they reference October? For that reason it is often more helpful to look at charts. The index discussed here is the average price for the 62% content iron ore delivered to the port of Tianjin (China). The index is computed by the Steel Business Briefing and represents demand levels for raw materials in China.

China import Iron Ore 62% Fe spot (CFR Tianjin port) USD/metric tonne (Bloomberg, Steel Business Briefing)

The chart shows that indeed we had a correction in the price of iron ore in October, but the index had since stabilized. With the Baltic Dry index no longer representative of global demand (at least not until 2013 when capacity is expected to stabilize), a better measure of demand is the price of iron ore delivered to China. And that index, while clearly off the highs, is certainly not falling off the cliff - for now.

Monday, January 30, 2012

Is Japan ready for another currency intervention?

The Eurozone crisis is putting upward pressure on the yen, with traders continuing to view it as a safe haven currency. Strong yen is making it increasingly difficult for Japan to compete in the global markets against nations like Germany who has a weak currency advantage. Even for something like autos manufactured in the US, there is still a component of parts that is brought from Japan.

USD/JPY (Bloomberg)

Japan had a trade deficit in 2011, which is unheard of for that country in recent years. Some of that was clearly driven by the tsunami disaster. There is no question however that a strong yen was a contributor.

Japam trade balance (Bloomberg)
In spite of the tremendously accommodating policy in 2011 including QE and zero rates, industrial production has been declining while equity and property markets are relatively weak. The environment looks deflationary, yet there are no more tools left in the BOJ's monetary toolbox. Except for one, albeit a temporary measure. Japan can intervene in the currency markets again in order to weaken the yen and give its exporters some relief.  This may in fact be BOJ's next move.

Japan would likely want the US and the Eurozone to help them put in place a coordinated move. But neither of their two biggest trading partners has much of an incentive to do so. Nevertheless BOJ may go it alone and find a quiet day to try to punish everyone who has on a speculative long JPY position.

Freddie Mac's "inverse floater" allowed more loan origination

Everybody is up in arms today about the Propublica story discussing Freddie Mac "betting against the borrowers" (hat tip Mike Konczal). The structured securities Freddie holds tend to be the "interest-only" component of a pool of mortgages. As long as borrowers in the pool keep paying, the holder of these securities receives cash. The more borrowers refinance, the less interest income is left in the pool. A holder of these securities therefore does not want borrowers to refinance and instead just keep paying as long as possible. How diabolical!
NPR: “We were actually shocked they did this,” says Scott Simon, who as the head of the giant bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest mortgage bond traders. “It seemed so out of line with their mission.”
And more...
Daniel Fisher (Forbes): ... I don’t get it. Freddie Mac did something potentially risky, but it was based on the reasonable assumption that interest rates can’t go much lower, but neither will they rise dramatically. According to the ProPublica story, Freddie bought $3.4 billion in “inverse floaters,” which are mortgage-backed bonds based on the interest payments from homeowners. As ProPublica points out, those securities can lose value when homeowners refinance or “prepay” in mortgage-banking terms. When that happens, investors get the principal portion of the mortgage back to reinvest but the stream of interest payments ends forever.
Freddie holds a massive portfolio of mortgages. Many of these borrowers have negative equity, can't refinance, and therefore pay higher coupon. Freddie can leverage that excess coupon stream via the interest-only securities and generate extra revenue with little capital.

Freddie holds both floaters and inverse floaters (much larger book of inverse floaters than floaters.)  Both are interest-only securities, but inverse floaters tend to be more stable. As rates rise, the coupon decreases, but there is more cash available to pay the coupon because prepayments stop.

With rising rates, Freddie's big mortgage portfolio will fall in value because mortgage durations will extend, paying lower than market coupon (negative convexity). Interest-only securities would do reasonably well because any remaining refinancing in the pool of mortgages will stop and the coupon revenue will extend. These positions therefore will be providing some offset to the mark to market losses in the main book in a rising rate environment. If rates keep rising however, the inverse floaters will indeed get hurt because they will receive an increasingly lower portion of the interest pool. But typically mortgage portfolio managers use interest rate swaps to offset some of that risk.

In a falling rate environment the coupon in the interest-only pool will be reduced due to some prepay, but a big chunk will keep paying because of the borrowers' inability to refinance. The interest-only securities will drop in value but still be reasonably stable, particularly the inverse floaters. Freddie's main mortgage portfolio on the other hand should go up in value because it will be paying above market rates with refinancing speeds contained.

