Blood in the Credit Markets - Game on - Greece, that Lehman feeling?

On the 26th of November I posted : European Sovereign Debt - There will be blood

Was it visionnary? Hardly so.

European politicians are running out of options. They can't keep kicking the can down the road, because the road has an end.

Greece Sovereign 5 year CDS is now trading upfront, following it's stratospheric rise to around 2190 bps (+435 bps on the day!), implying more than 80% cumulated probability of default:

2 years Greek yield hovering around 28.25%. It sounds like game over for Greece, at least that's what the market is telling us.

Ireland and Portugal 5 years Sovereign CDS widened by 34 and 25bps to 815 and 810 bps.

ITraxx Financial Senior at 171.5 bps and Itraxx Fin subordinated index was at 310 bps.
Itraxx Main Europe 5 year, representing 125 corporate investment grade names at its highest since January 10 at 112 bps.

Vix index which has been too complacent for too long, suddenly woke up today to move straight to around 24% before coming off slightly:

We need to monitor closely VIX, to see if it breaks above 30, which was the highest point reached on March 16th.

In relation to Greece, David Goldman has an interesting proposal to resolve the ongoing issue: "Europe Needs One Horrible Example"

An entertaining read to say the least!

In relation to US Banks CDS, still widening today:
S&P’s LCD group gave an update, surge in demand for default protection = Not the best sign.

"After a brief respite Tuesday, five-year protection costs for bank, broker and consumer financial companies rose another 4-6% today after widening a similar amount yesterday, with latest levels representing near or full retracement of net tightening moves across the sector over the first four months of the year, trade data show."

"Significant percentage moves wider in five-year CDS spreads since the end of May include Wells Fargo (up 31% to 107 bps), Merrill Lynch (up 29% to 182 bps), Bank of America (up 27% to 178 bps), Capital One Financial (up 25% to 125 bps), Morgan Stanley (up 23% to 176 bps), Citigroup (up 22% to 156 bps), American Express (up 17% to 85 bps) and Goldman Sachs (up 11% to 158 bps)."

I am sticking with my previous recommendations of avoiding US banks stocks.

It is still "Risk Off" mode for now.

Credit Complacency - HELOCs issues and market update.

In addition to last week post about complacency in the market place, it is important to look at the economic figures which were published this week in the US.

They were not great.

Consumer spending in April in the US at 0.4%, against a revised 0.5% in March. Higher grocery bills and gas prices are taking their toll on the US consumer, that's what Wal-Mart has been telling us. Lower gas prices and strong NFP (Non Farm Payroll) could help for higher consumer spending but the deleveraging is strong. We are not there yet. Disposable income is still flat. Saving rates are at 4.9%, lowest since October 2008, meaning US consumers are in fact dipping into their savings, facing higher bills.

Core inflation rose 1% in April, the most since September.

So, the US consumer needs commodity prices to cool down and lower unemployment numbers. We got on the 25th of May the revised Q1 GDP figures, everyone expected 2.2% from 1.8% and we got the small print at 1.8%.
Also, you need to take into account the following fact, millions of Americans who are delinquent on their mortgages are staying in their homes for free about a year and a half on average. This is helping them buying time to restructure their finances. This is currently providing an unexpected support for consumer spending, which still makes up about 70 percent of the US economy. This is the effect of what is called now "squatter's rent". This equates to increase income from withheld mortgage payments for US households.

According to JP Morgan's chief US economist Michael Feroli, the extra cash could represent a boost to spending that is equal to about half the estimated savings generated by cuts to payroll withholding in December's bipartisan tax plan.

27 percent of single-family homeowners with mortgages are in negative equity, this represents according to CoreLogic USD 744 billion of total negative equity. The strategic defaults and the non payment of mortgages is helping to maintain current level of US consumption. More than a third of mortgage defaults were strategic, according to a June 2010 survey by finance professors Paola Sapienza of the Kellogg School.
For more on strategic defaults:

Strategic defaults could get very ugly - Keith Jurow

How to reverse the tide which ultimately will affect the value of mortages still sitting on US banks balanced sheet?
You can find the proposals made by Lewis Ranieri, the pioneer of mortgage securitization in the following link to a Bloomberg article:

Banks Can Fix Crisis by Easing U.S. Homeowner Debt, Ranieri Says


Ranieri's plan urge "banks to reduce debt for qualified borrowers and recognize losses on second mortgages and home-equity lines of credit."
Good intentions, but recognizing losses on home equity lines of credit for some US banks would have for some, a very significant impact. There are roughly 13 million HELOCs outstanding.

The big US banks have USD 147 billion in exposure to >100% CLTV HE Loans (source CreditSights):
Bank of America - USD 47 billion
JP Morgan - USD 41 billion
Wells Fargo - USD 39 billion
Citigroup - USD 20 billion

CreditSights estimate that cost related to a potential mortgage servicer settlement, mortgage repurchases, and second lien home equity write downs could lead to almost USD 95 billion in pre-tax losses for the big banks (USD 33.8 billion for Bank of America, 26.3 for JP Morgan, 24 for Wells Fargo, 10.3 for Citigroup USD). Aggregate earnings impact would be of around USD 62 billion according to CreditSights.

