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.

A run up to the second leg down...and no this time it is not different.

Back in December I highlighted that the theme for 2010 will be sovereign risk and I was also indicating the headwinds facing Greece in particular and the PIIGS in general. Yet the rally runs unabated in the equity market and credit spreads are tightening still, although major structural issues have barely been addressed.

In a previous post as well I encouraged readers of this blog to track the CRB index as I was expecting commodities to surge higher as the "recovery" (which should be rebranded inflation) is gathering pace.



Gold is trading at record level again and oil is also trading much higher. The surge of Oil will have some consequences on the GDP growth. It will start to be a drag before becoming a threat.

At the same time VIX has dropped significantly.



At these levels, VIX is getting my attention and a long dated ATM call option is looking more and more attractive as I expect a volatility spike in the very near future, this summer most likely.

And by the way 42 banks have failed in the US this year so far according to the latest count on the FDIC list of failed banks:

http://www.fdic.gov/bank/individual/failed/banklist.html

What are the structural issues that needs to be fixed and what are the current threats:

-"Too big to fail" is not acceptable for banks.
Hedge funds can fail and it happens (this what capitalism is all about) and apart from LTCM it hasn't been disruptive to the markets. Banks are not hedge funds and should not be allowed to act like ones using deposit money.

Glass-Steagall act should either be re-enacted or a reduction in leverage should be enforced. The taxpayers and goverments cannot afford bailing out the financial system anymore and in many parts of the world, it is seriously crippled. In Ireland for instance, the situation for Anglo Irish Bank isn't great to say the least and they need additional injection of capital directly from the government to shore up their core capital and tier one ratio which has been seriously impaired by the hits they have taken on their loans. The level of their NPL (Non Performing Loans = really bad property loans...)is staggering: 11 billions of Euros, of which 4.2 Billions of Euros have already been provided. AIB’s equity core tier 1 at the end of 2009 was 5 per cent, excluding the 3.5 billion euros of preference share investment done by the Irish government previously!

Ireland’s “bad bank” — the National Asset Management Agency (NAMA) is initially removing 16 billion euros of bad loans from three of the five Irish participating banks to purge their balance sheet.
An estimated 80 billions Euros of bad loans will eventually be transferred by September
The Irish taxpayers will be picking up the tab for the next 7 to 10 years it will take to clean up the mess...

-OTC products in general and CDS in particular: they should be cleared on exchanges -period. It would reduce counterparty risk as well as adding liquidity and transparency.

-Senator's Chris Dodd proposed bills at the US Congress for the FED are purely and simply dangerous and seriously threatening the already impaired independance of the FED.

http://www.bloomberg.com/apps/news?pid=20601087&sid=ar1GEW82NxDU

-Greece, the tip of the Iceberg.
1999 rating of Greece before joining the Euro: BBB+
9th of April 2010: Greece rating according to Fitch is now BBB-
The end of the game is approaching fast, similar to Lehman's situtation prior to its demise, Greece is experiencing massive capital flight from its banks, 10 billions euros have already been pulled out of Greek banks. Unsecured consumer borrowings for Greek banks has increased from 10% in 2003 to more than 20% today as a percentage of household disposable income (this figure is 23% in the US). Although Greek banks, have better tier one ratios than their Irish counterparts, the capital flight they are experiencing is fast and furious and doesn't bode well for their funding needs. Always remember that the banking industry is a leveraged play intensively correlated to the economy it is operating in and given the GDP contraction Greece has experienced and the state of the public finances, their fate is linked. Before Fitch's downgrade on Greece, National Bank, EFG Eurobank and Alpha Bank's ratings where BBB neg according to Fitch. You can expect Greek banks to be downgraded as well.
It is truly a Greek tragedy.



-United Kingdom upcoming elections: Conservatives need a clear majority, markets would react negatively to a hung parliament which could slow down much needed spending cuts and hurt even more the GBP. Soros is now talking about devaluation being an option for the UK government recently at a conference organised in Cambridge. It could be effective in reducing the debt burden, boosting exports in the short term but inflationary in the long term which would mean rates hikes down the line.

The heart of America and the need for a defibrillator

David Goldman in his blog is right about the recovery. Until small businesses thrive again, it will not happen. What is so severe in the current recession is how profound they have been impacted this time around.

Small business (firms employing 500 workers or fewer) accounted for 64% of net new job creation for the past 15 years according to a small independent government agency called SBA (Small Business Administration).

According to an article in The Economist, cities with small firms have done better in creating jobs for the last 20 years.

In this recession, it has been very ugly for the small businesses of America. The small businesses employing less than 50 employees have accounted for 45% of the job losses!

