Wednesday, February 29, 2012

Treasury yields and credit spreads divergence is not sustainable

There is a great deal of discussion in the market about the dislocation between US equities and treasuries. It is somewhat surprising that people are only now starting to focus on the issue - the divergence has been visible for quite some time and was discussed here.

But another divergence which is quite striking exists now between corporate bond spreads and treasury yields. The chart below compares the investment grade CDX (index CDS) with the 10-year treasury yields.

The treasury market continues to trade with a built in "Europe risk premium". Some managers hold treasuries as a hedge against European surprises - a strategy that has worked quite well recently (as opposed to equity index puts). But this divergence is not sustainable in the long term and treasury yields should start rising later this year.

India struggling with slower growth and rising costs

India's GDP had taken a turn for the worse in Q4, with growth rate of 6.1% - below analysts expectations. The correction in growth looks similar to the 08-09 period.

India GDP growth (Bloomberg)

This is particularly troublesome, given that inflation remains high. Even as food inflation has receded somewhat, wholesale inflation ex-food remains high.

Source: ISI Group

Corporate staffing costs continue to grow at double digit rates and a weaker rupee combined with the recent increase in oil prices is putting upward pressure on fuel costs in India. In addition, with government bonds still yielding above 8%, corporations are struggling with high funding costs. In effect these high government bond yields are crowding out corporate debt. All this adds up to declining corporate margins.

Given the reduction in GDP growth, it is likely that RBI will lower rates on March 15th. But the central bank continues to be in a tough spot trying to balance these inflationary pressures with slower growth. Risks of a "hard landing" in India remain high.

Leveraged US firms faced headwinds in Q4

The relative health of the US corporate sector can be gauged by the metrics around leveraged companies, which tend to be vulnerable to fluctuations in economic conditions. Companies comprising the CDX High Yield Index make up a good sample for this analysis. These include firms such as TXU, Harrah's, Realogy, Royal Carribean, etc. The first metric that analysts tend to review is gross leverage (debt to earnings), which has risen somewhat in Q4 of 2011.

Source: Credit Suisse

Another important indicator is the level of corporate cash positions. And those have increased as well during last quarter.

Source: Credit Suisse

Subtracting cash holdings from the debt amounts, one obtains the "net leverage". In spite of higher debt levels, the large cash positions have brought the net leverage to the lowest level in years.

Source: Credit Suisse

Why would firms borrow more money (increasing gross leverage) when they have such large cash positions? The answer has to do with what these firms were experiencing in Q4 of 2011. The global economy, impacted by the events in Europe, looked like it may enter a double-dip recession,  So firms who had the opportunity to raise new debt did so, but kept a large portion of the proceeds in cash in preparation for rough times ahead. Companies also had direct reasons to become defensive, as they saw their free cash flow stay at depressed levels.

Source: Credit Suisse

The causes of lower free cash flow included increases in working capital, greater CapEx, lower gross margins, and higher inventory. Q4 was not easy for the HY CDX firms.

In spite of these headwinds, earnings have been coming in relatively strong with Q4 "beats" at roughly three times the "misses" (although a number of companies are yet to report). Going forward it will be critical to see how these firms perform and the metrics around their leverage, cash positions, and free cash flow, as these will tell us what risks the US corporate sector may be facing.

Tuesday, February 28, 2012

Lower debt burden drives improvements in consumer confidence

The recent strength in US consumer confidence has taken some analysts by surprise. The Conference Board confidence indicator came in today at 70.8 versus the average expectation of 63.
FoxBusiness: "Consumers are considerably less pessimistic about current business and labor market conditions than they were in January," said Lynn Franco, director of The Conference Board Consumer Research Center, said in a statement "And, despite further increases in gas prices, they are more optimistic about the short-term outlook for the economy, job prospects and their financial situation."
The chart below shows the confidence index almost at the post-2008 high (the high was reached about a year ago, just prior to the Libyan revolution).

Conference Board Consumer Confidence

So far analysts and the media have used the improving employment picture to explain this consumer optimism.
AP: There are reasons for optimism. The government says 243,000 jobs were added in January, pushing down the unemployment rate to 8.3 percent, the lowest in three years. Unemployment has fallen five months in a row for the first time since 1994. 
But there is a more fundamental explanation. The US consumer debt burden as measured in terms of interest coverage has been declining to levels not seen since the 70s. Historically low mortgage rates and reduced reliance on credit cards and home equity financing have brought down consumer interest payments as percentage of disposable personal income.

Source: ISI Group

This should in principle boost consumer spending going forward, assuming gasoline price increases do not derail the trend.

Update (3/1): The Bloomberg Consumer Comfort Index is now at levels last seen before the 2008 crisis (though still at depressed levels), confirming the general trend.