EPS Earnings impact:
Bank of America - USD 2.18
JP Morgan - USD 4.37
Wells Fargo - USD 2.96
Citigroup - USD 0.27

59 billion would be linked to write downs of HELOCS according to CreditSights, assuming 40% writedowns for Helocs with a CLTV above 100%. Given junior position of second liens, CreditSights is assuming 100% severity.

Impact on BASEL III Tier 1 common ratio would be:
146 bps down for Wells Fargo
113 bps down for JP Morgan
106 bps down for Bank of America
56 bps down for Citigroup

Conclusion:
I would stay clear of US Bank stocks for the moment, which follows last week post relating to loan growth issues for banks. There is no doubt in my mind that current underprovisioning by US Banks are artificially boosting earnings.

In Ireland, loss recognition has been dramatic even for Foreign-owned banks according to the Irish Time:
Just looking at the cumulative loan losses for Irish banks relating to the property bust, gives me the shivers: Irish Nationwide, total losses amounted to nearly 60% of its book, BoSI 32% and the Rabobank-owned ACC Bank 28%.

Foreign-owned banks count cost of carnage caused at their Irish branches


Pending home sales this month got absolutely whacked: -11.6% down, consensus was for -1%.
What's happening there? It means people are waiting for lower prices, which means than it will take even longer to clear the existing huge inventory I mentioned in last week post.
As a reminder, Short sales and Foreclosures accounted for 40% of existing home transactions in March, up by a third from last year.

New Homes Sales printed at 323000, consensus was for 305000. Nothing great, still in the abyss.

Initial jobless claims at 424K, consensus was for 400K.

University of Michigan consumer sentiment index increased a little to 74.3 from the preliminary reading of 72.4, possibly due to a small drop in gas prices. Please note the consumer sentiment index reading is still in a low area.

Update on bank failures this year: 44 so far. We were at 25, as I posted on the 25th of March 2011. We had 157 banks failures in 2010 according to FDIC.

Meanwhile in the European space, on the CDS sovereign space, spreads are still widening to new records for the peripherals:


Ireland and Portugal Sovereign CDS are now trading at the same levels, above 600 bps for the 5 year.

The full Greek CDS curve as quoted in the market on the 20-05-11:

That's how a fully inverted CDS curve look like...

Update on peripheral government bonds:
10 Year Greek Governmnent bonds are now yielding 16.57%, up 2.75% this month and 8.79% for the year.
10 Year Irish Government bonds are now yeilding 10.54%, up 0.83% on the month and up 5.89% this year.
10 Year Portugal Government bonds are now yielding 9.9%, up 0.39% on the month and 4.77% for the year.

German Bund 10 Year yield dipped this week below 3%, probably a sign of some sort of flight to quality. Here is an update on the 2-10 year curve for German debt:

We can see a nice ongoing flattening of the 2-10 spread on German government bonds.

Spanish Banks 5 year CDS have widened a bit for the weaker ones but haven't come back to their February levels, Santander and BBVA are still trading in the same range:


Itraxx Senior Financial 5 Year index is 60bps wider than Itraxx Main Europe 5 year CDS, 159 bps versus 97 bps. Financials have been widening again since the beginning of the year and single names CDS for banks as well, the worst offenders have been Irish banks CDS so far this year: Bank of Ireland CDS 1425 bps at the beginning of the year, 2415 bps now. Allied Irish, from 3019 bps to 4736 bps.

Continuing sovereign uncertainty means continued volatility for the financial sector, so watch closely the CDS space for banks for both senior and sub CDS 5 year CDS levels.

"Vanitas vanitatum, omnia vanitas" - This time is different or is it really? US macro outlook

US Corporate BBB Effective Yield close at 2004 lowest point:

High Yield CCC or Below Effective Yield as well extremely tight:



US Corporate 15+ Year Effective Yield back to 2006 levels...

The deleveraging story runs unabated for US Households:

Complacency is still the main story. Spread levels are very tight and the deleveraging is still alive and kicking.

Housing markets in the US continue to be very weak and a big concern for the macro outlook for the US economy.
First quarter delinquencies were on the rise. The seriously delinquent/foreclosures continue to slow due to the ongoing massive delays within the process. Are banks buying some time by slowing down the process?
Most likely.

The foreclosure route from first notice to completion according to CreditSights latest weekly housing monitor, takes now around 400 days and in some states 900 days (New Jersey and New-York).
There is currently 3.5 million homes in reported inventory as of the end of March 2011.
You might want to add the 4 million loans which are more than 90 days delinquent with a likely to enter the foreclosure pipeline in the future. And by the way, there are around 830,000 REO properties (Real Estate Owned, basically homes sitting now on Banks Balance sheet which have been repossessed) which are not typically included in the available inventory data.
So, the inventory is more likely to be closer to at least 4.5 Millions. How long you think it is going to take to clear this inventory? My guess is about 4 to 5 years. This is also Gary Shilling's view in his latest insight on the housing mess (May 2011 edition of A. Gary Shilling's INSIGHT).

