Saturday, 19 April 2014

Credit - Hocus Bogus

"Fake is as old as the Eden tree" - Orson Welles

Watching with interest peripheral yields touching record lows (Italian yields touched 3.068%, the lowest since Bloomberg started collecting the data in 1993) in conjunction with the blazing placement success of Greece's new issue, we reminded ourselves of the magical powers of our "Generous Gambler" aka Mario Draghi and one of our favorite quotes:
"The greatest trick European politicians ever pulled was to convince the world that default risk didn't exist" - Macronomics.

The current European bond picture with Italy and Spain 10 year government yields converging towards core European Yields - source Bloomberg:

This week's chosen title is a reference to the exclamation used by magicians, usually the magic words spoken when bringing about some sort of change. No doubt that the "whatever it takes" moment from our European magician Mario Draghi has indeed brought some sort of change, in yield terms for sure. 

But, our chosen title is as a well a literature reference to the great 1976 French novel "Hocus Bogus" by Romain Gary published under the pseudonym Emile Ajar. In this particular novel, the author goes back and forth from a clinic to a psychiatric institution in Denmark and whenever he receives visits, he feels cured without being cured and without any hope of leaving the dissimulation and delirium that affect him. Reality, lucidity and hope were nonentities for Gary/Emile, therefore continuously suspect. In similar fashion developed economies have been "cured without being cured" by central banks meddling and magician tricks hence the dual reference of this week's chosen title but we ramble again...

In this week's conversation we intend to once again to break our Magician's Oath in relation to market levels and economic woes in Europe and in particularly the deflationary bias plaguing the periphery. We will look as well at the magician tricks used by American banks to use cheap funding in order to meet new liquidity requirements. 

The Magician Oath
"As a magician I promise never to reveal the secret of any illusion to a non-magician, unless that one swears to uphold the Magician's Oath in turn. I promise never to perform any illusion for any non-magician without first practicing the effect until I can perform it well enough to maintain the illusion of magic."

When it comes to European magician tricks versus US magician tricks, so far the Europeans have indeed displayed a wonderful performance when one looks at Greek bond gains versus US Tech stocks as displayed by Bloomberg's recent Chart of the Day:
"Greek government bonds have been a more rewarding investment during the tenure of Prime Minister Antonis Samaras than any technology stock in the Standard & Poor’s 500 Index.
The CHART OF THE DAY compares price changes in Greece’s 10-year note and shares of First Solar Inc. since Samaras was sworn into office on June 20, 2012. First Solar, a power-plant developer and solar-cell maker, had the period’s biggest gain among companies in the S&P 500 Information Technology Index.
Greece issued the notes in February 2012 as part of the biggest sovereign-debt restructuring in history. They climbed 379 percent through yesterday under Samaras, who is seeking to revive the economy. Interest payments brought the total return to 393 percent. Shares of First Solar, which doesn’t pay any dividends, gained 344 percent.
“The market has a short memory,” Lyn Graham-Taylor, a fixed-income strategist at Rabobank International, said in a telephone interview yesterday.
Greece’s return to a budget surplus before interest costs has benefited bondholders, the London-based analyst said. The country ran a surplus of 2.9 billion euros ($3.9 billion) on that basis last year.
Both securities were close to record lows when Samaras became prime minister. The Greek notes set their low on May 31, 2012. Four days later, First Solar changed hands at the lowest price since the Tempe, Arizona-based company went public in November 2006." - source Bloomberg.

Credit wise both the US and Europe have managed to converge thanks to ECB's wizard in chief Mario Draghi when one looks at the trajectory of the respective investment grade CDS indices for Europe and the United States as "credit risk proxy" namely the Itraxx Main Europe and its US equivalent the CDX index since January 2011 - graph source Bloomberg:

But when it comes to stimulating inflation, both European and US magicians have so far failed to come up with the right "trick" given that the only inflation they have managed to create has been in asset price levels.

Central banks have indeed rekindled the "animal spirits" in true Keynesian fashion when it comes to asset prices, but also in true 2007-2008 spirit leading to a credit binge, particularly in the US junk-loan market as reported by Christine Idzelis in Bloomberg on the 15th of April in her article "Junk Buyout Loans Eclipse '07 Record in Deal Frenzy":
"The U.S. junk-loan market has never fueled so much dealmaking.
A total of $85 billion of loans have been raised this year to finance acquisitions, topping 2007’s record pace, data compiled by Bloomberg show. Issuance is set to accelerate as Avago Technologies Ltd. locks in the year’s second-biggest loan for its takeover of chipmaker LSI Corp. as soon as today and Men’s Wearhouse Inc. borrows $1.1 billion to fund its deal for Jos. A. Bank Clothiers Inc.
Leveraged loans are booming as the value of takeovers in the U.S. reaches levels last seen in 2008. While regulators have warned excesses may be emerging in riskier parts of the market as the Federal Reserve’s zero-interest rate policy extends into a sixth year, the loan surge underscores renewed confidence in the ability of the least-creditworthy companies to expand as the world’s largest economy strengthens.
“There’s a lot of money waiting to be put to work,” Judith Fishlow Minter, co-head of U.S. loan capital markets at Royal Bank of Canada, said in a telephone interview from New York. “The market is exceptionally strong.”" - source Bloomberg.