What happens however if the Obama administration launches some sort of a mortgage principal forgiveness program? The probability of this event is remote because many of these troubled borrowers also have home equity loans. It would be legally difficult to force a principal reduction on the "1st lien" mortgages, while "2nd lien" (home equity - often with a different lender) is still outstanding (hat tip Greg Merrill). 2nd lien loans will therefore have to be sorted out before such a program can be effective (and legal). Even if it does happen, it will definitely hurt the interest-only paper, but should be net positive for their main mortgage portfolio because it will reduce default rates.

It is also important to note that Freddie retained many of these positions from the secularization transactions in which it sold pools of mortgages. Often there simply weren't many "natural" investors in inverse floaters. But this securitization process gave Freddie more balance sheet to originate new loans.

Securitization of mortgage pools ("Gold Collateral" refers to pools of mortgages in Freddie's deals called Gold MACS)

It is true that Freddie has a responsibility to the mortgage borrowers. However it has a bigger responsibility to the tax payers who own the organization. And that responsibility includes managing the portfolio risk as a fiduciary. The interest-only securities are not hurting the borrowers, yet they capture some of the revenue back to the taxpayer. According to CBO, the US Treasury spent some $300 billion to prop up the GSEs. Shouldn't the taxpayers have the right to get some of this money back?

Can Germany decouple from Eurozone's "double-dip" recession?

Source: TheLocal
Staying on the topic of sentiment indicators, let's now turn to Europe for a quick look at Germany and the European Commission Economic Sentiment Indicators (ECESI). ECESIs are monthly indicators that use business and consumer surveys to assess the levels of economic "optimism". They combine current conditions as well as expectations (similar to the U Michigan index for US consumers.)
EC: The monthly economic sentiment indicator reflects general economic activity of the EU. This indicator combines assessments and expectations stemming from business and consumer surveys. Such surveys include different components of the economy: industry, consumers, construction and retail trade.
The chart below compares the ECESI Eurozone with the Eurozone year-over-year GDP. ECESI definitely seems to be a good leading indicator for GDP growth.

ECESI Eurozone vs. Eurozone GDP

Now let's look at the ECESI by country.  The index clearly shows Germany decoupling from France and Italy. If ECESI is a decent predictor of the GDP growth as the chart above shows, we should see German economic growth decouple from the bulk of the Eurozone. 

ECESI for Germany, France, and Italy

Another sentiment indicator of German economic optimism is pointing to a similar trend. It is called the ZEW Germany Expectation of Economic Growth (computed by ZEW, a German nonprofit center for European economic research). The chart below shows the index net change. Just as was the case with the U Michigan Consumer Expectations index, ZEW is based on survey of expectations, while current conditions measures may not necessarily indicate economic expansion.  Therefore one should be cautions when interpreting movements in this index.

ZEW Germany Expectation of Economic Growth
Nevertherless the surveys are pointing to a potential for Germany to avoid a "double-dip" recession, which is inevitable for many other Eurozone states.
ZEW: On average the experts estimate a likelihood of 71 per cent that the German GDP will grow during the first quarter 2012. If this comes true, Germany will not slide into a recession for the time being. A recession – speaking in technical terms – does only exist if the quarterly GDP decreases for two consecutive times.
Here are five reasons that may explain some of this economic optimism in Germany.

1. Mild winter has helped German construction industry from shutting down.
2. Similar to US firms, German companies have restructured since 08 and are in a much better position to withstand a Eurozone downturn.
3. Public finances are generally healthy (better than the situation in the US) - for now.
4. German domestic demand continues to be strong.
5. The weak euro is helping the export sector compete more effectively on the international markets.

Clearly risks to German economic expansion are tremendous, particularly if further assistance for periphery nations (via ESM or IMF) or German banks will be required. But if these survey based indicators are reasonable predictors of GDP growth, Germany may indeed achieve at least a partial decoupling.

Sunday, January 29, 2012

The jump in U Michigan sentiment index is driven by consumer expectations

The US economic news last week was not all negative - in fact it was more of a "mixed bag". The positive news came from the U.Michigan index of consumer sentiment.
Reuters: The Thomson Reuters/University of Michigan's final reading on the overall index on consumer sentiment rose to 75.0 from 69.9 the month before. It was the highest level since February 2011.
The current index level takes us back to where the sentiment measure was in early 2011, before the Eurozone crisis took hold of the financial markets. One question worth considering is how did the sentiment index decline of 2011 compare to a similar period in 2008?  The low point was August of 2011, a month that combined the US budget negotiations, the US debt downgrade, and the escalation of problems in the Eurozone. The sentiment in August was about as low as it was in November of 2008 - the lowest point of the financial crisis. This seems a bit surprising and not at all intuitive, with anecdotal evidence suggesting that 08 felt far worse than 2011.