The heart of America is failing and the Obama administration need to find a proper defibrillator soon to help them out in this downturn.

With activity picking up for some, small firms are being savaged by the credit crunch. They cannot get credit. Credit card debt and home-equity credit have been reduced drastically by the banks and seriously impaired by negative equity.

In conjunction to the lack of credit, small businesses cannot rely on regional banks because these small banks are getting crushed by their difficulties with the commercial property bust.

The Economist in its December 12th issue highlights the current situation:
"Nearly 40% of outstanding small-business loans exposure are held by banks with the greature exposure to commercial-property risk. In 1993, the figure was only 11%. As commercial property losses grow, banks will be forced to curtail lending."

Yes, this time around it is worse than during the Savings and Loans crisis which led to the demise of 450 banks.

Since the beginning of the year, a massive number of these regional banks have gone bust:

http://www.fdic.gov/BANK/HISTORICAL/BANK/index.html

List of individual banks which have failed since 2000:

http://www.fdic.gov/bank/individual/failed/banklist.html

Another 7 banks went down just on the 18th of December.

Lending for the small businesses of America is the key battle for the recovery.

Let's hope the US administration will find the right defibrillator this time around to jump start the heart of American economy.

On a final note, I wish you all a Merry Christmas!

Dubious Dubai and the issue of perception...

From Wikipedia definition of a "mirage"

"A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects or the sky. The word comes to English via the French mirage, from the Latin mirare, meaning "to look at, to wonder at". This is the same root as for "mirror" and "to admire"."

Suddenly last week, Markets reacted strongly on news relating to the difficulties arising in Dubai. Sovereign CDS protection on Dubai significantly widen on the news and Credit indices such as Itraxx Main and Banks CDS also took a hit. It took them a while to realised how inflated their perception of Dubai real estate companies creditworthiness was.

It was all about false perception. Similarities can be made on this story that made headlines recently. Perception of the credit worthiness on Dubai World was all about implicit guarantees from the Dubai Government. Investors invested believing in implicit support. Probably the same investors who believed in the sacro-saint AAA rating issued on dodgy CDOs and CLOs as a gauge of credit quality of the underlying pool of assets in the structure. Probably the same investors who believed that a callable LT2 bond will be called on the call date by the issuer, because it has been market practice in the past. How suprised they were when Deutsche Bank, nearly a year ago in December 2008, decided not to redeem some sub debt on the date of the call! Investors trade sub debt based on the date of the call to calculate the price of the bond.

This shows you how short memory is on the market and how perception can affect sound judgement.

I travelled to Dubai in October 2008 and I went to Cityscape 2008 (as per the picture above, all rights reserved). For me it was an eye opener on the real estate bubble in Dubai. As equities market were getting crushed following Hank Paulson's fateful decision of letting Lehman go under with catastrophic consequences (when an orderly wind down could have been managed under FDIC's supervision), 60,000 "Real" Estate professionals were meeting in Dubai to have a look at the pharaonic new projects which were presented in this event. It was history in the making, the top of the bubble.

What's next for Dubai?

From the 1973 movie My Name is Nobody, here is a reminder of a little story told in the movie...
In “My Name is Nobody,” the protagonist, Nobody (played by Terence Hill), tells a famous fable:
"There was this little baby bird that fell from it’s tree in the cold of snow. It starts peeping, “Pa peep! Pa peep!” as it was damn near freezing.
Along comes this cow. She looks down at the little bird and feels sorry for it. She raises her tail and… “splah!”
…She drops a steaming hot cow pie right on top of it.
The little bird starts again… “Pa peep! Pa peep!” Because it’s hungry.
Along comes a mean ole Coyote… It reachs down easy into the cow pie and picks the little bird up. He raises the little bird higher and brushes the dirt off him real nice.
And then… “Gulp!” Swallows the little bird down all in one bite!
My grandfather says there is a moral to the story, but you have to figure it out for yourself…
At the movie’s end, the aging gunfighter, legend Jack Beauregard (played by Henry Fonda) figures out the moral to the story:
Folks that throw dirt on you aren’t always trying to hurt you, and folks that pull you out of a jam aren’t always trying to help you. But the main point is: when you’re up to your nose in shit, keep your mouth shut."

Although Sheikh Mohammed bin Rashid al-Maktoum tried to reassure the market, there was a continued sell-off in the Gulf stock markets today.

It looks like perception has changed, like perception changed for AAA ratings for structured CDOs/CLOs notes previously, and for callable LT2 bonds.

The price for the bail out of Dubai will be costly and prized assets such as Emirates airlines could possibly change ownership and end up in the hands of their powerful saviours Abu Dhabi.