This is exactly what we envisaged when we wrote our post "2014: the Carry Canary":
"Looking at the continuous rally in the credit space, one has to wonder whether 2014 will indeed be the year of the credit carry trade which, as we posited last week, would be supported by a return of M&A, LBOs, as well as structured credit in similar fashion the year 2007."

Of course the carry game being played in the credit space is also seeing a rise in leverage as indicated in the same Bloomberg article quoted above:
"First-lien borrowings at speculative-grade companies equaled 4.2 times their earnings before interest, taxes, depreciation and amortization in the first quarter, the highest since the 4.6 ratio in the last three months of 2007, according to S&P Capital IQ Leveraged Commentary & Data.
A total $760 billion in mergers and acquisitions of U.S. companies were announced in the year ended March 1, according to data compiled by Bloomberg. That’s the most for a 12-month period since April 2008." - source Bloomberg.

Credit is of course not the only place where leverage is being used with maximum effect courtesy of central banks generosity, equities have also shown signed of increasing leverage being used for buying stocks in the US as illustrated by the rise of the S&P index (blue) versus NYSE Margin debt (red):

Yes, we know some people argue that concerns on the record amount of borrowing for US stocks are misplaced because, lower interest rates have made the borrowing much less expensive, as illustrated by  this Bloomberg chart:

We did use a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit": "That Which is Seen, and That Which is Not Seen". 

In similar fashion it can be used for the NYSE Margin debt. This is clearly illustrated in Bank of America's recent Monthly chart portfolio of global markets published on the 14th of April:
"Margin debt: absolute extreme but the 12-month rate-of change not extreme
Margin debt is a gauge of market sentiment and positioning. While the absolute level of margin debt is a source of investor concern, the YoY rate of change (RoC) is lackluster at 27.2% and did not test the extremes near 78% and 68% that accompanied the S&P 500 peaks in 2007 and 2000, respectively. The recent high for the YoY RoC was 42% in April 2010 and the rate of increase in NYSE margin debt from a May 2012 low of -12% in the YoY RoC is not consistent with the prior market peaks from 2007 and 2000."

Risk: Net free credit at -$178b – exceeds extreme negative level from Feb 2000
Net free credit is free credit balances in cash and margin accounts net of the debit balance in margin accounts. At -$178b (from -$159b in January), this measure of cash to meet margin calls is at an extreme low or negative reading that has exceeded the February 2000 low of $-129b. The risk is if the market drops and triggers margin calls, investors do not have cash and would be forced to sell stocks or get cash from other sources to meet the margin calls. This would exacerbate an equity market sell-off.
- source Bank of America Merrill Lynch

Many investors hope that the central banks magician spell "Hocus Bogus" will last long enough for them to exit in both credit and equities in an orderly manner, they once again suffer from "optimism bias" we think.

Moving back to central banks issues in coming up with the right magician "inflation trick", an illustration of the ECB's inflation conundrum can be seen in the deflationary forces at play plaguing the periphery like in Spain for instance, where deflation risk is clearly on the increase as depicted in the following Bloomberg chart:
"With deflation risk growing across the euro area, southern Europe economies' delivery on austerity targets will likely regain focus. Spain's budget deficit fell to 6.6% in 2013, just shy of the 6.5% European Commission target. With inflation falling 0.2% in March, vs. consensus calling for a 0.1% increase, the budget deficit target of 3% of GDP by 2016 may now require deeper fiscal adjustments, further denting GDP and the outlook for lending." - source Bloomberg.