U Michigan Consumer Sentiment
What drove the sentiment index to levels comparable to 2008? The index actually has two components: the Current Conditions Index and the Consumer Expectations Index. And it was the "expectations" component that pushed the whole index to this low point. In fact according to U Michigan, when it came to consumer expectations, the "end of the world" was coming in August of 2011 - a point on the index that was in fact lower than the expectations measure in 2008 (as shown in the chart below). This is puzzling. Were consumers reacting to all the market driven media frenzy in August that wasn't as prevalent in 2008? Were consumers not as focused on the state of the financial markets in the past as they are now?

On the other hand the "current conditions" component did not dive anywhere close to its 08 lows, which is more in line with other economic indicators.

Components of the U Michigan Sentiment Index

As a comparison let's take a look at another gauge of US consumer sentiment - the Conference Board Consumer Confidence Index. That index was behaving closer to the U Michigan Current Conditions component (above), with a dip that did not rival the 08 levels.

Conference Board Consumer Confidence Index

Some of this difference between these two gauges of consumer confidence was pointed out back in the 80s by some OSU researchers.
Researchers on index comparison:    Thus, it appears that the Index of Consumer Sentiment is capturing consumer reactions to what is happening with financial related factors (e.g., prices and interest rates) and to a lesser extent, such variables as the work week, the stock market, and the employment picture. In contrast, the Index of Consumer Confidence is picking up some additional information on employment related variables, such as the length of the work weeks the accession-layoff rate, and disposable income.
One therefore has to be careful in interpreting the U Michigan consumer sentiment indicator because it is a combination of current conditions as well as expectations. And when things turn ugly in the financial markets, it is more the expectations that drive the index lower, even if current conditions have not deteriorated as dramatically. Just as important is the fact that when markets improve rapidly as they recently have and the index spikes, it is driven more by expectations and not as much by a rapid improvement in current conditions of the US consumers.

Four facts behind the Q4 US GDP miss

Source: LA Times
The big US economic news last week was that the GDP growth number came in below expectations.
LA Times: The gross domestic product rose at a 2.8% annual rate in the fourth quarter as consumers bought more cars and other goods, the Commerce Department said Friday. That was below the 3% figure many analysts had projected. But it was up from a feeble 1.8% the quarter before.

However it is worth noting that the headline number does not tell the full story.  Here are four facts behind this GDP miss that should be considered:

1. The nominal GDP (vs. the real GDP), which is an important indicator of corporate profit growth was up 3.2%. Many believe that we need 4.0% nominal GDP growth to maintain robust corporate profitability growth. In that sense the nominal GDP number was even more disappointing.

2. A great deal of the GDP growth came from inventory build.
LA Times: More than half resulted from businesses increasing their stockpiles of products rather than from sales of goods and services, which reflect actual demand.
This is not great, because inventory builds are less likely to be repeated soon. This bodes poorly for GDP growth in the current quarter.

3. The Q4 inflation measure used to convert the nominal GDP into the real GDP was quite benign, only 0.4%.  That may explain the Fed's complete comfort with further accommodation.

4. The biggest drag on growth was a 3.7% quarterly decline in government spending. This is clearly a good indication from the government budget deficit's perspective, but is also a sign of what is to come as the US embraces more austerity measures. Without the impact of declining government spending, the nominal GDP measure was actually 4.9% (vs. 3.2% with government spending included).


Saturday, January 28, 2012

Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)
An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   
Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.


Friday, January 27, 2012

The fundamentals behind strong HY fund flows

Following up on the post about HY fund flows, the amount of new cash hitting the system has not only been unusually high, but also consistent on a daily basis.  As the chart below shows, we only saw one day of net outflows.

Source: EPFR

Here is the year-to-date cumulative net inflow ($7.4 bn YTD.)