Housing Starts still in the abyss...

Gary is expecting another 20% drop in prices given current inventories and pressure on prices. The more foreclosures, the bigger the inventory, the bigger the inventory, the longer time it will take to clear it and the bigger the pressure on house prices and acceleration in fire sales.

Another big drop in house prices will almost guarantee another recession because of its financial impact. You might want to track the levels of credit loss provisions in US Banks future quarterly results. In recent quarters some losses on loans relating to Real Estat have been offset by higher capital markets revenues and gains from lower credit loss provisions that were set aside under worst-case scenarios.

What we know thanks to Zeeshan Siddique in his article "1 Powerful Trend to Capture in the Banking Industry"

Credit Loss provisions have been declining for most US Banks:
-Citigroup: it declined to USD 2.9 billion for Q1 2011, compared to USD 8.4 billion in the first quarter of 2010 and USD 4.6 billion in the preceding quarter.
-Bank of America: quarterly profit in Q1 2011 after posting losses for two consecutive quarters thanks to its provision for loan losses which went down to USD 3.8 billion from USD 9.8 billion in the 2010 similar quarter.

Even nationalised Freddie Mac (FMCC) turned a profit this quarter thanks to lower loan-loss provisions. It has set aside less to cover potential credit losses amid "signs of improving credit quality". Credit-loss provisions were USD 1.99 billion, down from USD 5.4 billion a year earlier and USD 3.07 billion in the fourth quarter of 2010.

Zeeshan recommends buying stocks of well run banks, I have to disagree because lending is stagnant or still contracting at most U.S. institutions.
Also, Banks are losing revenue as a result of new federal rules that limit the types and amounts of fees they can charge consumers (regulatory changes coming from the CARD act of 2009). Lack of loan growth = poor revenue growth. Until the loan books of banks start growing again, I would avoid the sector. Loans still make up half of bank revenues.

Biggest Banks Beating Estimates Can’t Hide 13% Drop in Revenue
"Real estate loan balances at all FDIC-insured institutions, which represent more than half of outstanding bank credit, fell 4.4 percent in the fourth quarter to $4.27 trillion from $4.46 trillion last year, the FDIC said. New loans are earning significantly less yield, also cutting into revenue."

Economy 101: The two major economic factors that drive bank asset quality are unemployment and housing prices. So don't buy to much in the improving credit quality story. Stay cautious, housing and unemployment levels are key.

If house prices continue to drop, watch out for credit-loss provisions levels. We are getting New Home Sales on Tuesday next week, stay tuned.
Keep in mind the impact an additional drop in house prices could have on State and Local Tax Revenues, it could be even more devastating that it already is, as indicated by David Goldman:

The Coming Collapse in State and Local Tax Revenues
"in 2010, state and local governments collected about $88 billion in corporate income tax, $260 billion in personal income tax, $436 billion in property taxes, and $430 billion in sales taxes. Property taxes were the biggest single contribution"

So this is the reason why people are so jittery about Municipal Bonds...

While the latest NFP print at 244,000 in April was a good number, the unemployment rate moved up to 9.0% from 8.8%. Mixed results. USD GDP estimate came out at 1.8% annualized growth in Q1. This a very weak number for the recovery story. On the 26th of May we should get the revised figure for Q1, expectations are 2.1% revised for US GDP.

Remember we are still in a balance sheet recession which is still the worst recession you can get. So as John Mauldin points it, let's hope we muddle through that one, but I would not bet too much on that, particularly when I see the stupid valuations 1999 style we are getting, as illustrated with the Linkedin.com IPO: PE of more than 1300, and trading already at 135 times book value. You can also check Salesforce.com for some interesting valuations metrics as well.
I know, this time is different...

Apart from the ongoing deleveraging for households and housing continuing issues, corporate America is still sitting on a large pile of cash. Shares buy-backs and M&A activity are on the rise. My concerns relates to cushioning profit margins in Q2 due to rising commodity prices. Gap's share prices dropped 17% on Friday. Gap's 1st quarter profit dropped by 23%.
Rising prices for cotton and other commodities are eating into their profits this year. Its product costs are going to be 20% higher in the second half of the year. Because consumption is still weak, companies like Gap are having difficulties in raising their prices to compensate for the rise in commodity prices. They lack pricing power and their profit margins are therefore sinking.

In an environment plagued by rising commodities prices, pricing power is essential. Companies which have pricing power and can raise their prices accordingly without impacting their sales, should be followed closely. They will be in a better position to maintain their profit margins. Luxury companies for example, have more pricing power.

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:

http://www.actuary.org/pdf/life/fas157_0209.pdf

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:

http://www.businesswire.com/portal/site/home/permalink/?ndmViewId=news_view&newsId=20090417005227&newsLang=en

"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.