While the "Hocus Bogus" spell from our magician at the ECB has indeed supported peripheral yields, it has also enabled Spanish banks to rely less on debt issuance but more on the increase of deposits for their funding needs as displayed in the below Bloomberg graph:
"Santander and peer Spanish banks held 590 billion euros ($818 billion) of retail (household) deposits pre-crisis (mid-2007). This represented 21% in liabilities of a total 1.38 trillion non-bank deposits. Retail deposits have grown to 760 billion euros in 1Q, while corporate deposits declined 1% and funding from insurance companies, pension funds and other financial institutions has declined 5%. The banks' reliance on debt funding has fallen to below 10% of total liabilities, from 15%." - source Bloomberg

Whereas Italian banks have relied more on debt issuance for their funding needs as described by Bloomberg in the below graph:
"Debt outstanding for euro zone banks fell 3.6%, or 163 billion euros ($226 billion), in the seven years to 1Q. Italian banks' debt in issue (as reported by the ECB) grew 50% to 860 billion euros in the same period, with the 280 billion euro growth in outstanding debt almost 30% higher than French banks' debt growth. At 21% of total liabilities, Italy's utilization runs at 50% more than the 14% average across the euro zone. This growth has largely replaced the decline in interbank deposits." - graph source Bloomberg

On top of that, the deleveraging for Italian banks has hardly run its course and in similar fashion to the Italian government shedding real estate and its car fleet, Italian banks are as well busy shedding non-performing loans backed by real estate as indicated by Sharon Smyth and Elisa Martinuzzi in their Bloomberg article from the 16th of April entitled "Italy Banks May Sell $69 Billion of Bad Loans Amid U.S. Interest":
"Prelios SpA, the Italian asset manager studying a merger of two units with those of Fortress Investment Group LLC, said it expects Italian banks to sell as much as 50 billion euros ($69 billion) of bad loans in the next two-to-three years.
Italian banks are sitting on 160 billion euros of non-performing loans, a figure that will swell to 200 billion euros in the next two years as Italy emerges from recession, according to Riccardo Serrini, chief executive officer of Prelios Credit Servicing SpA, a unit of Milan-based Prelios.
“We’re currently assisting investors bidding for 10.9 billion euros of NPLs,” Serrini said in an interview in his office in Milan. “Ninety-five percent of investors are from the U.S. and about 70 percent of the loans are secured by real estate.”
U.S. investors, including some without a presence in Italy, are making up for the shortfall of Italian funds that can absorb the planned disposals, Serrini said. Italian banks, which have so far resisted distressed-debt sales, are now accelerating plans to shed bad debt, which has reached record levels. They are considering pooling bad loans into separate units, or bad banks, in an attempt to free capital and increase lending capacity, as well as selling loans." - source Bloomberg.

So it looks to us that Italy is indeed for sale.

Moving on to the subject of banking wizardry from American banks, they have indeed find cheap funding in order to meet new liquidity requirements thanks to the Federal Home Loan Bank system as reported by Clea Benson in Bloomberg on the 16th of April in her article entitled "Basel Rule Spurs Big-Bank Borrowing from US Home Loan Banks":
"Four of the nation’s largest banks, led by JPMorgan Chase & Co., are driving a surge in borrowing from the Federal Home Loan Bank system as they raise funds to buy assets that meet new liquidity requirements.
Lending at the 12 regional Home Loan Banks rose 30 percent to $492 billion between March of 2013 and December 2013, largely the result of advances made to JPMorgan, Bank of America Corp., Wells Fargo & Co. and Citigroup Inc., according to a report released today by the Federal Housing Finance Agency Office of the Inspector General.
The concentration of Home Loan Bank lending in four large institutions could present safety and soundness risks, the report said. In addition, auditors questioned whether lenders created to support housing finance should be providing funds so banks can meet standards set under the international Basel III accord.
“The increasing use of advances by members to meet Basel III’s liquidity requirements could raise public concerns about the system’s commitment to its housing obligations,” the report said.
The Federal Home Loan Banks, established by the government in 1932 to support mortgage credit, have an implicit government guarantee, meaning that investors expect they won’t be allowed to fail. They make advances to their 7,500 member financial institutions that can be used to originate home loans or for other purposes.
Citigroup, JPMorgan, Bank of America and Wells Fargo accounted for 27 percent of total advances from the Home Loan Banks at the end of 2013, up from 14 percent the year before, the report said. Lending to JPMorgan increased the most, to $61.8 billion in December 2013 from $13.3 billion in March 2012." - source Bloomberg.

What we find a great source of concern is that the Federal Home Loan Banks were established to support mortgage credit in the first place. But, looking at the state of US mortgage lending contracting to levels not seen since 1997 as per Bloomberg's recent article by Kathleen M. Howley, Zachary Tracer and Heather Perlberg entitled "Lending Plunges to 17-Year Low as Rates Curtail Borrowing", one might wonder if banks benefiting from implicit governement guarantee thanks to their borrowing binge are not indeed a clear violation of  the system's mission, namely supporting residential mortgage lending in the first place:
"Wells Fargo (WFC) & Co. and JPMorgan Chase & Co., the two largest U.S. mortgage lenders, reported a first-quarter plunge in loan volumes that’s part of an industry-wide drop off. Lenders made $226 billion of mortgages in the period, the smallest quarterly amount since 1997 and less than one-third of the 2006 average, according to the Mortgage Bankers Association in Washington." - source Bloomberg

From the same article:
"Lenders also are tightening credit standards, requiring higher FICO scores. More than 40 percent of borrowers in 2013 had scores above 760, compared with about 25 percent in 2001, according to a Feb. 20 report by Goldman Sachs Group Inc. analysts Hui Shan and Eli Hackel. 

