Saturday, 29 January 2011

The acceleration in the deterioration of Sovereign Credit - The impact of youth unemployment and the jobless recovery.

"As we peer into society's future, we -- you and I, and our government -- must avoid the impulse to live only for today, plundering for our own ease and convenience the precious resources of tomorrow. We cannot mortgage the material assets of our grandchildren without risking the loss also of their political and spiritual heritage. We want democracy to survive for all generations to come, not to become the insolvent phantom of tomorrow."
Dwight D. Eisenhower.
Farewell Adress - 17th of January 1961

Interesting Regression Analysis - as displayed by M&G Investments:

The issue is clear, youth unemployment is very high in peripheral countries in Europe. The danger being, the higher the rate of unemployment, the higher the risk for social unrest linked to the deterioration of Sovereign Credit, the slower the economic growth:

European map displaying Youth Unemployment Rates for 2009:

As the below graphs, shows, there is clearly a divide in Europe and the speed of the economic growth is impaired for many countries, such as Italy and France due to the very high level of unemployment for youths. Italy and France are in the danger zone clearly. They are already above the European average rate for youths unemployment rate. It does not bode well for the economic growth of the countries above the average. Structural reforms are urgently needed. Spain cannot delay any longer structural reforms of its very inefficient labor market.

The performance of labor markets generally reflects the performance of the economy as a whole.

Germany is powering ahead, with its very low youth unemployment level:

It is very important to look at the impact of youth unemployment in the light of recent events in Tunisia and now Egypt. There is a direct correlation to these events. It does not bode well for other countries facing similar youth unemployment levels, in the table below you can see the levels of the youth unemployment rates in 2001:

Youth unemployment clearly plays for a large part in the social unrest we have recently witnessed in Tunisia and now Egypt.

"Muslim-majority countries in North Africa and the Middle East have the highest percentage of young people in the world, with 60 percent of the regions' people under 30, according to study by the Pew Forum on Religion and Public Life."

The arabic countries have a growing youth population:

CDS spreads for North African and Middle-East are widening due to the contagion from Tunisia (October 2010 until End of January 2011):

North African Middle-East CDS OCT10-JAN11 - Egypt, Lebanon, Tunisia, Morocco:

Sovereign Wideners for the 28th of January 2011 - CMA's Sovereign CDS data:

Egypt's cumulated probability of defaults now stands at 24%, above Spain which stands currently at 21% according to CMA.

Are young arabs satisfied with efforts to increase the number of quality jobs? (Gallup survey April 2009)

The jobless recovery:
During the recent crisis, youth unemployment has surged dramatically. The jobless recovery is a serious obstacle to the reduction of youth unemployment and rapid economic growth:

"EU Employment Commissioner László Andor has admitted that the EU is experiencing a "jobless recovery", amid warnings from the International Labour Organisation (ILO) that the situation might not improve this year."

"More than 23 million workers are currently registered as unemployed across the whole of the EU. This means that the number of job seekers has increased by 46% (some 7.3 million people) since March 2008.

Europe's young people are facing an especially difficult situation. Across the EU as a whole, the youth unemployment rate, for those under 25 years of age who are not in full-time education, is now at a record level of 21%."

"Young people in Spain face an especially difficult challenge in trying to find work, as more than 43% of young people under the age of 25 (not counting those in full-time education) are registered as unemployed."

"It is key that reforms are undertaken to reduce the rigidity that characterises many European labour markets. Flexibility is crucial in times of recovery in order to promote job creation," BusinessEurope declared.

For those of you who would like to go through the latest report on the Global Employment Trends for 2011, the International Labor Organization (ILO) report is available at the following address:

The jobless recovery is typical of a balance sheet recession.

In the US, unemployment among people under 25 with bachelor’s degrees reached 9.6% in December, up from 8.6% in November and 5.9% just two years earlier. A stagnant labor market means the USA cannot create enough jobs for the thousands of young people set to graduate in 2011.

Are we going to witness a major conflict between generations? We were warned by Dwight D. Eisenhower in his prescient Farewell Address delivered 50 years ago on the 17th of January 1961, a must read...

"Crises there will continue to be. In meeting them, whether foreign or domestic, great or small, there is a recurring temptation to feel that some spectacular and costly action could become the miraculous solution to all current difficulties."
What would Dwight D. Eisenhower have thought about Bernanke's QE2, about TARP, about Alan Greenspan?

In his great farewell speech Dwight D. Eisenhower also added:
"But each proposal must be weighed in the light of a broader consideration: the need to maintain balance in and among national programs, balance between the private and the public economy, balance between the cost and hoped for advantages, balance between the clearly necessary and the comfortably desirable, balance between our essential requirements as a nation and the duties imposed by the nation upon the individual, balance between actions of the moment and the national welfare of the future. Good judgment seeks balance and progress. Lack of it eventually finds imbalance and frustration. The record of many decades stands as proof that our people and their Government have, in the main, understood these truths and have responded to them well, in the face of threat and stress."

Dwight D. Eisenhower's wisdom was clearly not taken onboard. He would have been deeply shocked by the Financial Crisis Inquiry Report
and its conclusions but that's another matter...

Tuesday, 25 January 2011

The moral hazard mistake of 2003 - The violation of the European Stability Pact

Germany and France violated the Stability Pact on purpose in 2003.

The Stability and Growth Pact (SGP) was an agreement among the 17 members of the European Union to facilitate and maintain the stability of the Economic and Monetary Union.