Source: EPFR

It is clear that zero rates is one reason for these inflows, but what about fundamentals of the HY market? Are they really that attractive? Three items driving fundamentals are worth mentioning:

1. Defaults continue to stay near record lows and spreads seem interesting on a relative basis.

Source: JPMorgan

2. Leverage on in HY corporations in the US remains stable.

Source: JPMorgan

3. US corporations' liquidity, even at leveraged companies, has been rising steadily in the last few months (hat tip Royal Arse)

Source: JPMorgan

But even with these strong fundamentals, the speed of inflows we are seeing is unlikely to be sustained for long. The trend is somewhat troubling because a good portion of these flows is coming from retail investors. Some of the more leveraged names, particularly in the CCC range are still quite vulnerable to global economic shocks. Given the recent rally (the US JPM HY Index is up 2.8% YTD), the overall sector could sell off sharply with a sudden surprise out of Europe.


The Fed extended start of tightening by 3 months, not 18

It looks like some in the media are now using the appropriate language with respect to the Fed's latest action. Reuters, who tends to be fairly accurate in their reporting, described the extended low rate environment as being "probable" instead of "certain".
Reuters: The statement by the Fed, which announced on Wednesday it would probably keep interest rates near zero until at least late 2014 - some 18 months later than the Fed had suggested last year.
Given that we are working with probabilities instead of certainties, how did this event change the the timing of expected rate hikes?  After all the general perception (as per Reuters quote above) is that the rate hike has been extended by 18 months.

The best markets to provide visibility into the Fed's future policy are the Chicago Board of Trade Fed Funds Futures contracts. The chart below compares the implied Fed Funds rates prior to the Fed's announcement as well as now.

Fed Funds rate implied by the Chicago Board of Trade Fed Funds Futures (Bloomberg)

The curve has definitely shifted further out, but not by 18 months as is generally believed. The shift is actually only about three months.  The current curve is implying the first rate hike to be in the early part of 2014. So for those who are planning on zero rates throughout 2014 and into 2015, pay attention to the market - it may tell you otherwise.


Restoring confidence in the Eurozone's sovereign credit markets

Portuguese bonds continue to sell off as the market focuses on Portugal becoming the next Greece. Portuguese spreads have completely decoupled from the rest of the Eurozone periphery.

Portugal vs. Italy 5y spread to Germany

But Portugal is not trading down in a vacuum - the valuation of the nation's bonds is tied to the outcome of the Greek restructuring process.  The markets are not only reacting to Portugal's insolvency but also to the market structure uncertainty. The sovereign credit markets in Europe are broken and two key events must take place to restore confidence.

1.  The ISDA Committee must do the right thing and trigger the Greek CDS (call this a "credit event"). Even without the Collective Action Clause on Greek bonds, this is a default and should be treated as such. The impact on the market may actually be positive because it will mend (at least in part) the broken sovereign CDS market. This has implications for Portugal as investors will once again view sovereign CDS as potent protection against default (similarly to stock put option holders having the ability to exercise their puts). At least in some cases, holders of Portuguese bonds may choose not to dump their holdings because of the availability of a reliable CDS market (which now trades at 39 points upfront).  Just as important is the fact that banks who are lenders to Portuguese corporations will have a reasonably liquid hedge for their assets. Since there is little CDS traded on Portuguese corporate bonds, a reliable sovereign market could be a good proxy.

2. The ECB must take the same haircut on Greek bond holdings as the private bond investors. It's bad enough that the market views sovereign bond holders as being subordinated to the IMF, the EFSF, and in the future to the ESM. Now also being subordinated to the ECB makes the sovereign bond market look completely rigged. A BNP Paribas research note put it quite eloquently:
BNP Paribas: The ECB has no legal right to be treated as a preferential creditor. Others who bought Greek debt at the time, or who held onto debt they already held, should have been appraised of the ECB’s preferential treatment. The ECB’s standing should have been made clear in law. Not to have done so in advance is not only unfair, but it also distorted the markets. If the ECB knew in advance that it would be treated more favourably than the private sector sellers it bought its bonds from, then it acted unfairly and abused an asymmetric information advantage;
Yes, Germany and others in the Eurozone will be upset because the ECB's loss in Greek debt will wipe out more than a year's worth of earnings and may require an injection of public funds.  But the ECB must take a loss in order to assure investors that private holdings are pari passu with the ECB's positions. Otherwise investors will be constantly worried about the amount of ECB's holdings to determine the size of the ECB's "senior tranche" vs. their "junior tranche". The same bonds having two seniority levels depending on who holds them is not a viable market. Not only will this further impair existing Portuguese bonds, but will make it impossible for Portugal and Greece to return to the markets even after they restructure.

The Eurozone must take other steps as well to restore confidence in the sovereign credit markets, but these two actions are critical not just for Portugal but for the rest of the euro area periphery.

