Saturday, June 30, 2012

Over 2.5 million delinquent mortgages to be resolved this year; shadow inventory shrinking quickly

In spite of the fear mongering taking place in the media and in the blogosphere with regard to the US housing "shadow inventory", considerable progress is being made in shrinking the oversupply of distressed properties around the country.

CoreLogic: -
  • As of April 2012, shadow inventory fell to 1.5 million units, or four-month’ supply and represented just over half of the 2.8 million properties currently seriously delinquent, in foreclosure or REO.
  • The four-month’ supply of shadow inventory is at its lowest level in nearly three years. It parallels the unsold months’ supply of non-distressed active listings that hit a more than five-year low in April, falling to a 6.5-months’ from a 9.1-months’ supply just a year ago.
  • Of the 1.5 million properties currently in the shadow inventory, 720,000 units are seriously delinquent (two months’ supply), 410,000 are in some stage of foreclosure (1.1-months’ supply) and 390,000 are already in REO (1.1-months’ supply). 
  • The dollar volume of shadow inventory was $246 billion as of April 2012, down from $270 billion a year ago and a three-year low.
  • Serious delinquencies, which are the main driver of the shadow inventory, declined the most in Arizona (-37.0 percent), California (-28.0 percent), Nevada (-27.4 percent), Michigan (-23.7 percent) and Minnesota (-18.1 percent).
Source: CoreLogic

It is important to note that the CoreLogic numbers exclude homes that are already listed in the market - it only shows the "shadow" (unlisted) inventory. That means that the overall inventory of distressed homes is far greater than the chart above shows (maybe 2 to 2.5 times that number).

Two key components are impacting the decline in shadow inventory:

1. A smaller portion of loan delinquencies now results in a sale due to the various loan restructuring programs and
2. the inventory has been hitting the market much faster than people anticipated.

The pie chart below is the projection from JPMorgan of how delinquent mortgages in the US will be resolved this year.

Source: JPMorgan

Here is what this breakdown tells us:

1. Not all of the "shadow inventory" is expected to hit the market.
JPMorgan: - ... increased modification efforts and other foreclosure alternatives should remove a sizable amount of inventory ... In addition to the ongoing HAMP and proprietary mod programs, which were pacing at around 500,000 loans annually at the end of 2011, increased incentives to HAMP forgiveness, relaxing DTI [debt-to-income] requirements, and requirements to forgive principal in the AG [Attorney General] settlement should boost modifications by hundreds of thousands more loans. In all, we expect over 1mn loans to be modified in 2012.
2. Short sales are becoming a larger part of liquidations, putting the inventory on the market much faster.
JPMorgan: - ... servicers have been aggressively pursuing short sales as a lower severity alternative to foreclosure; short sales are nearly half of liquidations now.
3. REO bulk sale and rental programs will reduce the inventory further.

Overall some 2.5 million loans will be resolved this year. Note that a good percentage of these 2.5 million homes is already listed in the market and therefore is no longer included in the shadow inventory number. Nevertheless this year's mortgage resolutions are expected to materially reduce the supply.
JPMorgan: - ... All in, we think over 2.5mn loans could be resolved this year, putting a major dent in inventory. Of course, given the large supply and volume of continuing delinquencies, we expect it will take years to work through all the defaults, but significant progress is being made, which gives us reason to be more bullish on housing than we have been for years

Despite the summit agreement, it will be a while before the ESM is authorized to buy Italian bonds. Germany still holds the key.

On Friday Angela Merkel got the Bundestag approval she was seeking. Germany approved the Fiscal Compact and the ESM. Germany views the Fiscal Compact as a way to enforce austerity in the periphery countries.
FT: - ... the Bundestag passed the fiscal compact with 491 of 608 votes cast and the ESM with 493 of 604 votes, giving Ms Merkel a comfortable two-thirds majority which she needed for passage of each bill.
This vote was already planned and had nothing to do with the summit. But Merkel had to defend her decision to concede on direct bank bailouts and the use of the ESM to buy sovereign paper. Her argument is that the ESM has by no means been given a blanket bailout authority.
FT: - “There will be conditionality,” she added. A country such as Italy would have to apply for market intervention and sign a memorandum of understanding based on the European Commission’s recommendations before bond-buying would be approved in the primary market.
It basically means that nations will sill need to apply for a bailout just as they had to do prior to the summit. The stigma associated with the process will still be there. The difference is that the mechanism for such bailouts would assure a (supposedly) rapid approval and a direct response. But the Germans can still "veto" potential actions by the ESM going forward.

And Germany's unease with the summit agreement is already visible. The opposition politicians are unhappy about both the direct bank bailouts and the sovereign paper purchases.
FT: - The opposition Social Democrats earlier summoned Wolfgang Schäuble, finance minister, to attend an emergency meeting of the Bundestag’s powerful budget committee, with senior lawmaker Carsten Schneider demanding he explain Ms Merkel’s “180-degree about-turn” from previously blocking direct cash injections.