In order to do so, the actual criteria that member states must respect was the following:

-an annual budget deficit no higher than 3% of GDP (this includes the sum of all public budgets, including municipalities, regions, etc)
-a national debt lower than 60% of GDP or approaching that value.

German finance minister Theo Waigel in the mid 1990s was the proponent of the SGP.

The idea was to limit the ability of governments to exert inflationary pressures on the European economy.

The Council of European Ministers failed to apply sanctions against France and Germany, despite punitive proceedings being started when dealing with Portugal (2002) and Greece (2005), though fines were never applied and the the European Court of Justice later declared that decision invalid.

In March 2005, the EU Council, under the pressure of France and Germany, relaxed even more the rules:

"The Ecofin agreed on a reform of the SGP. The ceilings of 3% for budget deficit and 60% for public debt were maintained, but the decision to declare a country in excessive deficit can now rely on certain parameters: the behaviour of the cyclically adjusted budget, the level of debt, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures."

The great idea of German fiscal discipline was betrayed by the Germans themselves creating a dangerous moral hazard which lead us to today's European disaster. I always believed in "leading by example": if you want to be respected as a leader, you need to lead by example.

Would the situation be different today if the German and the French had respected prior engagements relating to fiscal discipline? I certainly think so.

How ironic it is today to see Germany clamoring for fiscal discipline in peripheral European countries when a short time ago, they had betrayed the very idea they stood behind for so many years.

In 2003, Pandora's box was opened, with the consequences we are all witnessing today.

If you look at the period of 2000 until 2003, you will notice countries like Belgium, Ireland, Spain were in fact managing much better their public finances than the likes of France and Germany.




Source: OECD Economic Outlook 76 database

At the time of the violation of the SGP, peripheral countries like Portugal, Ireland and Austria did complain about the case of double standards, because they were trying to abide to the SGP rules.

What were the dire consequences for the violation of the pact?

The ECB had to step in and follow a tighter monetary policy.
Between 2003 and 2004 it allowed real interest rates in the eurozone to fall to zero. The ECB also abandoned the so-called monetary pillar of its strategy -- "a prudent cross-check that looked at the rate at which money supply was growing". For several years, money growth exceeded the ECB's target rate of growth of 4.5 per cent a year. This equated to overreliance on credit in the Eurozone. It made the Eurozone government fiscal balances overdependent on tax revenues from activities that were based on borrowing, namely housing and construction: hence the housing bust in Spain, Ireland, etc.

The basic premise of the SGP made sense. It could not have been possible to launch the euro without a proper framework to promote financial discipline in a currency union not complemented by full political union. But once again, what lead to the current disaster was the lack of discipline of the politicians.

Back in 2003:

"Commission president Romano Prodi stressed that while 'maximum available flexibility' should be applied, the Commission 'must and will apply the treaty for the common good'. Mr Prodi also expressed doubts that higher deficits would help the EU recover from the economic downturn. This strict stance was welcomed by several smaller eurozone members as well as aspirant countries determined to stick to the pact underpinning the euro."

But we know the story Romano Prodi failed and Germany and France jointly betrayed the SGP in 2003, which lead to the ECB having to step in as explained above.

As Mr. Trichet said recently:

"Monetary-policy responsibility cannot substitute for government irresponsibility".

"Mr. Trichet continued to dwell on perhaps his biggest policy-related defeat of 2010: the rejection by governments of his demand for strict, automatic sanctions on countries that exceed Europe's budget deficit limits. Under a French-German accord reached in October and backed by other governments, the ultimate decision on sanctions will be left in the hands of political leaders and not be applied automatically."

Until automatic sanctions are set up as recommended by Mr Trichet, politicians will still have the ability to postpone structural reforms (in order to seek re-election...).

"We should be inflexible in applying sanctions if rules are breached," Mr. Trichet said, and penalties should include "fines, reduced access to EU funds, and other pecuniary consequences."

I completely agree with Mr Trichet. Unless sanctions are applied automatically, the European system and the SGP will be abused.

Courage under duress? Don't count on European politicians...

Friday, 21 January 2011

US Banks results - Update on Goodwill Impairments and DVA/CVA impact on earnings.

Following my previous posts on the rise of Goodwill impairments for Banks as well as a post on the impact of FAS 159 - Debt Valuation Adjustments on earnings, please find below an update in relation to latest earnings release for Morgan Stanley and Bank of America.

Morgan Stanley also faced the same music as Citigroup in relation to the Boomerang effect of FAS 159 and the tightening of its credit spread:

Morgan Stanley Reports Full-Year and Fourth Quarter 2010:
•Full-Year Net Revenues of $31.6 Billion and Income from Continuing Operations of $2.44 per Diluted Share
•Fourth Quarter Net Revenues of $7.8 Billion and Income from Continuing Operations of $0.43 per Diluted Share
Net Revenues for Full-Year and Fourth Quarter Include Negative Impact of $873 Million and $945 Million, Respectively for Tightening of Morgan Stanley’s Debt-Related Credit Spreads

Due to DVA, sales and trading net revenue for the quarter ended December 31, 2010 included negative revenue of $945 million (fixed income: $842 million; equity: $103 million) and sales and trading net revenue for the quarter ended December 31, 2009 included positive (negative) revenue of ($589) million (fixed income: ($453) million; equity: ($221) million; other: $85 million).

In relation to Bank of America the impact of Goodwill impairments is significant on earnings:

Bank of America Reports Fourth-Quarter and 2010 Financial Results
Fourth-Quarter Net Loss of $1.2 Billion, or $0.16 per Diluted Share, Includes Goodwill Impairment Charge of $2.0 Billion

Excluding Goodwill Impairment Charge, Fourth-Quarter Net Income Was $756 Million, or $0.04 per Diluted Share

Total goodwill impairment charges for Bank of America in 2010: 12.4 billion USD.

