Bulls vs. bears - a contrarian indicator?

Individual investor has turned bullish on the equity markets, but only modestly so. The chart below from Credit Suisse/AAII shows the relative difference between individuals who are bulls vs. those who are bears.



There is a general perception out there that one should be positioned as a contrarian to individual investors. However if you look at the chart of the S&P500 over the same period, it's not clear if the retail guys always get it wrong. Certainly a bullish view in 2004 would have worked.



But many argue that the overwhelmingly bearish views this year had kept the equity markets strong, and any sign of strong bullishness from the retail investor going forward is a signal to get out.

Keep your money "local"

A recent article in the NYTimes had put a nice spin on the numerous failures of community banks:

NYTimes: “People are angry with all the shenanigans on Wall Street,” [Camden R. Fine] said. “They believe their money stays local when they put it in a community bank, rather than sent off to Never-Never land.”

Yes, the money stays local alright. In fact there are numerous cases of real estate developers (you know, the local ones) getting on the boards of local banks to "advise" these banks to lend to them. Some even formed their own banks. Yes, why not use those local deposits to get rich on local construction projects with just a bit of help from the national taxpayer via the FDIC.

The chart below shows where that "local" money went. This is a comparison of commercial real estate loans as percentage of banks' assets for community banks vs. the large banks. It includes construction loans for those local strip malls, office space, single family housing developments, and those great condos. Many of those are nice and vacant now and the "local" developers are not local any more - they closed shop and skipped town.


source: FRB

These credit driven construction projects had created millions of jobs financed by those local FDIC secured deposits. But they were "bubble jobs" that were not sustainable and are not coming back any time soon. And people wonder why US employment continues to struggle.

Of course Mr. Fine does a good job blaming the large banks - after all it's an easy target. The taxpayer should in fact be angry with the regional banks who have put the FDIC in the red.

So next time you plan to open that account at Chase, hold off, think about it. Maybe you should keep your money local too, so it doesn't end up in the Never-Never land.

The saga of the CDS-bond basis trade

Last year saw the largest blow out of CDS-bond basis spread. A typical trade involved buying a bond, leveraging it, and buying protection on the name. The idea was that over time any spread between bond yield (less financing cost) and CDS would disappear over time. Given that it was a hedged trade (long credit and long protection), prime brokers provided significant leverage such as 20:1. But as funds went searching for liquidity with redemptions looming, they unwound the trade, forcing the basis spread to widen. As it widened, prime brokers asked for additional margin to support losses on the trade. Margin calls on the leveraged trades forced a spiral of unwinds, creating the largest widening of basis spread ever.




Earlier this year credit started to rally as the demand for corporate bonds picked up. The spread to CDS began to narrow again. But recently the narrowing has stalled. What happened?

The answer goes back to banks' balance sheets. In 2008 banks got jammed with LBO debt that they had commitments to finance. With the LBO craze of 07, billions in leveraged institutional loans and bonds that banks would normally be able to sell to CLOs and hedge funds ended up on their balance sheets. Some banks sold the debt at steep discounts and provided financing as they did so. Many had no choice but to hold it. The chart below shows corporate loans on banks' balance sheets spiking in 08.


Source: FRB

Being unable to unload the corporate debt didn't stop banks from reducing their risk by purchasing CDS protection. However this year the markets opened up and banks started dumping their positions. As they sold bonds and loans, they unwound the CDS protection, becoming net sellers of CDS. That forced CDS spreads to tighten, holding the CDS-bond basis from narrowing further.

Some expect this basis to resume its tightening as banks finish unloading the bulk of CDS they had bought. But it will not go back to flat for a while, simply because prime brokers no longer provide the leverage they used to. And without the leverage the basis trade just will not be profitable enough to make it worth while.

Insurance firms try to break free from rating agencies

The rating agencies are not just under fire from regulators and lawsuits, but also threatened by new competitors from outside the traditional ratings roles.

WSJ: Under the proposal being considered, the NAIC [National Association of Insurance Commissioners] would arrange the contract and work with the analytical firm. Any firm large enough to handle the job could seek it, with insurers paying fees to the NAIC to cover the cost. The proposal, expected to pass, comes from trade group American Council of Life Insurers.

But the alternatives are not without controversy, and it's unclear whether these other firms come with their own string of conflicts. One of the firms considered for the job for example is BlackRock, which is raising eyebrows across the blogosphere:

Reuters: It’s amazing how well the company has positioned itself to clean up the mess left behind by the financial crisis. It already has chummy ties with the government, including the Federal Reserve which tapped it to manage and eventually liquidate toxic assets the central bank took on from AIG. It’s also the risk and analytics manager in chief for the Fed’s MBS purchasing program.