Thursday, January 26, 2012

The chase for yield is on

The US high yield (HY) market is starting to look somewhat frothy. We've had over $7 billion of fund inflows this month with $2.5 billion this week alone. Of the $2.5bn, roughly $1.5bn went into HY mutual funds and $1bn into HY ETFs. That compares to about half a billion into mortgage-backed bond funds and $700mm into muni funds (according to EPFR Global). With the Fed on hold for a while, investors are chasing yield.

For HYG (HY ETF) for example, the growth in the number of shares has been unprecedented, and the ETF again now trades at a 2% premium.

HYG Shares Outstanding (Bloomberg)

One can also see rising risk appetite in the HY primary market as well.  Some new issues that hit the market are quite risky.  For example Realogy, a company that nobody would look at a month ago, comfortably sold new bonds.
LCD News: Realogy's return to market was met with strong demand, with both tranches of secured notes pricing tight to talk, and the paper is volatile this morning in post-break trading. The 9% intermediate-lien notes due 2020, for instance, are pegged at 100/100.25 in the Street, against a break around 101 and trades earlier this morning at 100.375, according to sources. Pricing was at par.

Realogy's 7.625% notes due 2020 also priced at par, and this morning's markets are generally at 100.5/101, sources said. Meanwhile, the previously outstanding 11.5% exchange notes due 2017 are trading at 95.75 this morning, versus 95 yesterday but 90 before the new issue hit the market, trade data show.
The company is highly leveraged and is extremely vulnerable to economic shocks. (For those interested in learning more about Realogy's "distressed" past, read this excellent post).

Spreads are still above last summer's lows and the fundamentals are strong, but we could easily see a pullback in this market. 


Cap-and-Trade is dead, even in California

With the collapse of the CCX carbon credit trading, the only viable market based program for carbon emissions reduction has been developed at a state level in California. In conjunction with Cap and Trade, California implemented a law called California’s Low Carbon Fuel Standard (LCFS). Recently however Judge Lawrence O’Neill issued an injunction to stop LCFS from proceeding as planned.

The sticking point seems to be the discriminatory nature of the program against power generated outside the state that is viewed as hampering interstate commerce. This is why such programs are difficult to implement at the state level vs. nationally.
Judge O’Neill: "California is attempting to stop leakage of GHG emissions by treating electricity generated outside of the state differently than electricity generated inside its border. This discriminates against interstate commerce.”
Legal experts now believe that this injunction will also derail California's Cap and Trade program.
Marten Law: With respect to electricity, the cap-and-trade program imposes requirements on emissions of fossil fuel-based generation in California, requiring an allowance to be submitted for each ton of regulated GHG emissions in California. In order to avoid leakage of emissions to other states, California has imposed an allowance requirement on imported electricity representing the emissions of GHGs imputed to such electricity.
California Air Resources Board who sponsored these initiatives will appeal the LCFS injunction, but for now the whole program has been put on hold.

With Hollande in the lead, France may be making a shift to the left

With a dimming employment picture in France, chances of a potential regime change in that nation have increased substantially. Sarkozy, should he decide to run again, will be opposed (among other candidates) by the Socialist candidate, François Hollande, who was chosen by his party in the October primaries.

Based on Intrade probabilities, Hollande now has an over 65% chance of winning the presidential election this spring (although trading volumes have been quite low.)

Probability of Hollande winning the 2012 presidency

The opinion polls on the most likely scenario of Hollande vs. Sarkozy (in the second round of voting) paint a similar picture.