The goodwill impairment charge of 2 billion USD is directly linked to Countrywide.

As indicated in my previous post "Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"

"It is therefore paramount to track goodwill impairments in relation to future banks earnings. As we can see in the case of Bank of America and DBS, the impact on the income can be very significant."

Thursday, 20 January 2011

Dumb and Dumber - QE2 and the risks linked to global rising Yields in 2011

The discussion around the debt ceiling could trigger a sell-off as high as 100bps in US Treasuries, like in 1996. You want to track the TBT ETF in 2011 as a caution (please see below).

Zerohedge goes into the detail of what could happen if we have a 1996 replay in relation to the debt ceiling discussions.
"It is difficult to disentangle the full effect of the 1995-96 debt-ceiling crisis on bond yields since Fed expectations were also changing rapidly during that time. If there is any conclusion to be made, it is the market generally shrugged off the government shutdowns and instead focused on macro developments.

The government reached the debt ceiling in November, and Treasuries generally rallied over the next three months even as the situation in Washington continued to deteriorate. That said, the Fed was also easing monetary policy during this period, having lowered rates by 50bp to 5.25% between December 1995 and January 1996. Nonetheless, reviewing press reports from this period suggests that the market seemed to ignore the debate over the debt ceiling in the early stages, having assumed that politicians would never allow the US to go into default and that a resolution would be brought about quickly. The biggest move occurred in the final days of 1995 when the market was generally optimistic that a resolution would be achieved.

At the start of the New Year, the market realized that negotiations were falling apart with Treasury Secretary Rubin warning sending the 10-year yield 8bp higher. Around mid-February markets began to react negatively to any news related to the budget stand-off; that is until late March when the ceiling was lifted. Treasury yields increased about 80bps in less than a month during this period."

Marc Faber on 2011 Barron’s Roundtable: Why Everyone Will Be a Billionaire Soon:
Marc Faber and Bill Gross from Pimco had an interesting conversation relating to the state of the US economy and the risks.

Here what Bill Gross had to say:
"I don’t know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation. We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings. We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential. And, on the short end of the yield curve, we are looking at creditors receiving negative real interest rates for a long, long time. That, in effect, is a default. Ultimately creditors and investors are at the behest of a central bank and policymakers that will rob them of their money."

This a point Felix Zulauf made:

"There are two worlds—the industrialized world and the emerging world. The industrialized world continues to live in a fiction: that it can afford its current lifestyle by going further and further into debt. At some point, the bond markets will riot against that."

For the entire Barrons January 2011 Roundtable:

Given current risks on a sell-off on US treasuries, it is important to track the following ETF as mentioned previously, namely the TBT: ProShares UltraShort 20+ Year Trea (ETF) (Public, NYSE:TBT):

ProShares UltraShort Lehman 20+ Year Treasury, seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond Index (the Index).

TBT is already up 9.49% in 3 months and 16.63% in just 3 months. Year to date so far: 5.64% up.

That's the result of a rise in inflation expectations in my book...

Rising global yields is a key issue for 2011.

The excellent Doug Noland in his latest Credit Market Bulletin share the same views:

"The possibility for a surprising jump in Treasury bond yields is a major 2011 issue. On the one hand, Treasury is not interest-rate sensitive; the marketplace doesn't have to fear much of an issuance impact from a moderate rise in borrowing costs. On the other hand, this dynamic would imply that yields are poised to surprise on the upside when the markets eventually force borrowing restraint. It doesn't take a wild imagination to envisage a market problem leading to an economic problem, to additional "TARP" (the Trooubled Asset Relief Program bailout) more rescues and a jump in borrowing costs - all combining for a dramatic deterioration in our nation's debt position.

That borrowing restraint is being imposed upon US municipal finance is a major 2011 issue. The year has commenced with municipal bond yields adding to Q4's surprising jump. Today, state and local finance is our credit system's weak link."

Doug goes on:

"Here in the US, policymaking has turned simple: run massive deficits, keep rates at zero, and have the Fed monetize debt until the private sector can be trusted to do the heavy lifting. Well, don't hold your breath. So, for Issues 2011, we can assume the Fed stands pat on rates. And while they have little credibility, both congress and the Fed are talking tough against bailing out troubled states across the country. Whether they can stick to this rhetoric is an Issue 2011. The dollar continues to benefit from the capacity of policymakers to inflate credit, a dynamic that will compound our dilemma when the markets turn their sights on disciplining Washington.

I'll posit that each year of massive government marketable debt issuance reduces the likelihood that central bankers will be able to exit their market liquidity backstop operations. History has shown how systems become precariously addicted to inflationary measures and market interventions. The Fed's balance sheet will only move in one direction. And when push comes to shove, they may be forced to buy municipal debt or monetize more Treasuries to help finance bailouts.

For now, the most important issue of 2011 is that serious structural deficiencies ensure that the Federal Reserve errs on the side of liquidity creation. This would seem to ensure a year of even greater monetary disorder, with the risk of heightened instability throughout global fixed-income, currency, commodities and equities markets."

Dumb and Dumber...

Tuesday, 18 January 2011

Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings - Citigroup latest results

Citigroup's latest results clearly show the impact of tightening CDS spreads on earnings.