NAIC of course is considering other firms:

WSJ: In addition to BlackRock, the insurance regulators also recently have talked to Pimco Advisory, part of Newport Beach, Calif., bond-powerhouse Pacific Investment Management Co., a unit of Allianz SE; Promontory Financial Group, a Washington, D.C., firm founded and headed by Eugene Ludwig, a former U.S. comptroller of the currency; and Andrew Davidson & Co., a 17-year-old New York firm that also has a specialty in evaluating complex structured securities, according to the regulators.

Pimco is plugged into various government programs to such an extent that they were advised to keep away from PPIP (as they promptly did) to avoid any perception of conflicts. Allianz is itself an insurance firm, making it unclear how effective they would be advising their competitors on potential investments. Promontory Financial Group may have political ties given their founder. Andrew Davidson & Co is a financial analytics firm that in fact developed the models many firms used to value RMBS and CDO products before the crisis. It's not clear how this expertise would qualify them to evaluate credit worthiness of securities purchased by insurance firms going forward.

These are just some of the challenges faced by the investment community as they try to shift away from reliance on the rating agencies. But the shift is definitely under way.

hat tip Ed.

A warning on derivatives regulation

If it ain't broke, don't fix it. This is what the LSTA is saying about the Total Return Swap (TRS) market.

Bloomberg: Proposals to regulate privately negotiated derivatives may reduce “sorely needed liquidity” in the high-yield, high-risk loan market, according to the Loan Syndications and Trade Association [LSTA].

TRS has been utilized before, during and after the crisis, and credit losses associated with the product have been immaterial. The reason is simple. TRS providers have generally required significant initial margin as well as variation margin. Even during the worst of the crisis, JPMorgan (which is generally extremely conservative) was providing TRS financing on leveraged loans. It had the ability in many cases to terminate the contracts (not to roll maturing TRS), but it didn't. It increased initial margin for new transactions, but kept the business running.

Banks can not hold the bulk of the corporate loans they originate because they are balance sheet/capital constrained. There are numerous investors out there interested in this product, but require some leverage. In this environment TRS is the only way to achieve it. The proposed derivatives regulation may significantly hurt this market and other markets. The concept that if it's not standard, kill it, will not only hurt large corporate finance, but will impact middle market companies as well.

Bloomberg: The highest capital requirements, while not defined, would be imposed for derivatives that aren’t backed by clearinghouses, which would likely include total-return swaps because they differ from deal to deal. “TRS, which are customized, could see punitive capital charges,”

As a general comment, included below is the statement from Dave Hall of Chatham Financial for the House Committee on Financial Services. It's a warning about unintended consequences of derivatives regulation:

OTC derivatives are very important tools for businesses to efficiently and effectively reduce risk. Their use is now accepted for many good reasons and is now common – in fact, 94% of Fortune 500 companies and thousands of small businesses use derivatives to manage business risks.

Dave Hall - Chatham Fin Corp

The stabilization of the US housing prices

The direction of US home prices continues to be a hotly debated subject. The e-mail on our recent post on the topic keeps coming. Many Armageddon forecasters are too young to have remembered the numerous stresses the US economy and housing have undergone in previous cycles - so this crisis truly feels like the end of the world. And why would you buy a home if the world is ending?

There is no question that the housing market continues to be vulnerable in the short term, particularly given the uncertain employment outlook. And if the US government hasn't been involved, one could argue the price declines have more to go. But the politicians and the Fed will go out of their way to stabilize the US housing prices.

More importantly, the prices may now be at the "pre-bubble" levels (at least with respect to the national averages) after a spectacular growth and a similarly drastic correction. The following chart shows the ratio of house prices to median household income.





It's not likely we will see significant price appreciation from this point on, but for those who are buying a home instead of investing in property, it's not necessarily a bad time to do so.

EURIBOR vs EURO LIBOR

Something's rotten in the kingdom of LIBOR measuring organizations. Euro LIBOR, computed by the British Banker’s Association recently has been visibly below EURIBOR computed by the European Banking Federation. The two should be right on top of each other - both are surveys of major banks on term rates for wholesale Euro deposits. The chart below shows that recently we've had quite a spread between these.


EURIBOR - EUR LIBOR (bp)

source: Bloomberg


There are subtle differences in the calculations. LIBOR throws out the lowest and the highest quartile of the quotes, averaging out the rest. EURIBOR throws out the top and the bottom 15%. It is possible that EURIBOR includes some quotes that are quite high, which are excluded from LIBOR. It could be explained by a bank that is in need of significant Euro financing and is trying to attract wholesale deposits by quoting a higher rate.

This type of dispersion has not happened before to such extent. If anyone has a better explanation, we would love to hear from you: tips@SoberLook.com

Retail loves fixed income

Mutual fund flows show a clear preference for fixed income, which in part explains some of the rally in credit. The charts below from Credit Suisse/AMG show the striking difference between equity and bond fund flows this year.