Source: BNP Paribas

WSJ: The poll, carried out by CSA Jan. 23-24, showed that 31% of potential voters would chose Hollande if elections were held now, while 25% of them would pick Sarkozy, CSA said. Hollande gained two percentage points, while Sarkozy lost one point since the last comparable poll held by CSA Jan. 9-10.
Other candidates such as a centrist Francois Bayrou could change the political landscape (it's not a two-party system like the US.)  Also the far-right candidate Marine Le Pen, who would push for France's exit from the Eurozone, has gained some ground. But for now it looks like Hollande is ahead. This is a significant development for the financial markets in France and may have implications for the Erozone as a whole. 
Bloomberg: “We must make an effort for more fairness and to rein in the financial industry,” Hollande said today as he detailed his campaign platform in Paris. “We will separate the speculative sector from the credit sector.” 
Hollande will clearly push for new French laws that would be similar to Vicker's recommendations in the UK. Other financial regulation such as prohibiting stock options could be considered as well .
Reuters: "In the battle ahead, my main adversary has no name, no face and no party. He will never run as a candidate. He will never be elected, but he rules inspire of all that. My adversary is the world of finance," Hollande said to a standing ovation in a packed conference hall on the northern outskirts of Paris.
Hollande would be the first Socialist president since Francois Mitterrand. Mitterrand too was not very fond of financial services:
Reuters: Mitterrand, who ruled France for 14 years, won power in 1981 a decade after he became Socialist Party leader with a similar tirade against what he then called the "power of finance, finance that corrupts, finances that buys, flattens and ruins, finance that rots through to the very conscience of man."
This election is particularly important given the pressure on Eurozone banks, the new Eurozone treaty and subsequent implementation of the ESM. Such change of leadership in France may even shift the balance of power in the Eurozone and potentially challenge the current state of Franco-German relations. In particular Hollande may pressure the Germans to have the ECB embark on quantitative easing involving direct purchases of sovereign bonds. This in what Hollande calls tackling "speculation efficiently".  Because to a true Socialist any negative market reaction is just another form of speculation.
Bloomberg: “I know how much you hold dear the rules on the independence” of the ECB, Hollande told delegates at the German socialists’ annual convention. “But equally I want it to take more notice of the situation in the world of the real economy.” The ECB must use its powers “fully” to combat the crisis, “expanding its role as a credit source to tackle speculation efficiently,”


The squeeze on dollar funding in the Eurozone continues

The latest data on US money market funds is continuing to show reduction in holdings of Eurozone banks' commercial paper (CP). Again, money funds do not sell their CP, they just let it mature without rolling into new paper from the same banks.  Instead money market funds are buying Australian, Canadian, Japanese, and some UK bank paper (in addition to their holdings of US CP).

Non US holdings by US money market funds (Source: Fitch)

These Eurozone banks in turn are replacing their dollar funding with dollar loans from the ECB via the Fed's liquidity swap.

Fed Liquidity Swap

The impact of this transition will be a substantial reduction of dollar assets and even whole dollar businesses at European institutions. US corporations, real estate firms, US energy projects (where some European banks used to be active), etc. should not expect to see substantial new lending from  Eurozone banks going forward.  Dollar lending business will now be dominated by US banks who have easy access to dollar funding.   


Wednesday, January 25, 2012

Deteriorating employment situation in France

The headline number for French unemployment rate has been fairly steady in the past couple of years - between 9.5 and 10% (Bloomberg). The unemployment rate numbers however don't show the number of job seekers in France, which has been on the rise and recently reached the highest level ever.  This index tends to be more of a leading indicator for the overall employment conditions in the country.

Number of job seekers in France (broad category). Source: Barclays Capital

Just as a background, category A represents the unemployed (registered with job centers), B represents part-time workers (under 78 hours per month), and C are people working over 78 hours a month.

The latest numbers show a significant jump in job seekers, currently at 17%  above the long-term average. 
ShareNet: UNEDIC said it expected the number of people out of work to rise by 214,500 by the end of 2012, taking the headline unemployment figure to 3.07 million from 2.86 million at end-2011, which was the highest level since April 1999.
This employment picture in France is a clear sign of deteriorating economic conditions in the Eurozone as a whole. It is particularly alarming to see this not just in the periphery but also at the core.

Fed's low rate statement is not a pledge

There is no shortage these days of mainstream media misinterpreting current financial and economic events. The Fed's action today in fact created just such a misunderstanding.
Forbes: Wednesday’s Fed pledge to keep rates low for even longer helped perk up a stagnant market. About forty minutes after the statement and just over an hour to the Bernanke presser, the Dow Jones industrial average was up 36 ...
In fact there is no "pledge" from the Fed, and Bernanke made that point quite clear in his news conference. This is what was actually in the Fed's statement:
Fed Statement: ...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
The FOMC survey indicates that the Committee members on average think that rates will stay low in 2014 because of slow economic growth. But the members are somewhat divided on that view as the scatter plot below shows. This is the Fed's forecast, which provides guidance for rates going forward and not any sort of commitment or a "pledge".

Target Federal Funds Rate at Year-End- FOMC survey (source: the Fed)

Here are the averages of the FOMC projections based on the scatter plot above.

Source: Capital Economics
There is no indication from this forecast that the Fed is absolutely committed to keep the target rate at 0-25bp through 2014.