Credit valuation adjustment (CVA) refer to the fair value of liabilities which in the case of Citigroup equates to a 1.1 billion USD hit on its earnings. The company incurs a negative revenue mark when the value of the debt/liabilities increases.

In my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008", published in July 2010, we studied the impact on earnings with FAS 157 and FAS 159.

For more on FAS 157 and FAS 159 please check the link below to the American Academy of Actuaries paper on the subject:

Citigroup's hit on earnings is linked to a tightening in its CDS 5 year spread. The more the CDS 5 year spread tightens in 2011, the more pressure Citigroup will face on its earnings.

In April last year Citigroup had the following positive results thanks to CVA in its Quarter 1 results:

"Fixed income markets revenues of $4.7 billion reflected strong trading performance, as high volatility and wider spreads in many products created favorable trading opportunities. Interest rates and currencies and credit products had strong revenue growth. Revenues also included (all reflected in Schedule B):
o A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads
o A net $30 million positive CVA of Citi’s liabilities at fair value option

There you have it, the boomerang always come back, in that case FAS 159...

For more on Citigroup's past CVA:

Monoline Insurers Credit Valuation Adjustment (CVA)

During the first quarter of 2009, Citigroup recorded a pretax loss on CVA of $1.090 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty's current credit spread, to the expected exposure profile. The majority of the exposure relates to hedges on super senior subprime exposures that were executed with various monoline insurance companies. See "Direct Exposure to Monolines" for a further discussion.

This excerpt taken from the C 10-Q filed May 11, 2009.

Monoline Insurers Credit Valuation Adjustment (CVA)

During 2008, Citigroup recorded a pretax loss on CVA of $5.736 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty’s current credit spread, to the expected exposure profile. In 2007, the Company recorded pretax losses of $967 million. The majority of the exposure relates to hedges on super senior positions that were executed with various monoline insurance companies. See “Direct Exposure to Monolines” on page 70 for a further discussion.

These excerpts taken from the C 10-K filed Feb 27, 2009.

Nightmare on Main Street - The impact of the rise of energy and food prices on US Households

Where is US M1 Velocity of Money heading in 2011? Is a double-dip on the horizon?

In past crisis when Velocity dropped significantly, recession occurred. We have to keep a close eye on the evolution of velocity in the US.

US Business Inventories are still rising:

US Inventories from 1992 to 2010:

But as the title of this post states, storms are gathering as indicated in the latest publication from David Rosenberg, Chief Economist at Gluskin Sheff.

It is the fith time in modern history we have seen both food and energy prices rising in double-digits annual rate: 1979, 1980, 1996 and 2008.
In those five times we experienced two recessions, 2008 was a lead to a major recession. At this rate it is estimated that energy bill is going to amount to 60 billions USD for the US Household and the Food bill by 40 billions USD. Add to this end of debt service, it is another 100 billions USD headwind.
Bye bye Federal Fiscal stimulus...

Gasoline prices since last August in the US have gone from 2.65 USD per gallon to over 3.00 USD per gallon. 50 Billions USD hit for the already struggling US consumers.
John Mauldin ( in his most recent message, provided the latest letter from Van Hoisington and Dr. Lacy Hunt from the Hoisington Fourth-Quarter Report. They tell us the following:
(Hoisington Investment Management Company:

"For example, in late 2010 consumer fuel expenditures amounted to 9.1% of wage and salary income. In the past year, the S&P GSCI Energy Index advanced by 14.6%. Since energy demand is highly price inelastic, it seems there is little alternative to purchasing these energy items. Thus, with median family income at approximately $50,000, annual fuel expenditures rose by about $660 for the typical family. In late 2010, consumer food expenditures were 12.6% of wage and salary income. In the past year, the S&P GSCI Agricultural and Livestock Commodity Price Index rose by 40%. If we conservatively assume that just one quarter of these raw material costs are ultimately passed through to consumers, higher priced foods will have added another roughly $626 per year of essential costs to the median household budget. These increased costs could be considered inflationary, however, with wage income stagnant, higher food and fuel prices will act like a tax increase. Indeed, the approximately $1300 increase in food and fuel prices is equal to 2.6% of median family income, an amount that more than offsets the 2% reduction in the social security tax for 2011."

Van Hoisington and Dr. Lacy Hunt go on:

"Reflecting the inflationary psychology of the higher stock and commodity prices, mortgage rates and municipal bond yields have risen significantly since QE2 was first proposed by the Fed chairman, increasing the cost and decreasing the availability of credit for two sectors with serious underlying problems. Also, Fed policy has pushed most consumer time, money market, and saving deposit rates to 1% or less, thereby reducing the principal source of investment income for most households. Clearly the early read on QE2 is negative for the economy."

Thank you Dr Ben Bernanke, QE2 is a complete failure.

UK inflation for December: 3.7% - QE is creating inflation as I expected.

In the post I published on the 16th of November 2010: "Another Letter from the Governor to the Chancellor - UK CPI at 3.2% in October", I continued to argue that inflation would keep rising in the UK. This post was the continuation of what I foresaw back in February 2010, that QE in the UK would be inflationary. It has been a recurring theme in my posts (see previous posts in April and May as well on why QE is inflationary).

I advised the following in February 2010, the need to track the movements of the CRB index, which could be done via the LYXOR ETF denominated in Euros.
I wrote:
"You need to closely monitor commodities prices because they are steadily going up again as the CRB index is showing. Lyxor CRB ETF denominated in Euros displays this increase: FR0010270033 is the ISIN."