Dissatisfaction was also voiced by members of Ms Merkel’s coalition, who worried she might have compromised her principle of giving aid only with tough conditions.

Wolfgang Bosbach, a lawmaker from Ms Merkel’s Christian Democratic Union and long-standing opponent of eurozone aid, said summit decisions about direct bank aid and readier help to lower sovereign-bond rates had seen Germany “finally and irrevocably” abandon the EU’s no bailout clause.
Clearly the Germans know their national exposure to the periphery will be increasing. And depending on the ECB's decision to ease policy next week, the risk to Bundesbank will increase as well. This is sure to make Germany's authorities uneasy about further bailout approvals.

There is also the issue of the German Constitutional Court that is looking into the ESM scheme. The approval could take weeks and could potentially be linked to a constitutional change or even a public referendum. And that would open a Pandora's box.
Reuters: - There is a chance it could link approval to a change in the constitution - which would require Germany's first national referendum in the post-war era. At the very least, experts say, the court could say approval for any future integration, beyond the ESM and fiscal compact, would require constitutional change.
Thus in spite of Mario Monti's apparent "victory" at the summit, there will be a great number of hoops to jump through before the ESM is actually ready to buy Italian bonds. Some of the risk asset rally we've had on Friday may therefore be reversed once market participants fully absorb this reality.

Friday, June 29, 2012

Italy's consumer hits a wall. The only boost to sentiment can come this Sunday.

The latest economic indicators coming out of Italy are just awful. The recession is getting far worse than most economists had predicted. That's part of the reason Monti has been pushing so hard to get the ESM and the ECB to buy Italy's debt. With such a deep recession engulfing the nation, the fiscal situation can't be good. Here are the latest economic figures.

As Italy's industries slow dramatically (see Industrial Production below) and unemployment hits 10%, the consumer begins to struggle.

Italy Industrial Production (YOY)

What's particularly troublesome is that Italy's inflation remains stubbornly high.

Italy CPI (YOY)

And high unemployment mixed with relatively high inflation has pushed Italy's misery index to new recent highs.

Italy Misery Index 

This trend has played havoc with Italy's consumer sentiment. The index of consumer confidence is now sharply below the lows of 2008.

Italy Consumer Confidence Index

This decline in confidence is now translating into a record drop in retail sales. Retail sales numbers tend to be volatile, but this last decline clearly stands out (below). And that coupled with higher taxes and increased austerity measures will do more damage to industrial production and employment ....

Italy Retail Sales YOY

Unfortunately at this stage there is nothing that Monti's government can do to give Italian consumers an immediate boost. The ECB who is clearly going to cut rates next week can also do little to ease tight credit conditions in Italy. There is only one thing that could (at least temporarily) boost the morale of Italian households. Italy needs to win the EURO 2012 soccer championship. So if you choose to watch the finals on Sunday, root for Italy - they need this victory even more than Spain.

German CDS vs SovX

As a quick follow-up to the post on Germany's growing exposure, here is a scatter plot of German CDS vs. SovX WE - the Western European sovereign CDS index. It shows that on a relative basis, German CDS spread is elevated. As the nation's exposure increases, we should see this divergence become more pronounced.

Housing affordability

Here is an interesting chart form Barclays Capital that measures the US housing "affordability". They take the ratio of median home price to median family income and compare it to the "pre-bubble" average. By this measure we are around the levels of the early 90s housing recession.

US housing affordability (source:  Barclays Capital)

Germany's growing exposure

With the latest summit "agreement" (assuming it gets off the ground) Germany will continue to increase its exposure to the Eurozone periphery. The nation's exposure will grow via its share of the ESM as well as the ECB who will be buying Italian bonds. That's in addition to what is already committed via the EFSF and its share of the IMF. There are also large direct exposures via the bilateral loans pooled by the European Commission (such as loans to Greece). And then there is the exposure that the media doesn't like to talk about because of the ongoing "debate". It is the Bundesbank's TARGET2 exposure, which just hit a record of about €700bn.

Bundesbank's TARGET2 exposure (€bn)

So what does 700 billion really mean in the context of Bundesbank's balance sheet? The balance sheet has grown as the exposure increased, right? But the reality is that TARGET2 is becoming an increasingly dominant component of Bundesbank's balance sheet. Almost two thirds of the central bank's assets are now tied in this "debated" exposure. And as funds flow out of the periphery states, the proportion is only getting larger.

In fact it is beginning to dwarf all the other assets. So here is a question: if you were Jens Weidmann or the the Bundestag or Angela Merkel or the German public for that matter, and you were looking at the chart below of Bundesbank's assets, what would you think? But no need to worry because these are just accounting entries and as long as the Eurozone stays intact there is no risk.

Cornered by other Eurozone leaders, Merkel concedes

With Hollande supporting Italy and Spain, Germany has became isolated. "Merkozy" is no more. Worn down Merkel conceded, sending risk assets to a massive rally. Caught in a short squeeze, the euro rallied nearly 2 % this morning. But with all the hoopla, let's take a step back and see what exactly did Germany agree to in the middle of the night. Here are some highlights.