Der Spiegel hypes hedge funds' role in Greek restructuring - and gets the Hype Award

Mainstream media has been hyping up the hedge funds' role in the Greek restructuring process. The evil speculators are at it again, "holding out" on the voluntary exchange for new bonds. The argument goes that hedge funds bought bonds at a deep discounts and also bought the CDS protection. If there is a disorderly default or an involuntary restructuring, these funds would lose money on their bonds but more than make up for it on the CDS. Der Spiegel argues that these speculators are getting "free money" in this transaction.
Der Spiegel (Stefan Kaiser): Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.
But let's check Der Spiegel's math. Evil Capital Hedge Fund buys a Greek bond at €30 (per Der Spiegel's comment) and a CDS protection that would cost them say €70. According to Der Spiegel the bond ends up worth €10 after the Greek default. The CDS will pay out par less the recovery amount or €100 - €10 = €90. So the trade makes them €20 on the CDS (from €70 to €90) and the bond loses them €20. Evil Capital is net flat on the trade, not up " almost 100 percent".

Some may argue that the shorter maturity CDS is cheaper than €70, closer to €60. But shorter term bonds are actually more expensive, closer to €40 (the 3/12 maturity bond is around €38). So the same math applies and Evil Capital still barely breaks even on the trade. Amazing. No free lunch here - the market is a bit more efficient than Der Spiegel gives it credit for. And Evil Capital may not be that smart after all.

Nevertheless hedge funds are still derailing the negotiations according Der Spiegel and the Greek Government won't stand for it.
Der Spiegel (Stefan Kaiser):  The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.
But wait a minute here. What other bond holders may be holding out? The answer is that the other big holdout may in fact turn out be the ECB. With the support of the German government, the ECB does not want to participate in the voluntary exchange.
Bloomberg: While the ECB faces pressure to join private-sector investors in accepting losses on Greek debt, the central bank sees any participation as risking damaging confidence in the institution, two people familiar with the Governing Council’s stance said. The debt was acquired for monetary policy purposes and the ECB is firmly opposed to any restructuring, they said on condition of anonymity because the matter is confidential.
Therefore not only there is no free lunch in the Greek CDS-bond trade, but the holdouts may actually be dominated by the ECB, not hedge funds. For their focus on sensationalism rather than unbiased journalism, Der Spiegel and Stefan Kaiser get the Sober Look Hype Award. Congratulations.

And by the way, this Der Spiegel story opens with the following photo. Read the caption.

NYSE business "strained" by the Greece negotiations? And we wonder why the public is confused about financial markets.


The story of two risk indices

The latest reading from the Credit Suisse Risk Appetite Index shows that we are now out of the "panic mode".  In fact the index is back to the pre-crisis (of 2011) levels.

CS Risk Appetite Index (Source: Credit Suisse)

One way to check the validity of being back to July-2011 levels of risk appetite is to compare the CS index to another indicator. Let's take a look at the Fisher-Gartman Risk Index, developed to allow investors to participate in the "risk on" trade.

Fisher-Gartman Risk Index (Source: Dow Jones)

This index has not recovered nearly as much as the CS one. According to Fisher-Gartman we are at the highs of the Nov-2011 levels. How can one explain such a difference in risk indicators?

We know that the CS index is calculated from bond and equity prices including emerging markets.  On the other hand the Fisher-Gartman index has a substantial commodity and currency exposure.

Fisher-Gartman Risk Index Components (source: Dow Jones) - click on chart to expand

This next chart compares the CRB Commodity Index with the S&P500.  Equities have outperformed commodities by over 10% since the beginning of last year.

CRB Commodity Index vs the S&P500 (Bloomberg)

Similarly one could compare a basket of currencies as represented by the Deutsche Bank US Dollar Short Futures Index with the equity index.  The equity outperformance vs. currencies isn't as pronounced as it is for commodities,  but it is still close to 5% over the same period.

 Deutsche Bank US Dollar Short Futures Index vs. S&P500 (Bloomberg)

We now have the explanation for the CS Risk Appetite Index pulling significantly ahead of the Fisher-Gartman Risk Index.  The difference is driven by the underperformance of currencies and in particular commodities that are not present in the CS index.  The question of whether we have pulled out of the "crisis mode" therefore depends on which markets one believes better represent the global risk appetite.

Tuesday, January 24, 2012

The "robo-signing" settlement's impact on the mortgage market

Tonight is the State of the Union Address and rumors are circulating that Obama will announce the robo-signing settlement with the big banks. The number thrown around is about $25 billion. The idea is to use these funds to help troubled homeowners avoid default via refinancing and/or principal forgiveness.