The LYXOR CRB ETF was around 19.5 Euros in February 2010 when I previously posted:

Now the same LYXOR CRB ETF index is at around 24 Euros, a nice 24% increase nearly year on year (if you put the trade on that is...), reflecting the surge in commodities. The Thomson Reuters/Jefferies CRB Index (TR/J CRB) is currently made up of 19 commodities as quoted on the NYMEX, CBOT, LME, CME and COMEX exchanges. These are sorted into 4 groups, each with different weightings. These groups are:

Petroleum based products (based on their importance to global trade, always make up 33% of the weightings)
Liquid assets
Highly liquid assets
Diverse commodities.

In my book we have Stagflation in the UK, inflation, low growth, high unemployment.

"In economics, stagflation is the situation when both the inflation rate and the unemployment rate are persistently high. It is a difficult economic condition for a country, because when inflation and economic stagnation are occurring simultaneously, a policy dilemma results since actions that are meant to assist with fighting inflation might worsen economic stagnation and vice versa."

Keynes wrote:

"Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some."

How do you stop inflation creeping up in the UK? Very simple, the Bank of England will be pressured to raise rates sooner than later, because Mervyn King must be tired of having to write a letter to the Chancellor regularly.

The governor must write to the chancellor every three months when the inflation rate deviates more than a point from the central target in either direction...

The RPI figure for the whole of 2010 was 4.6% - the highest rate since 1991.

Below inflation from 2000 to 2010 in the UK:

The Bank of England is indeed in a very difficult quagmire.

The risk of a double dip in for the UK economy is alive and real.

This is what I wrote on the subject on the 16th of November 2010:

"There is still a very real risk of a double-dip recession in the UK. At some point the Governor of the Bank of England Mervyn King will have to raise rates to counter the rise in prices. This will put additional pressure on housing prices as well as mortgages and put more households into trouble, which would impair even more the damaged balance sheets of many UK banks."

And yes, you can have inflation in a deflationary environment:

"The inflation debate or why you can have inflation in a deflationary environment"

Monday, 17 January 2011

Are Fannie Mae and Freddie Mac on the path to a crash à la Thelma and Louise?

The tragic ending of Thelma and Louise could be similar to what awaits Fannie Mae and Freddie Mac.

"Despite the fact that America's housing-finance system has cost taxpayers more money than any bank bailout and many consider its flawed structure to be the single biggest contributor to the financial crisis, it seems most people don't know how it works or care how the housing-finance problem is resolved."

"The federal government now stands behind the vast majority of mortgages in the United States, and upwards of 90% of those originated since the financial crisis took hold. The Federal Reserve still holds over $1 trillion worth of residential mortgage-backed securities (RMBS) on its balance sheet, having purchased them to increase liquidity and spur additional lending."

"Yet the very system that has kept the U.S. housing market on life support has also drained federal coffers. Fannie and Freddie have so far cost the U.S Treasury Department $150 billion, a number that may rise to $363 billion, according to the FHFA."

How to Fix Mortgage Mess in Three Steps: Laurence Kotlikoff:

"Fannie Mae and Freddie Mac. What cute-sounding names. They suggest adorable siblings, not twin financial disasters that may cost $1 trillion when we get the final bill.

According to Edward Pinto, Fannie Mae’s former chief credit officer, in 2008 the two government-supported mortgage finance companies, along with the Federal Housing Administration and other U.S. agencies, were holding or guaranteeing some 19 million subprime home loans, or about 70 percent of all such debt.

Much of these toxic assets, as well as many of Fannie and Freddie’s prime mortgages, aren’t performing or will likely default. Nationwide, 8 million mortgages -- or one in 10 -- are under water, with the property’s value at least 25 percent below what’s owed.

The Federal Housing Financing Agency puts Fannie and Freddie’s losses at about $300 billion. But industry experts, like Janet Tavakoli, suggest the real number is closer to $700 billion. And if home prices fall another 20 percent to return to their long-term trend, the tab might climb to $1 trillion."

I agree with Laurence's statement in relation to the sick Fannie Mae and Freddie Mac. It is time to end this very expensive joke, once and for all.

The US government has no place in the mortgage business. Look at how the mortgage business has been managed in Denmark for a clue on how a sound mortgage system work.

The first Danish Mortgage Act was passed in 1850. Issued mortgage loans have a maximum loan to value (LTV) of 80% for residential properties.

"To fund the loan, banks issue mortgage bonds. The strict legal framework of the “balance principle” requires mortgage bonds to match the value and terms of the corresponding mortgage loan the bank is funding. The framework has provisions limiting the currency, interest, and liquidity risks of bonds. The strict regulations of the mortgage market limit the risks shared between bond-holders and mortgage institutions, create transparency, and offer investors security. This helps the continued growth of the mortgage market despite tough macroeconomic conditions."

"A due on sale clause in a loan contract means that borrowers have to pay their loans in the event the property has to be sold. This clause isn’t attached in Danish mortgage loan contracts, as borrowers can transfer the remaining loan to the new owner, or can buy back the bonds. This is especially beneficial to borrowers who experience situations where house sales are involved.

This payment system discourages borrowers from defaulting their loans, as they remain liable for the payment of their loan if they default."

For more on the subject relating to the Danish system:

"Denmark’s mortgage bonds haven’t suffered a default since they were introduced after the great Copenhagen fire of 1795."

Fannie and Freddie were set up in 1968 and 1970. The question that need to be adressed by January 31st is the following: "What is the appropriate role of the government in the housing market?" The Dodd-Frank reform bill required the Treasury Department to issue a comprehensive proposal to Congress.