1. Spanish banks will be bailed out (€100bn) directly out of ESM/EFSF rather than going through the Spanish government. This will avoid increasing Spanish government debt.Amazingly only last week Merkel said she could never agree to direct lending to these banks because she would be unlikely to "get her money back".

2. The Spanish bank bailout will not subordinate the bond holders as was expected.

3. Perhaps the most important agreement was that the European Stability Mechanism (ESM) could buy government bonds to reduce periphery borrowing costs. The only official statement was that the ESM will be used to buy bonds in “in a flexible and efficient manner”. No further details for conditions on such purchases were provided. This is clearly a victory for Mario Monti, who's been pushing hard for this measure.
EURO AREA SUMMIT STATEMENT: - ... We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States ...
4. There is an agreement to set up a single banking supervisor in 2013.

That seems to be it. A few observations:
  • As expected, there is no agreement on a "banking union" that would provide deposit insurance across the euro area.
  • The ESM, having already committed €100bn to Spain's bank now only has €400bn of capital. Given the amount of debt the periphery nations will need to roll in the next couple of years, this is hardly credible. And the Eurozone leaders have not agreed on the details of how capital will be released. We all know how easily the leadership gets caught up bickering over the details.
  • There will be pressure on the ECB to do what the ESM may be unable to do - expand the SMP program to buy more periphery bonds (so much for central bank independence). It already bought €220bn, but Monti and company will expect far more. That basically means QE.
Overal the market reaction may be premature. There is nothing final about these agreements and they do not get at the heart of the problems of run on banks and investors' ability to absorb more sovereign debt - particularly at the risk of subordination by ESM. There may also be significant backlash from German politicians and the public.

Thursday, June 28, 2012

The Fiscal Compact is in trouble

In the US the public had little interest in the recent French elections. But as predicted here some months ago, Hollande's victory has shifted the balance of power in the Eurozone (which will have a significant impact on the global and the US markets). Some investors in the US should have paid more attention to this.

Today in support of Italy and Spain, Hollande is putting the Fiscal Compact (to which Sarkozy agreed late last year) on ice.
Bloomberg: - Hollande put French endorsement of a German-inspired deficit-control treaty on hold, and Italy and Spain withheld approval of a 120 billion-euro ($149 billion) growth-boosting package unless Germany authorizes steps to calm their bond markets.

By provoking an open breach with German Chancellor Angela Merkel, the new French leader overturned the austerity-first consensus that has dominated the debt-crisis response and risked fracturing the Berlin-Paris alliance that built the European Union and euro.
Monti will walk away from the Fiscal Compact unless the ESM and/or the ECB are used to buy Italian bonds. He is basically saying he's done all he can domestically, and now it's the Eurozone's turn to help him bring down borrowing costs. And Hollande is on board with that. However Germany, who has the most to lose by indirectly becoming the biggest owner of hundreds of billions of periphery bonds, is clearly opposed to this move. The Fiscal Compact is in danger of collapsing. Without it there is little hope of pulling out of the Eurozone crisis.

Europeans' views of the euro

The latest Pew surveys that focused on the benefits of the euro and the ongoing wish to maintain the common currency have revealed some interesting results.

  • The Brits are really really happy the UK is not part of it.
  • The Greeks want to keep the euro more than the Germans.
  • And the Italians more than the others think it was a bad idea.

Source: BNP Paribas (* nations outside the euro area; click to expand)

In spite of large corrections, housing excess (and denial) persists in the Eurozone

Here are the latest statistics from Barclays Capital on the state of major housing markets around the world. A few observations:

Japan and Germany have basically been stagnant (although there are stories that German property markets have picked up). China's housing is right in line with the US because China's high inflation rate has held real home prices subdued in spite of large nominal price appreciations. Ireland and Spain are coming off their bubble (though still high on a relative basis), while the UK and France look quite elevated.

Real (inflation adjusted) house prices (Source: Barclays Capital; gray area is forecast; Q1 1997 = 100)

Residential investment as percentage of GDP (chart below) tells us who is still building and possibly overbuilding. Clearly in the US residential construction is a shadow of what it was even before the bubble. The Eurozone on the other hand seems to keep pouring quite a bit of money into residential development. That's surprising given the economic state of the euro area.

Residential investment as % of nominal GDP (Source: Barclays Capital)

So who in the Eurozone is in the "building mood"? The next chart breaks it down by country. Spain's resi investment is off the highs, but still about 6% of the GDP - the excess has clearly not been fully unwound. Spain should be where Ireland is now and therefore has ways to go. The banks financing this must still be in their denial mode - and the rest of the Eurozone will be paying for it later. Ireland and Portugal on the other hand got the message loud and clear, getting rid of the excess.

The rest of these nations just keep building as if nothing had happened, keeping the overall Eurozone investment levels high relative to other developed nations. And the banks are obviously financing all this investment. More denial.

