Small business lending is profitable as long as lenders stay away from the really small businesses

A couple of months ago we discussed the SBIC program, a government initiative that provides leverage to mezz funds focusing on small business lending (see post). Attached is the SBIC 2012 annual report with some interesting data. One result that stands out is the contrast in long-term performance between smaller SBIC funds and the larger ones.

Typically an SBIC fund will lend to maybe 15-20 companies. If investors put $20 million into the fund and the SBA lends the fund another $40 million, that the fund has $60 million to put to work. That means that such a fund will typically provide $3-4 million dollar loans to each of the portfolio companies. A $5 million fund on the other hand would provide $750K - $1 million dollar loans (roughly). It turns out that lending to the "larger small companies" is far more profitable than to the really small ones.

The loss ratio (the percentage the government lost on it's loans to these mezz funds) due to defaults is almost negligible for funds that are above $17.5 million, but increases sharply for smaller funds (that provide smaller loans to smaller companies).

Source: SBA

Similarly the annualized returns (IRR) are quite good for the larger funds, while one barely breaks even with the smaller funds.

Source: SBA

The data above covers funds launched between 1998 and 2006. Keep in mind these are finite-life funds. A fund will typically invest for the first four years and then all the realizations are returned to investors over the next few years. The 2004-2006 funds did a great deal of their investments prior to the financial crisis but had to get their money back after the impact of the downturn. The data therefore includes the full impact of the Great Recession. The results indicate that small business lending with government leverage can in fact be quite profitable (across different points of the economic cycle), as long as these mezz funds stay away from the really small firms.



SBIC Program FY 2012 Annual Report

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DE central banks' balance sheets approaching $6 trillion; expected to grow another $1 trillion in 2013

This is a well covered subject, but it's worth taking a quick look at the combined balance sheets of the developed economies' (DE) central banks. We are quickly approaching six trillion dollars.

Source: ISI group

It is important to note that not all of this would qualify as "QE". For example the Fed expanded balance sheet in 2012 without materially impacting either the bank reserves or the monetary base (see discussion). Although it was unintentional, the Fed effectively "sterilized" its purchases. The ECB also views some of its programs as sterilized.

Nevertheless it is expected that the developed nations' central banks will expand their balance sheets by another 1 trillion dollars in 2013. This will be driven mostly by the Fed and the BOJ (see discussion). And unlike last year, the US monetary base will grow sharply in 2013 (and so will Japan's). Central banks continue to feed the markets' addiction to stimulus (see discussion).

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With domestic crude production in the US rising sharply, WTI is becoming less relevant as a benchmark

The US Department of Energy reported a large drop in crude oil stocks last week. As expected, a great deal of that decline was driven by a drop in crude imports - a trend that has been ongoing for some time now (see discussion). The chart below compares 2012 US imports with that in 2011.

Source: EIA

And in spite of that drop is inventory, the US crude oil market is extremely well supplied for this time of the year.

Source: EIA

As crude oil supplies stay at unusually high levels due to domestic production, the US oil market is becoming more decoupled from the global energy markets. One can see this effect in the persistently elevated Brent-WTI spread (see discussion). A year ago it was believed that as the Seaway Pipeline begins moving crude from Cushing Oklahoma to the Gulf of Mexico (with the flow's direction now reversed), the price of the two crude oil markets should converge (Brent and WTI represent the same type of crude, just delivered to different locations). That has not occurred, and the Brent-WTI spread remains in the $20/barrel range.

Brent-WTI spread (source: Ycharts)

With US imports declining, the US crude is increasingly viewed by oil traders as less representative of the global oil market. Commodity indices and asset allocators are rebalancing out of WTI and into Brent (see discussion). The best evidence of this effect can be seen in the futures trading volumes. For the first time in history, more Brent than WTI futures have been traded during 2012.

Source: EIA

EIA: - One of the many effects of the well-documented disconnect between the prices of Brent and West Texas Intermediate (WTI) crude oils has been the increase in trading volume for Brent futures. In 2012, for the first time, more Brent futures contracts traded on the IntercontinentalExchange for the year as a whole than WTI futures contracts traded on the New York Mercantile Exchange.

Going forward Brent will continue to dominate as the global benchmark for crude oil (which is unfortunate for our friends at the CME). U.S now pumps oil at the fastest rate in nearly two decades (using horizontal drilling and fracking), making the nation less vulnerable to price shocks. Even compared to 2011, the contrast in production levels is quite impressive.

Source: EIA

At the same time, markets in Europe and Asia are still constantly at risk of supply disruptions due to geopolitical risks. And anyone trying to hedge against these risks will increasingly employ Brent (instead of WTI) futures, options, and swaps.

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JPMorgan: US recovery about to "hit a pothole"

As discussed earlier (see post), US manufacturing sector has begun to recover. Manufacturing orders in the US as well as in Emerging Asia (see post) have diverged from other large economies. This trend is becoming reflected in the broader economic activity.

Source: JPMorgan

However according to JPMorgan, the result of the latest fiscal negotiations will soon create headwinds for this expansion and dampen GDP growth. The tax increases on  higher income households as well as the hike in payroll taxes will crate a drag on growth. That in turn will limit global economic activity.

JPMorgan: - Regionally the US and Emerging Asia are leading the move up in our global surveys. In the US, early December labor market reports and consumer indicators reinforce this message. Unfortunately, the economy is about to hit a pothole as the household sector absorbs a large front-loaded drag resulting from the fiscal cliff agreement. The increase in payroll taxes and higher marginal rates on high-income households is set to depress 1H13 income growth by roughly 2%-pts at an annualized pace. 