Tim Rood, a former Fannie Mae official, compares the idea of relinquishing federal support to going cold turkey off of a powerful drug:
"You see some folks trying to draw the analogy between markets like Canada which have never had any government support or backing for the mortgage market and which seems to have achieved - on a much smaller scale - the nirvana of housing in homeownership rates, perfect matching of interest rate risks and all that," says Rood, who's now a managing director at D.C. consulting firm The Collingwood Group. "But it's like trying to compare an Amish baker to Keith Richards. There's no policy equivalent to methadone. We've been on it forever - you can't just say 'Look how easy it is to live without government involvement or backing of the mortgage market.' It's just not an easy thing to undo."

The answer is to privatize the system, following a Danish approach to mortgage financing:

"Affordable housing doesn't have to mean that everyone has to own a home. It's still a great dream and everyone should still aspire, if they choose to, to own a home. But when it comes to the government fostering 'affordable housing,' that might be rental housing."
says Edward Kramer, a former banker and regulator who is now a consultant at Wolters Kluwer.

Below is what George Soros has to say about the Danish system and reforming the US mortgage market in 2008. The problems of the US mortgage market are yet to be addressed.

Soros: Denmark Offers a Model Mortgage Market
There is a safe way to securitize home loans.

By George Soros

"The American system of mortgage financing is broken and needs a total overhaul. Until there is a raealistic prospect of stabilizing housing prices, the value of mortgage-related securities will erode and Treasury Secretary Henry Paulson's efforts will come to naught. There are four fundamental problems with our current system of mortgage financing.

First, the business model of Government Sponsored Entities (GSEs) in which profits accrue to the private sector but risks are underwritten by the public has proven unworkable. It would be a grave mistake to preserve the GSEs in anything resembling their current form.

Second, the American style of mortgage securitization is rife with conflicts where entities that originate, securitize and service mortgages are generally not the same as those that invest in mortgage securities. As a result, the incentives to originate sound mortgages and to service them well are inadequate. No wonder that the quality of mortgages degenerated so rapidly.

Third, mortgage-backed securitizations, which were meant to reduce risk by creating geographically diversified pools of mortgages, actually increased risk by creating complex capital structures that impede the modification of mortgages in the case of default.

Finally, and most fundamentally, the American mortgages market is asymmetric. When interest rates fall and house prices rise, mortgages can be refinanced at par value, generating the mortgage equity withdrawals that fueled the housing bubble. However, when interest rates rise and house prices fall, mortgages can only be refinanced at par value even though the market price of the securitized mortgage has fallen.

To reconstruct our mortgage system on a sounder basis, we ought to look to the Danish model, which has withstood many tests since it was brought into existence after the great fire of Copenhagen in 1795. It remains the best performing in Europe during the current crisis. First, it is an open system in which all mortgage originators can participate on equal terms as long as they meet the rigorous regulatory requirements.
There are no GSEs enjoying a quasimonopolistic position.

Second, mortgage originators are required to retain credit risk and to perform the servicing functions, thereby properly aligning the incentives. Third, the mortgage is funded by the issuance of standardized bonds, creating a large and liquid market. Indeed, the spread on Danish mortgage bonds is similar to the option-adjusted spread on bonds issued by the GSEs, although they carry no implicit government guarantees.

Finally, the asymmetric nature of American mortgages is replaced by what the Danes call the Principle of Balance. Every mortgage is instantly converted into a security of the same amount and the two remain interchangeable at all times. Homeowners can retire mortgages not only by paying them off, but also by buying an equivalent face amount of bonds at market price. Because the value of homes and the associated mortgage bonds tend to move in the same direction, homeowners should not end up with negative equity in their homes.

To state it more clearly, as home prices decline, the amount that a homeowner must spend to retire his mortgage decreases because he can buy the bonds at lower prices. The U.S. can emulate the Danish system with surprisingly few modifications from our current practices. What is required is transparent, standardized securities which create large and fungible pools. Today in the U.S., over half of all mortgages are securitized by Ginnie Mae, which issues standardized securities. All that is missing is allowing the borrowers to redeem their mortgages at the lower of par or market.

Because of the current havoc in the mortgage market, there is no confidence in the origination and securitization process. As a result, a government guarantee is indispensable at this time, and may be needed for the next few years. As the private sector regains its strength, the government guarantees could, and should, be gradually phased out.

How to get there from here? It will involve modifying the existing stock of mortgages, so that the principal does not exceed the current market value of the houses, and refinancing them with Danish-style loans. The modification will have to be done by servicing companies that need to be properly incentivized. Modifying mortgages that have been sliced and diced into securitizations may require legislative authorization. The virtual monopoly of the GSEs would be terminated and they would be liquidated over time.

A plan to reorganize the mortgage industry along these lines would inspire the confidence that would allow a successful recapitalization of the banking system with the help of the $700 billion package approved last week."

Mr. Soros is chairman of Soros Fund Management and the author of The New Paradigm for Financial Markets (Public Affairs, 2008).

For an additional essay from George Soros on the subject please see below:

Both GSEs Fannie and Freddie have been held in federal conservatorship since September 2008 and have received roughly 134 billion USD in taxpayer money to stay afloat so far...

US Home Ownership from 1980 until 2010:

The End of the American Dream:

The current S&P Case Schiller index 20-City Home Price Index:

Ben Bernanke is well aware of the issue with both GSEs. There cannot be a sutained recovery in the housing market before the Obama administration releases its recommendations for the future of Fannie Mae and Freddie Mac.
The dominance of the GSEs in mortgage finance needs to be reduced.