To see what this means in the context of the overall mortgage market, let's perform an oversimplified calculation. Let's take someone who is currently paying 5.5% on her 30-year mortgage. Refinancing at current rates and paying 2 points as well as full fees would mean that within 3 years of refinancing the borrower will recover the fees and start saving. That basically implies that anyone with a mortgage rate materially above 5.5% should be refinancing if they can. Again for simplicity, let's take the full universe of FNMA 30-yr Fixed securities and look at the mortgage characteristics of the underlying pools of loans. The chart below shows the amount of loans outstanding vs. the average mortgage coupon (WAC) in the pools.

Again this is oversimplified, but the borrowers in the red portion of the chart (higher than our 5.5% example above) should be all refinancing as quickly as possible. The question is, are they refinancing?  The next chart shows the prepayment (refinancing) speed (PSA) over the past month vs. the average coupon.

The chart demonstrates that these homeowners are indeed refinancing but at a lower speed than the onses with a smaller coupon.  One would think the trend should be reversed - the higher the coupon the quicker people would want to refinance.  But that's not the case.  In fact fewer high coupon borrowers are able to refinance because those who could, already did.  The remaining homeowners are either really slow or just can't refinance because they have "negative equity" (mortgage principal higher than the value of their homes.).

Much of the refinancing is coming from the lower coupon borrowers, those with newer mortgages (since such low mortgage rates are a recent phenomena.)  The folks on the red part of the chart represent over half a trillion dollars in mortgages. And it doesn't mean that everyone with a 5.5% coupon can refinance either. This exercise just represents the FNMA conforming 30-year mortgages, which is only a part of the overall mortgage universe.

This simplistic calculation tells us just how ineffective the $25bn settlement would be. In fact only about 100,000 borrowers who could be helped with these funds because only some of the funds would go to the homeowners. However there are some 11 million borrowers with negative equity and need help.

So why bother, given this is such a drop in the bucket?  The answer is there may be a couple of potentially positive outcomes, though both are low probability events at this stage.

1. This settlement and the subsequent support for those few homeowners will give the government some idea of how effective partial principal forgiveness and lower rates are in reducing default rates and cutting overall losses for lenders/investors.  Currently this subject is debated. These statistics may pave the way for a much bigger government sponsored refinancing package (although it is not at all clear whether the taxpayer should be supporting such action).

2. The deal may accelerate the foreclosure process that has been put on hold by banks because of the "robo-signing" legal proceedings. Timely foreclosures are key to stabilizing the housing market because they move assets from weaker holders to stronger ones. A couple of million homes in foreclosure could come to the market quicker, reducing the overhang. This may delay the market recovery in terms of prices, but the recovery would be healthier when it does take place.

Many uncertainties in this deal still remain, such as numerous states deciding not to participate in the settlement. States may want to pursue their own litigation that could tie the banks up in court for a long time.  And that would delay foreclosures and make banks even less willing to provide new loans.

Either way, don't forget to tune in at 9 pm EST tonight and listen for the words "robo-signing".


Portugal in markets' crosshairs

Portugal remains vulnerable, with the bond market looking increasingly pressured this week.
WSJ: The cost of insuring Portugal's debt against default was at record highs Tuesday and its bond yields remained at elevated levels amid concerns that a possible second bailout for the country in 2013 would include a Greek-model haircut for private-sector bondholders.

Worries have mounted among experts that Portugal won't be able to return to markets for funding next year, forcing it to request a second bailout package
Even though the WSJ keeps discussing Portugal sovereign CDS, the real focus should be on the bonds, since in the wake of Greece sovereign CDS market is becoming dysfunctional. Portuguese 5-year bond spread to Germany is near the highs.

Portugal 5-year spread to Germany (Bloomberg)
It is important to track the 5-year more than the 10-year point because in a stressed credits the bigger yield/spread moves tend to happen in the shorter end of the curve. Portugal's yield curve is inverted - a typical behavior for distressed bonds. Note that the move in the "belly" of the curve has been more pronounced than the 10-year move.

Portugal inverted yield curve now and on 1/13/12 (Bloomberg)
Once Greece is "sorted out", Portugal will come into market's focus even more. The notion that they can return to markets for funding in 2013 seems increasingly unlikely. Therefore a high probability of a Greek-style mess for Portugal will be pressuring European markets going forward.
Sales Cartoon #6021 by Andertoons
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