Residential investment as % of nominal GDP (Source: Barclays Capital)

LIBOR is becoming less relevant, even in the US

The Barclays LIBOR scandal is expected to open doors wide open for private litigation. We know what that means for Barclays - the stock is down 11% for the day. But what does that mean for the LIBOR index?

It is possible that some banks will simply stop contributing to BBA in order to avoid running into similar problems in the future. Controlling flow of information across "the wall" (traders to contributors) in large institutions is difficult and expensive, and given that banks make no money by contributing, it may not be worth the risk.

As discussed before, this index is completely artificial in Europe. LIBOR/EURIBOR represents unsecured interbank lending which is not taking place among European banks, as they have almost entirely shifted to secured financing (repo) either with each other or increasingly with the ECB.

And even in the US where interbank unsecured lending still takes place, the market is becoming much less relevant. The chart below shows the total size of interbank loans for all US commercial banks going back to the 80s. The number is just over $100bn, which may seem like a large amount, but it's a fraction of what it was at the peak.

Interbank loans on balance sheets of all commercial banks
in the United States (4-week moving average, $MM)

What's even more striking is what this number represents as a fraction of the overall bank assets in the US (see chart below). Interbank loans are now just over 1% of total bank assets - the lowest in history. And there is some evidence that most of it is under one week in tenor. That means that even in USD, the 3-month LIBOR generally does not represent actual transactions.

Interbank loans as percent of banks' total assets
for all commercial banks in the United States (4-week moving average)

There are a number of reasons for this decline. Banks don't want the credit risk of lending to other banks when they can deposit money at the Fed who now pays them interest. Just as importantly banks don't want to rely on interbank borrowings for funding because that funding could disappear very quickly in a crisis.

Instead banks are increasing customer deposits (see this post for more info) because those tend to be far more "sticky". And regulators, rating agencies, and stock analysts prefer it that way.

We clearly need some alternatives to LIBOR that may represent actual transactions, ideally in an active market.

Wednesday, June 27, 2012

Frenzied buying of investment grade corporate bonds

Investors seem to have a bottomless appetite for investment grade (IG) corporate paper. Issuers are coming to market to borrow money at ridiculously low rates. Even for the longer maturities the spreads are 1-2% above the corresponding treasury yield. Here are some examples:
  • Tyco: 10-year notes at Treasuries + 190bp
  • Markel: 10-year notes at Treasuries + 225bp (this firm is BBB)
  • John Deere: 10-year notes at Treasuries + 122bp
  • Caterpillar: 10-year notes at Treasuries +110bp
People are lending to CAT at 2.7% for 10 years! Who is buying this paper? Institutional investors of course, but also mutual funds, and ETFs. The ETF situation is particularly scary because it is driving some of these low yields and should be viewed as short-term money.

Below is a chart of shares outstanding for LQD, the iShares IBOXX investment grade corporate bond ETF. This thing is now $22.3 billion in assets (growing rapidly as new money pours in), and Larry Fink is opening the Champagne - again. LQD paid out 1.7% in dividends YTD (3.4% annualized) and investors can't get enough of it. People are betting that rates/spreads will go down even further and they will get capital appreciation on top of the crummy interest income. This looks like another crowded trade that is not going to end well.

LQD shares outstanding

Distressed vs non-distressed housing market bifurcation

Some readers have pointed out that the improvement in the housing market they are seeing has been in better neighborhoods and for non-distressed properties. There is no question that we have a bifurcated market.

Non-distressed properties are down on average 25% from the peak while the distressed property market is down 40%. As the chart below shows, the non-distressed segment has shown far more (relative) price stability than the overall market.

Source: Morgan Stanley Research.(also DataQuick ; using Repeat Sales methodology)

Strangely, Mario Monti may object to a full blown banking union

As expected, the bickering over the proposed Eurozone banking union has begun. And as discussed, the stronger economies will object to the scheme.
WSJ: - The idea of closer European banking ties gained steam earlier this month when European Central Bank President Mario Draghi raised the issue in testimony to the European Parliament.

But Ms. Urpilainen said Finland couldn't accept a system that was based on shared liability.

"It is important to develop EU banking regulations and supervision and to safeguard depositors. However Finland cannot accept a banking union based on shared responsibility," she said in a written response to a question tabled by the opposition Finns Party.

She said the European Banking Authority could be mandated with new powers to oversee the European banking system, but added that national governments should still be the ultimate regulator of their financial systems.

"The European Banking Authority could be provided with stronger measures to ensure stronger national oversight. But this cannot change the principle that supervision should be implemented at the national level in the first instance," she said.
But even some in the Eurozone periphery may object to this banking union idea. Here is why.

It has been suggested that the euro area leaders should dip into the EFSF/ESM funds to provide a backstop to the yet-to-be-created entity that would guarantee Eurozone's deposits.
Reuters: - The euro zone's permanent bailout scheme, the European Stability Mechanism, could be used to backstop a fund to protect bank deposits or wind up failing lenders, according to a document prepared for European leaders meeting this week.
Without additional capital, such backstop would dramatically raise ESM's credit risk by increasing its exposure (with rapid downgrades by the rating agencies, etc.) If funds are diverted to guarantee depositors, there will be far fewer resources to support periphery governments. Funds going to Spain's banks, for example, are already taking a bite out of EFSF/ESM capitalization. And now the entity will be asked to guarantee  €11 trillion of deposits across the euro area?