It is up to the US Congress to work on a solution. Let's hope the the Treasury Department issue a comprehensive and intelligent proposal to Congress before the 31st of January.

A tale of two markets - Credit versus Equities

At the start of the Financial crisis, with the subprime debacle of the summer of 2007, there was a big disconnect between the credit markets and the equities markets. Volatility was falling on the equities market meanwhile credit spreads were simply exploding, sometimes with gigantic intraday movements. I remember seeing 100 bps intraday move on the 5 year Itraxx Crossover index.

Credit markets, were early indicators of trouble in 2000 and 2007.

Tracking the implied volatility skew from equity options can be a good indicator of market movements in the equity world. Skew indicates the difference in demand for put options and call options. Following the standard measure of three-month volatility skew can be very useful.

In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money)equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study.

The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates. In a recent post, we touched on the subject in relation to the wall of maturities facing financial institutions up until December 2012 competing at the same time with Sovereigns in the need as well and the risk of crowding out.

Both credit and equity markets (as well as equity volatility) are driven by macroeconomic news.

There is a belief that fixed income markets are "smarter" than equity markets. It was certainly the case in 2007.

Today we have again an interesting disconnect:

In the graph you have:
Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year government bond, GDBR10), and at the bottom Eurostoxx 6 months Implied volatility.

At the same time, European High Yield debt is tighter than Bank Sub debt.

Europe's Junk Proves Safer Than Risky Bank Debt:

"The extra yield buyers demand to own high-yield non- financial notes instead of government securities fell below that on bank subordinated debt on Jan. 6, and is now 29 basis points lower, according to Bank of America Merrill Lynch index data. Before November, speculative-grade bond spreads had never been within 100 basis points of those on bank notes, which on average are rated eight steps higher."

"Relative yields on speculative-grade European company debt shrank 51 basis points to a three-year low of 437 since Oct. 31, a month before Ireland asked for an 85 billion-euro bailout, according to Bank of America Merrill Lynch’s Euro Non-Financial High-Yield Constrained Index. Subordinated bank bond spreads widened 125 basis points in the same period to 466, approaching the highest since July, the EMU Financial Corporate Index, Sub- Type shows."

"Financial credit has “significantly decoupled” from the rest of the corporate bond market since November because of higher expected losses and increased volatility amid the sovereign crisis, Morgan Stanley strategists led by Andrew Sheets said in a Jan. 14 report."

This leads us to discuss Capital Structure Arbitrage.

Capital Structure Arbitrage is according to the definition: any of a number of trading strategies designed to arbitrage the relationship between assets issued at different parts of a company's capital structure. Examples include convertible arbitrage (trading convertibles against equity options, for example), trading secured loans versus unsecured bonds of the same issuer and trading senior debt against subordinated debt of the same issuer.

It will be a big theme in 2011 according to UK Special Situations manager Alex Breese:

He said: "The capital structure arbitrage currently presented by corporate bonds yielding less than the free cash flow yield on equity will encourage the quoted sector to buy equity, either through share buybacks or merger and acquisition activity."

"This will be one of the key drivers for the UK market in 2011."

And probably a key driver in the credit space in general.

Friday, 7 January 2011

European Psycho - Bond Haircuts and the current financial bonds sell-off

If you are in an emergency and need haircuts on your bonds, please contact Patrick Bateman...

Big sell-off in Financial bonds in the last two days.
Reason being, the EC Proposals for resolution regime relating to the treatment of senior financial bonds holders in the case of a bank facing difficulties in the Eurozone.

Only new senior debt will be exposed to losses outside a liquidation of a bank, through a debt-write down resolution tool. This process is to allow rapid restructuring in Europe of a bank's liability structure. The differences in insolvency laws in Europe did not allowed for a rapid wind down.
It is a move in the right direction given restructuring on a financial institution needs to be executed rapidly. It is also to alleviate the risk of government taking on the full brunt of the banks in difficulties and over-exposing taxpayers.
The example of Ireland clearly showed the issue, where Ireland's public finances were put in disarray due to the massive bail out need of its financial sector (please see previous posts on that subject: The European Vortex, The Irish Black Hole, Ireland in the need of a lucky Shamrock). The resolution of distressed banks lacked flexibility in the legal framework in Europe and put too much risks on already strained European public finances.
It is the application of a resolution regime which was supported by the G20. No firm should be too big to fail or too complicated to fail and taxpayers should not bear the cost of the resolution of the distressed bank as emphasized by the G20 previously.

The commission will report by the end of 2011 on appropriate measures for other kind of financial companies including insurance companies.

It's likely to raise the cost of debt for EU banks which ultimately has to be negative for bank equity. In a deleveraging environment given banks are leveraged play on the economy, one can expect the ROE (Return On Equity) of banks to be weaker in this new regulatary environment as well as smaller GDP growth period.

But why the sell-off?

Because it seems the language protecting existing debt is a bit weak in the working paper.

As I indicated in my previous post, the race for funding, and the risk of crowding out, will penalise weaker bank in the short term.

This is already happening on the widening of CDS spreads on peripheral banks for both senior and sub CDS, for instance, on the 7th of January, you can already see Spanish Banks spreads widening significantly:

Source: Anonymised CDS run from the market, sent on Bloomberg.

Spanish Banks CDS from the 8th of October 2010 until the 7th of January 2011:

European Banks CDS from the 8th of October 2010 until the 7th of January 2011:

Also note the spread between Itraxx Main 5 year and Itraxx Financial Senior, made new highs as well, 102 Itraxx Main 5 year versus Itraxx Fin Senior at around 204 bps.