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Was today's treasury sell-off an overreaction?

The 10-year treasury note yield has climbed above 1.9% today - a level we haven't seen since last spring.

10y treasury futures price intraday (source: barchart.com)

The selloff in treasuries was triggered by the FOMC minutes, with several members targeting the end of 2013 or earlier as the completion (or at least a slowdown) of QE3. According to Barclays, this sell-off was an overreaction.

Barclays Research: - The FOMC minutes showed few members willing to continue asset purchases until about the end of 2013 and several others considering it appropriate to slow or stop purchases well before the end of 2013. We believe at 10y real yields of -62bp, well above the levels even before the QE3 announcement, the market has over-reacted. Even if the Fed were to stop purchases by middle of 2013, it would have bought ~$460bn in 10y equivalents, which argues for much lower real yields.

Ultimately, the FOMC's approach to asset purchases will be set by the employment numbers (see discussion). The December employment report (Friday morning) will therefore be quite vital in setting the trajectory of long-term rates.

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Small business recession explains poor sentiment

According to Intuit, after a gradual recovery since 2009, US small business revenues have been consistently declining for most of 2012. Recent declines have lasted for 9 consecutive months (in black below) and are visible across all major industries. The smallest decline has actually been in the real estate sector, where revenues haven't grown since 2005. The ongoing declines in revenue explain the persistent weakness in small business sentiment in recent months (see discussion).

Source: Intuit

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Estimating automobile-based lending growth in 2012

Several readers have asked about the auto loan component of the US consumer credit growth (discussed earlier). The Fed doesn't provide this data directly, but there are a couple of ways to assess the trend in auto related credit growth.

1. The Fed shows two components of consumer credit on banks' balance sheets. The first is all the revolving credit (mostly credit card debt) shown in the previous post. The second component is what they label as "Other consumer loans". Taking all the consumer debt without mortgages (shown separately) and credit cards (the first component), we are left primarily with auto loans and private student loans (government sponsored student loans are now held by the federal government). Given that private student loans tend to be crowded out by the government programs, one could conclude that a large part of this portion of the banks' balance sheets represents auto loans.

"Other consumer loans" (source: FRB)

That component has indeed been growing, increasing by some $21bn during 2012. Though it's a large number, it makes up about 7.5% of the total increases in loans and leases for the year. Part of the issue with this measure however is that when it comes to auto loans, not all of the debt is held by banks. A great deal is held by finance companies and ultimately securitized (as demand for asset backed securitizations has been on the rise).

2. It therefore makes sense to look at the problem from the consumer debt perspective (as opposed to bank balance sheets). The Fed provides monthly consumer debt outstanding broken down by revolving and non-revolving loans. Taking the non-revolving loan balances (including securitizations) and subtracting government held student loans should provide an estimate of auto loans outstanding (although the measure is still "polluted" by private student loans). By that measure total auto loan balances only started growing in 2012, rising about $32bn for the year.

$mm, source: FRB

Unfortunately this measure is on a two-month lag and therefore incomplete for the purposes of assessing credit expansion for 2012.

3. Another measure that supports the estimate above can be obtained from SIFMA. It is the total auto ABS (securitized auto loans) outstanding reported on a quarterly basis.

Source: SIFMA

The data also shows an increase in auto loans during the first three quarters of 2012 on the order of $24bn in ABS securitization alone.

Even if the exact amount is difficult to estimate at this stage, it is clear from the above three measures that the US experienced a decent size expansion in auto loans during 2012 (although it is still a fraction of corporate lending taking place last year). And that credit expansion in turn helped drive brisk auto sales that exceeded the Cash For Clunkers program in 2009.

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Egyptian pound hits record lows; banks running out of dollars

The Egyptian pound (EGP) came under further pressure again this morning (see earlier discussion), with the central bank no longer able or willing to maintain the previous currency peg.

BBC: - The Egyptian pound has fallen further against the US dollar, despite efforts by the country's financial authorities to halt its slide on the money markets.

The renewed decline came as the central bank held the second in a series of currency auctions.

It sold $74.8m at a cut-off price of 6.3050 Egyptian pounds to the dollar, less than the equivalent price of 6.2425 in Sunday's first auction.
...
The auctions are aimed at rationing the availability of dollars, in a first step towards allowing the Egyptian pound to float freely.

As always the government is "not concerned" about this situation. Here is a quote from the official source (ESIS):

ESIS: - Egypt is not concerned about the dollar’s recent rise against the Egyptian pound, President Mohamed Morsy said on Monday 31/12/2012.

The market will stabilize within days and funds are being pumped in to balance the market, Morsi said during a meeting with Arab media members.

And the Presidential Spokesman Yasser Ali had this to say:

The Central Bank of Egypt has put in place urgent measures and kept watchful eye on the monetary market after some people aroused panic over the entire banking system of the country...

All is well...

In the mean time the pound hit a record low this morning vs. the US dollar in an unprecedented move.

EGP per one dollar (EGP weakening)

As the wealthier population of the country desperately tries to move their savings abroad (and willing to pay up for hard currency), the pound could be facing panic selling. According to a local source, last week a number of commercial banks already ran out of dollars and savers are now buying up euros. With Egypt being one of the largest importers of wheat in the world, food prices are bound to rise further (as it takes more EGP to buy the same amount of food).

With the government now being forced to ask the IMF for a loan, austerity measures are inevitable. And for a nation as divided and volatile as Egypt, government austerity combined with food inflation is not going to end well.

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