Italy's banks are not nearly as troubled as Spain's, making Italy's objective different from its troubled neighbor. Italy needs investor confidence in its fiscal situation. Mario Monti has done a decent job in making some headway on this front by increasing taxes, cutting pensions, and pushing through significant labor reforms. But Italy also needs ESM's help in rolling its massive amounts of debt. Monti's goal therefore has been to release some of ESM funds specifically to buy periphery government debt - not to engage in rescuing banks or backstopping deposits
Reuters: - Italy put forward a proposal at a G20 summit in Mexico on Tuesday for the euro zone's rescue funds to start buying the debt of distressed European countries, and the idea is expected to be discussed at a meeting of leaders in Rome on Friday.
Therefore as strange is this may sound, Italy might actually side with Finland in objecting to the banking union in order to preserve EFSF/ESM. And with Italy objecting, the chances of the scheme being implemented as proposed are close to none.

Brent - WTI curves are not converging any time soon

The Brent-WTI crude oil spread has dropped materially from the peak, but managed to stay above $11/barrel. It has now recovered to $13. What's more interesting is the difference in the shapes of the two curves - particularly given that Brent and WTI are essentially the same products.

Brent and WTI futures curves

Brent is in backwardation, while WTI is in contango. Backwardation generally means tighter supply (more demand for the spot product) - a bullish indicator, while contango tends to indicate the opposite. It says that the crude market in the US (particularly in Cushing, OK) is well supplied, which is not the case with Brent (at least not nearly as much).

There is talk however that the gap between these two curves will close fairly soon (ht John A).
Bloomberg/BW: - The energy guys at Goldman Sachs, led by analyst David Greely, think that by the end of 2012 the price of WTI will be just $5 below Brent, largely because new pipeline projects, such as the recently reversed Seaway, will allow more domestic crude to reach refineries along the Gulf Coast, making WTI more valuable. In essence, the more domestic crude that reaches the Gulf Coast, the stronger the floor beneath the price of WTI becomes.
Some people doubt Goldman's forecast however. If traders truly believed in this rapid convergence, the two curves above would be approaching $5 spread six months out. Instead the difference in the January 2013 contracts is above $11. Analysts instead are looking at brisk US crude production that has been on the rise this year (we had signs of that increase earlier in the year).

US crude oil production (thousands of barrels per day; source EIA)

It means that in spite of the reversed Seaway pipeline that is delivering US crude to the Gulf Coast (to the large US refineries), there is still not enough pipeline capacity to accommodate this increased production, putting downward pressure on WTI.
Bloomberg/BW: - “Five dollars is not likely,” says Fadel Gheit, an analyst at Oppenheimer. “And even if it does go to $5, it’s not going to stay there.” Gheit points out that as long as WTI stays above $70, drilling companies can still make money producing new wells, which in turn, he says, will keep WTI anywhere from $8 to $12 below the price of Brent.

LIBOR manipulation: "dude, you’re killing us"

The FSA released records of their LIBOR manipulation claim against Barclays. The full document is attached below. Some of the trader/submitter conversations are incredible - and it's quite amazing what people will say on recorded lines, e-mails, or text. No wonder it's going to cost Barclays half a billion to settle. Here is a sample:
FSA: - ... on 5 February 2008, Trader B (a US dollar Derivatives Trader) stated in a telephone conversation with Manager B that Barclays’ Submitter was submitting “the highest LIBOR of anybody […] He’s like, I think this is where it should be. I’m like, dude, you’re killing us”. Manager B instructed Trader B to: “just tell him to keep it, to put it low”. Trader B said that he had “begged” the Submitter to put in a low LIBOR submission and the Submitter had said he would “see what I can do”;
[another conversation] “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards [billion] fixing for the desk and each 0.1 [one basis point] lower in the fix is a huge help for us. So 4.90 or lower would be fantastic”.
Here is an example of Barclays manipulation of EURIBOR in 2007. Hard to argue against this type of evidence.

Source: FSA

And much much more in the document.

Barclays LIBOR maniputation

Pending home sales stronger than expected

Slowly but surely the US housing market is climbing out of that deep hole it was in for some time. Pending home sales came in way above expectations (5.9% MoM vs. 1.5% expected).

US Pending Home Sales Index (SA)

A couple of things worth noting about the pending home sales chart above.
  1. Contrary to popular belief, the housing recession started in 2007, possibly even in 2006, not after the Lehman crash in 08.
  2. The First-Time Homebuyer Credit stimulus program had a tremendous impact on home sales. It tells us that tax incentive programs are quite effective but have a short "half life".