JPMorgan originated $17 billion of home loans in the first quarter of 2014, lower than at any time during the housing crash. The New York-based bank made $52.7 billion of mortgages a year earlier. Marianne Lake, JPMorgan’s CFO, cited severe winter weather as among the reasons for the first-quarter drop." - source Bloomberg

This recent article follows another article written by Jody Shen on the 10th of October 2013 in Bloomberg entitled "JP Morgan Taps Taxpayer-Backed Banks for Basel Rules":
"FHLBs, cooperative institutions owned by their borrowers, were created in 1932 to provide savings-and-loan institutions with a way of tapping stable funding after a string of failures caused by runs on deposits. Their Washington-based trade group now says the aim “is to support residential mortgage lending and community growth in all areas of the country.”
In 1989, Congress allowed commercial banks to join the network, which comprises 12 regional FHLBs that raise money jointly in the bond market to fund lending to members and their investment portfolios. Because of the perception the government would step in to prevent a default, FHLBs can sell securities at yields similar to Treasuries and the bonds carry the top rating from Moody’s Investors Service and the second-best from Standard & Poor’s, the same as its U.S. ranking." - source Bloomberg.

Of course the reason behind the drop in mortgage origination is that the leverage community such as private-equity forms, hedge-funds and real estate investment trusts and other institutional landlords have been perfectly positioned to benefit from the "Hocus Bogus" recovery and in the front line to gain on the 23% surge in home prices since the post-bubble low in March 2012 according to the S&P/Case-Shiller index. According to Bloomberg more than $20 billion has been spent so far by the leverage community to buy as many as 200,000 rental homes in the last two years.

No wonder US Family Housing Starts has been falling in conjunction with US Furniture sales, as well as the Baltic Dry Index as of late, pointing, we think to some important "crosswind" in the much vaunted US recovery- graph source Bloomberg:
Since 2006:
- in red the Baltic Dry Index,
- in orange US Family Housing Starts
- in blue US Furniture Sales.

As we indicated in our January 2013 conversation "The link between consumer spending, housing, credit growth and shipping" :
"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

Top US Imports by commodity - source Bloomberg:
"The top five U.S. imports account for about 35% of the total in 2013, and include furniture, machinery, electrical equipment, apparel and vehicles. Furniture has been the top containerized U.S. import over the past six years, at 11.6% of the total in 2013, according to Datamyne. China was the largest furniture exporter to the U.S., followed by Vietnam and Malaysia in 2012. Higher imports may help absorb excess capacity and boost rates for containerliners." - source Bloomberg.

Any change in consumer spending trends is depending on a more pronounced housing market revival and will directly impact container traffic, it is that simple.

But when it comes to mortgage origination, mortgage volumes have fallen 57% year on year as shown in the below Bloomberg chart:
"Mortgage volume may have fallen 57% yoy in 1Q, driven by a 71% decline in refinance volumes, according to Mortgage Bankers Association forecasts. Volume is expected to be 23% lower compared with 4Q. Profitability indicators are also modestly lower yoy, though relatively stable with 4Q. Mortgage banking volumes should remain well below those of recent years in 2014, though revenue pressure may begin to be offset by expense cuts, including significant staff reductions." - source Bloomberg.

All in all, this is indicative of the shift in mortgage origination and also indicative of the latest system abuse by US banks to obtain cheap funding to meet liquidity requirements set up by the regulators. 
While we previously argued that LTROs in Europe amounted to "Money for Nothing", the latest US banking regulatory trick does indeed display a similar feature given that even with better FICO scores lending standards have been tightened.

End of the day, if central bankers are powerful magicians, bankers are no doubt accounting wizards.

"I will speak of one man... that went about in King James his time... who called himself, The Kings Majesties most excellent Hocus Pocus, and so was he called, because that at the playing of every Trick, he used to say, Hocus pocus, tontus talontus, vade celeriter jubeo, a dark composure of words, to blinde the eyes of the beholders, to make his Trick pass the more currently without discovery, because when the eye and the ear of the beholder are both earnestly busied, the Trick is not so easily discovered, nor the Imposture discerned." - Thomas Ady, A Candle in the Dark, 1656

Stay tuned!

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