As a reminder from a previous post:

Itraxx Western Sovereign Index 5 year is around 215 bps.
Normal Risk is inverted.
Corporate risk is tighter than Financial Senior risk which is also tighter than Sovereign Risk in Western countries.

"Deutsche Bank AG’s recent 1 billion USD of five-year, 3.25 percent notes fell 0.04 cent to 99.87 cents on the dollar, Trace data show."

"Allegheny Technologies Inc.’s 500 million USD of 5.95 percent notes due in January 2021 have risen 1.9 cents to 101.8 cents on the dollar, Trace data show. The Pittsburgh-based producer of specialty metals sold the debt on Jan. 4, Bloomberg data show". And Allegheny Technologies is rated BBB-...

Forget about hedging via the SOVX Index Option market with Volatility at 98%...It isn't cheap anymore...

Also in the news, Swiss National Bank confirmed it hasn't taken Portugal's foreign-currency bonds as collateral. It said the bonds were never part of its list of SNB eligible collateral due to settlement reasons.

At the same time you have VIX at 17.4%...and given NFP came at a disappointing 104K (unemployment rate at 9.4% down from 9.8%, please note you have 1.32 million discouraged workers...and that is a new record), complacency is the word to use (definition of complacency: "self-satisfaction accompanied by unawareness of actual danger or deficiencies").

VIX, one year graph as of the 7th of January 2011.

Bottom line, it seems there is less short term risk and more value in selected corporate bonds, than in financial ones or European Sovereigns at the moment.

Thursday, 6 January 2011

Play it again Sam ! - European problems not going away in 2011...

Portugal came back to the market today and auctioned 500 millions euros worth of bills repayable in July. The yield stood at 3.686% from 2.045% back in September 2010 for similar maturity bills.

A year ago Portugal was only paying 0.592 % to borrow for six months.
Portugal need to raise 20 Billions Euros this year and it is not going to be cheap for them to do so.

On the 23rd of December, Portugal was downgraded by Fitch Ratings from AA- to A+. S&P might downgrade further Portugal to A- in April, which will automatically increase its cost of funding.

Moody’s said on Dec. 15 it may cut Spain’s Aa1 credit rating and on Dec. 16 placed Greece’s Ba1 bond ratings on review for a possible downgrade. Ireland’s credit rating was cut by five levels by Moody’s on Dec. 17.

Below table displays the European Government spreads versus Germany in early 2010 and the situation at year end:

Early 2010:

By year end:

2011 is the raising money race year. Competition between Sovereigns and Banks to raise money fast will be furious. It is already happening. Deutsche Bank and Rabobank kicked of the race on the 4th of January by selling US bonds. Deutsche bank issued 1 billion USD of 5 years notes paying 3.25% (130 bps more than comparable Treasuries), while Rabobank sold 2.75 USD billion of securities, according to data compiled by Bloomberg. On the 5th of January, it was the turn of Societe Generale and Intesa to tap the market and issue bonds.

Europe Banks Race Sovereigns to Bond Investors:

“There are several European government bonds paying more than banks for debt so it’s hard for lenders to raise cash in this situation,” said Serafi Rodriguez, a fixed-income trader at Banc Internacional d’Andorra.

Both funding costs for banks as well as for sovereigns is going up as reflected in the widening of CDS spreads we saw last year.
Evolution of CDS spreads between the 21st of September until the 21st of December:

European Sovereigns CDS spreads widened:

Asian Sovereigns CDS spreads were stable:

The risk of "Crowding Out" is alive and real. I previously posted on this very subject in February 2010: Crowding Out.

Banks need to raise 1.1 trillion USD this year.
From January 2010 until December 2012 the amount needed to be raised by banks amounted to 2.2 trillions Euros.

The important issue of rising global yields is a very important one. Debt markets are going to be more and more discriminating. This has serious implications in the development of the government finance bubble. Some cracks appeared with Greece in 2010 and you can expect similar cracks to show in 2011. After Greece and Ireland, Portugal seems to be the most obvious next weakest link to unfold.

In this race to funding, and with the markets becoming more and more selective, the competition will be fierce in 2011. The implications for public finances will be great. The era of cheap funding is definitely over.

Western countries are still trapped in a secular bear market. Particularly the US. Unemployment is still hovering around 9.8% after 4 trillion USD increase in government liabilities in just 9 quarters in conjunction with an extended near zero interest rate policy. Dear Ben, there is nothing to be proud of and QE2 is not going to be the remedy for the structural issues and housing mess which are still plaguing the US economy.

In this environment, Gold can continue to rise in 2011 as illustrated by the current term structure for Gold futures:

In relation to the evolution of yield on 10 year European Government debt, Ireland and Greece have reached new highs:

Evolution of Greek 10 year yield in the last 6 months until the 5th of January 2011:

Evolution of Ireland 10 year yield in the last 6 months until the 5th of January 2011:

Play it again Sam...

Sunday, 2 January 2011

Happy New Year 2011 ! Best wishes !

It has been a little bit more than a year I have started this blog.

I would like to thank all of the people who have supported it by providing me with specific reports, news and insights on markets.

I would also like to encourage you to make this blog even more interactive in 2011 by adding your comments to the posts I publish. Don't hesitate to contact me with your feedback.

If you like this blog please add it to your favorites. You can as well become a follower and recommed it if you like the contents of the posts.

Wishing you again all the best for 2011, sincerely,

Martin T.
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