MRO - LTRO relationship

Some have asked to see a longer period chart of the MRO (main lending facility) balances at the ECB. Here is the chart from the beginning of 2010 comparing MRO and LTRO. Keep in mind that the LTRO program existed before Draghi took over the ECB. The difference is that the program in the past was mostly 3 months in maturity rather that the 3-year loans that Draghi introduced. Note that maturities/reductions in LTRO generally corresponded with increases in the MRO balances. And of course the recent LTRO loans reduced MRO balances to almost zero - until recently.

Coal inventory at China's power plants hits record; indicates reduced power usage

This weekend we discussed the massive buildup of thermal coal inventories at China's key ports. The reason for the buildup is the reduction in power usage (driven by slower economic activity) which increased coal stocks at China's power plants. We now have the data that demonstrates this "downstream" inventory increase.

Source: ISI Group

Tuesday, June 26, 2012

The evolution of the mortgage origination pie

Source: Inside Mortgage Finance

Time for LTRO-III?

In his weekly update on the ECB balance sheet, Kostas points out (among other developments) an increase in lending to banks (now at €1.24 trillion - a new record). Much of the increase comes form MRO - the ECB's main lending program. The bulk of these new loans likely represent the replacement of lost deposits at Spanish (and other periphery) banks as run on the banking system there continues.

The first LTRO funding was put in place shortly after Mario Draghi became the head of the ECB. MRO levels were quite high at the time. The 3-year LTRO programs Draghi put in place drove down MRO balances dramatically as banks rolled their short-term financing (MRO) into the long-term LTRO.

Since the last LTRO funding however, the MRO amount has risen significantly, particularly in the past few weeks. It is now above the level it was prior to the last LTRO, indicating a sharp increase in demand for liquidity. That may be a signal for the ECB that it is time for a third round of LTRO in order to ease the tight liquidity conditions.

MRO balance

Eurozone's banking union will not be credible; FDIC-type fund seems out of reach

There has been a great deal of discussion about the Eurozone's so-called "banking union" that would create pan-Eurozone banking regulation and depositor protection.
NYTimes: The summit, which will be followed by a separate meeting of euro zone leaders on Friday, is expected to focus on agreeing on the elements of a banking union, which is seen as a concrete step even though it would not come into operation until 2013 at the earliest. Those elements would include a system to liquidate insolvent banks, a central deposit guarantee fund, and a bigger supervisory role for the European Central Bank, among other measures.
The issue with any such arrangement is that the euro countries' banking systems are just too big for their "home" economies.
Barclays Capital: - Nobody questions the credibility of the US government as a rescuer of last resort of the US banks. And that is because the US banks’ total liabilities only represent 1x the GDP of the US. Where it becomes problematic is when the system gets too big, and that goes to the heart of the problem with Europe's banks; simply put, they are much too big for their individual sovereigns to protect credibly.
[for example] The largest US bank – JP Morgan – has liabilities equal to 13% of US GDP. By contrast 20 European banks have liabilities of more than 50% of their home country's GDP.

Source: Barclays Capital

That would mean that the Germans and other stronger economies would in effect have to backstop deposits in Spanish (and other periphery) banks.
Barclays Capital: - ... deposit protection must mean, for example, German taxpayers becoming liable for bailing out Spanish savers. Anything short of that, in our view, renders a union almost irrelevant for today’s crisis.
Some have suggested that this deposit guarantee come from an FDIC-like European entity that taxes banks and builds up a large capital base to provide this protection. This way no one country would be responsible for making whole the depositors of another nation.

However there is a major problem with this approach. The Germans (and others) already have such entities and would not want to simply contribute the capital they've built over the years to the rest of the union. Some in Germany have referred to this as "looting of the German banks' deposit insurance funds". That means the entity would need to be capitalized "from scratch". But to create a Eurozone's version of the FDIC with credible capitalization would take years.
Barclays Capital: - In the long run, funding a deposit guarantee scheme can come from charging the banks a fee, but near term the maths suggests it has to come from taxpayers. The eurozone has €11trn of deposits. Taxing 20% of all banks’ profits for half a decade would still leave the scheme with assets below US FDIC levels.
And a one shot capital infusion worth hundreds of billions is simply not possible at this stage unless you plunder the EFSF/ESM.

With a tax scheme in place, all the German banks would need to pay this large fee for years, even though they already have a credible domestic program. There is little chance German politicians would agree to this. Even if such an entity were to be established and funded, some of Eurozone's banks are so large (the French banks for example), the entity would need to be capitalized considerably better than the FDIC.

In the mean time the taxpayers of some nations would be on the hook for deposits in other countries - there is simply no way around that. It is therefore highly unlikely that the voters of the stronger Eurozone economies will support such policies and that a credible depositor protection scheme is even possible.

The Fed is putting an end to the TruPS market

Trust preferred securities (TruPS) used to be quite popular among banks as a form of funding. These high dividend securities were effectively junior debt instruments (getting interest treatment for tax purposes) but got equity-like treatment for capital purposes (Tier 1 capital). Many used to trade at a deep discount because of bank risk (government bailout would subordinate TruPS) and guys like David Tepper made a great deal of money buying these in 2009. Before the financial crisis, investors even used to securitize TruPS in a CDO. But under the new regulatory regime (Fed's interpretation of Basel III) that's changing.
Knight Capital Group: - Several banks have decided to redeem their trust preferred securities following the Fed’s June 7 meeting that proposed a phase out of the Tier 1 capital treatment of the securities. Banks have 90 days from the June 7 meeting to redeem the securities under the “capital treatment event” clause.
The TruPS market is now rapidly shrinking as banks refinance these securities, replacing them with regular equity and debt.
Reuters: - Citigroup, JP Morgan and SunTrust Bank are planning to redeem more than $15 billion of trust preferred securities next month, following the US Federal Reserve's release of new capital rules last week.
BAC, TCB, BBT, WBS, KEY are some of the other banks redeeming. This was a fairly unique asset class and it's not clear where this capital will end up moving. For example, PFF, the preferred securities ETF ($9bn market value) was loaded with these. As TruPS pay down, the ETF will be forced to move capital into far lower yielding or riskier securities.

ht @RennieScinto

So much for peak oil being just around the corner

Those who keep professing that "peak oil" is just around the corner or has already been reached should take a look at this Harvard paper (ht John A). The author (Leonardo Maugeri) analyzed oil exploration and development projects field by field globally to determine how oil production is expected to grow. Assuming oil price stays above $70 per barrel, here is what the increase in production will look like by 2020 (in Million Barrels per Day).

Source: Belfer Center for Science and International Affairs, Harvard University

Here is the breakdown of changes in production by country. The largest capacity increases will come from Iraq (whose reserves are thought to be the largest in the world), followed by (interestingly enough) the US, Canada, and Brazil.

Source: Belfer Center for Science and International Affairs, Harvard University  (click to enlarge)
Oil - The Next Revolution

Monday, June 25, 2012

DB projects consumer deleveraging will be complete within two years

Deutsche Bank's latest research on US consumer leverage suggests that the deleveraging process may have another couple of years to run. They determined the long-term trend line based on consumer debt to GDP ratio from 1953 to 2003, thus excluding the bubble years. Then they compared the current leverage to this line and looked at the rate of convergence. The intersection with the trend line is expected to take place in a year.

To be on the conservative side, they also assumed another year for the leverage ratio to overshoot to the downside and/or the nominal GDP to grow at slower rate than 4%. Note that the 4.0% nominal US GDP growth projection is not unrealistic (that's roughly where it has been recently). They verified this result by repeating the exercise using debt to disposable income measure rather than debt to GDP.
DB: - ... extrapolating the current trend further, household debt to GDP would intersect its long-term trend line by Q3 2013. It may be that households overcompensate, or nominal growth is less than 4.0% so we are conservatively estimating two years for the end of the deleveraging process. The story is broadly similar when comparing household debt to gross disposable income. This ratio has declined from a peak of 123% in Q1 2009 to 107% as of Q1 2012—the lowest level since Q3 2003 (106%). This tells us that consumers are nearing the end of the deleveraging process.

Source: DB

With existing home inventories tight, new home sales have stabilized

New single family home sales in the US rose more than expected during May.
Reuters: (Reuters) - New single-family home sales surged in May to a two-year high and prices rose from a year ago, further signs the housing market recovery was gaining some momentum.

The Commerce Department said on Monday sales jumped 7.6 percent last month to a seasonally adjusted 369,000-unit annual rate, the highest since April 2010.

That was well above economists' expectations for a 346,000 pace and the highest since April 2010, when sales were inflated by a homebuyer tax credit.
This provides further evidence to recent reports of tight inventories in the existing single family home markets.  People are not in a rush to sell existing homes at low prices and the shadow inventory is not flowing into the market at the rate some have been expecting (while "shadow demand" is growing). Tighter inventories in the existing home markets are increasing demand for new homes.

Clearly this volume looks puny relative to recent history. Also anecdotal evidence suggests that homeowners are waiting for prices to firm up to sell, thus limiting the rate of appreciation (at each price point, new exiting home inventory will enter the market). Nevertheless it seems that new home sales have now stabilized.

US New One Family Houses Sold  -
Annual Total SAAR (U.S. Census Bureau;
Note: the spike and drop in 2010 is due to the First-Time Homebuyer Credit)

India needs to cut fuel subsidies to avoid fiscal deterioration

India's government took action today to stem the currency declines, as INR reached all-time lows on Friday.
Reuters: India announced steps on Monday to bolster the embattled rupee, including a $5 billion increase in the foreign investment cap in government bonds, but disappointed markets hoping for bolder action to prop up a currency that hit a record low on Friday.
And here is the result:

INR per one dollar

The market pretty much shrugged it off, leaving the INR to USD exchage rate almost where it was before the new policy was announced. Too little, too late.

Beyond India's economic deterioration, one of the things that's spooking investors (and keeping the currency weak) is the government's fiscal situation. With strong GDP growth, government debt levels looked acceptable. But the slowdown will materially increase risks to sovereign bondholders (particularly as RBI becomes a key buyer - remember subordination? ).

Deutsche Bank has proposed a good solution - cut fuel subsidies, especially for diesel, which is the most subsidized fuel.
DB: - It is imperative that a fuel price adjustment is made to prevent serious deterioration of the fiscal outlook, which is under the scrutiny of ratings agencies. Policy actions to raise fuel price, expedite asset sales, pushing through some investor friendly reforms are needed sooner than later. Global oil price decline is a necessary but not sufficient development to turn around India at this juncture.
India's government has been financing growing fuel subsidies, creating market distortions as the usage of diesel vs. other fuels spiked.

Source: DB

Over time as government price increases failed to keep up with the market, the subsidies became ever more expensive, putting the government budget at risk.

Source: DB
DB: - Diesel constitutes almost 55% of the fuel subsidy bill on an average, followed by LPG (25%) and kerosene (20%). Lower global oil prices will help to reduce the subsidy bill, but a weak rupee and rising consumption (in the absence of price hikes), will tend to dilute some of this beneficial impact and keep the pressure on the fiscal intact.
In FY11/12, when real GDP growth slowed substantially to 6.5% (from 8.4% in FY10/11), fuel consumption growth in fact rose to 4.9%, up from 2.3% in FY10/11, led mainly by a surge in diesel consumption (7.8% vs. 6.8%).
When price increases are not passed to the consumer, there is no incentive to decrease usage and subsidies can grow out of control (supply/demand fundamentals are out of balance). Here is an example. Remember the bankruptcy of Pacific Gas and Electric Company (PG&E) in California?
Wikipedia: - In 1998, a change in the regulation of California's public utilities, including PG&E, began. The California Public Utility Commission (CPUC) set the rates that PG&E could charge customers and required them to provide as much power as the customers wanted at rates set by the CPUC.
When the wholesale power price spiked (partially driven by manipulation - which would be much harder to pull off without the subsidies), the utility was unable to pass it on to the customer. And the consumer cranked up the power with little regard for the overall implications because power was so cheap. Subsidies forced on PG&E's ended up putting it into bankruptcy. 

Making cheap fuel available to the country at the expense of rising debt levels may look like a popular political solution, but it will not end well. A gradual reduction in these subsidies (as painful as it may be) will be critical to restore confidence. And while crude prices are subdued, this may be the best time to do it.

The US debt to GDP ratio will soon look like the Eurozone periphery

Barclays Capital released the latest forecast of gross government debt-to-GDP ratios for a number of nations. Here is how the US compares to the more leveraged countries in the Eurozone going forward.

Debt to GDP ratio for select countries (source: Barclays Capital)

The market has instilled some discipline around the periphery nations' debt growth. There is a natural limit to how much they will be able to borrow. Not so for the US, as the world seems to have a seemingly endless appetite for US government paper (for now). And of course the Fed is always there to pick up any slack. At this rate in a few years the US debt to GDP ratio will look very much like that of the Eurozone periphery.

Sunday, June 24, 2012

As Argentina's economy hits a wall, "compulsive buying of dollars, alongside football, is a national pass-time"

Argentina's economic troubles are getting progressively worse. Labor problems stemming from inflation are putting increasing pressure on the government, whose policies have put it on the defensive abroad and domestically.
WSJ: - The protesters took over the field early Thursday, destroyed crucial equipment and jeopardized the flow of gas to untold numbers of people in Argentina, Pan American had said in a previous statement Friday.

The end of the protest will come as a big relief to both Pan American and Argentine President Cristina Kirchner, who has been struggling to deal with dissatisfied union members across the country.

Rampant inflation has curbed purchasing power, but the Kirchner administration has pressured labor to delay signing agreements to raise wages, angering rank and file union members.
The government is actually threatening independent economists against publishing realistic inflation numbers, which are thought to be dramatically higher than the official 10%. Some estimates are putting it above 25% or even higher. With this rate of devaluation, the mistrust of the peso is now so strong that buying of US dollars has reached a fevered pitch in the streets. Dollar now trades at some 30% premium to the official exchange rate.
AFP: - Argentines are on edge since the government imposed draconian measures to control money changers, measures which have complicated their compulsive buying of dollars which, alongside football, is a national pass-time.

So-called cellars, the few places where US dollars can still be illegally bought, have sprung up in the capital, but the greenback in these places is now sold at a premium -- up to six pesos. The official exchange rate is 4.5.

The vendors lining Florida street in the city center are constantly at risk of being caught by policemen, who have dogs trained to sniff out dollars.
Dollar fever rose when President Cristina Kirchner opted to impose radical controls on currency exchanges and curb imports to protect $46 billion in reserves and a $10-billion trade surplus.
This uncertainty is damaging domestic investment, while foreign investment has collapsed. The latest economic reports from last week are dismal, with industrial production dropping 4.6% YOY vs. the average expectation of 1%. And with Argentina's key customer Brazil slowing as well, there is little chance of a rebound.

Argentina Industrial Production (YOY)
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