Bloomberg Consumer Comfort Index

Surging home sales in Shanghai point to renewed strength in China's property markets

China's "property bubble" is alive and well. Even as new home prices in Shanghai declined 5.7% last week, home sales have spiked. Property developers' margins are certainly high enough so that they can offer discounts in order to increase volumes.
Shanghai Daily: Over the last seven days the sales of new homes, excluding government-funded affordable housing, surged 68.3 percent from the previous week to 140,400 square meters, according to a report by Shanghai Deovolente Realty Co.
A rumor has been widely circulated recently that the authorities will permit people who do not have a permanent residence but have lived in the city for three years to purchase a second property.  Many non-residents went shopping.
Property Wire: China’s financial centre Shanghai has eased home purchase restrictions to allow a broader pool of buyers to purchase a second property.

The city has decided to allow residence permit holders who have lived in the city for at least three years to buy a second home, according to a source at the city’s housing regulator.

It previously limited the second home option to locals, or those born in the city or who worked for an extended period of time and were officially recognised as locals, without specifying guidelines for non locals.
But today it seems the authorities have either denied or backed away from this policy. This is quite telling, as it may indicate the central government's concern about a renewal of the property bubble. With signs of property markets heating up again, the policy my now be shifting away from easing existing curbs on home purchases. Liquidity remains high, while investment opportunities outside of the property markets are quite limited, particularly given current inflation levels. Many who "missed the bottom" in 2008 are now looking to buy in fear of missing the "bottom" again. Even the Beijing market is picking up.
China Daily: According to industry watchers, the property market has been warming up. Property sales in Beijing and Shanghai, for instance, both rebounded last week. In Beijing, 2,186 new and second-hand apartments were sold last week, up 30.2 percent week-on-week, according to the municipal government.

Monday, February 27, 2012

Oil denominated in EU currencies is at record highs; demand destruction likely

Here is why crude oil prices, even without further appreciation, may create demand destruction in the EU. Denominated in EU currencies such as the euro or even more so in sterling, Brent crude is now at record highs.

Brent crude in GBP, EUR, and USD (Bloomberg)

The EU oil consumption has been tightly linked to the region's GDP growth. The combination of these record energy prices for the EU (given weak currencies) with the Eurozone's credit crunch will significantly reduce EU's demand for crude in 2012. That's why Iran's stance to stop selling oil to certain EU nations should have zero impact.

The chart below shows just how much EU's demand for oil could potentially drop, given Capital Economics' forecast for the GDP declines. Geopolitical risks aside, this certainly does not provide support for an extended rally in crude prices going forward.

Source: Capital Economics

More signs of Draghi's "stabilization"

Here is another sign of Draghi's "stabilization". The survey of euro area banks shows material tightening conditions in the banking system (as expected). And this is inclusive of Germany, one nation in the Eurozone that is not experiencing a credit contraction. That means the periphery is in deep trouble.

Net % of banks expecting to tighten loan criteria (source: Capital Economics)

Draghi was able to keep the Eurozone's financial system from the precipice, and he deserves full credit for that. But to claim that he sees signs of stabilization in the Eurozone economy in the face of this data will only serve to undermine the central bank's credibility.

Sunday, February 26, 2012

You may want to hold off on buying that Italian villa

The Italian central bank conducts a periodic survey of real-estate agents in Italy to assess the state of the property markets. They recently completed this survey, with 1,522 real-estate agents participating across the country. The results aren't great - the Italian real estate market has taken a sharp turn the worse.
Italian Housing Market Survey: The percentage of agents reporting a fall in housing prices during the fourth quarter rose to 66.5 per cent, compared with 51.2 per cent for the third quarter. Once again, extremely few respondents (under 1 per cent) reported a rise in prices. There was accordingly a further worsening in the negative balance between “up” and “down” answers, from 50.3 to 65.9 percentage points. The deterioration was sharpest in the South.
The results for the short-term (current quarter) outlook for prices in their regions are also showing a substantial deterioration.
The balance between “favourable” and “unfavourable” assessments of the short-term outlook for the local market worsened sharply to a negative gap of 45.7 percentage points, from 22.3 points in the previous survey.
Source: Banca D'Italia 

The credit contraction is beginning to take its toll on the Italian economy, with property market deterioration as one of the early signs of this recession. So if you've been looking to buy that Italian villa at bargain prices, it may be prudent to give it a year or two before jumping into this market.

The Fed stands to make good money on AIG assets, assuming the assets (Maiden Lane II & III) can be sold

The Fed stands to make good money if it could liquidate its holdings of the AIG rescue facilities. The table below shows what the Fed needs to get back in order to break even ("Current Senior Loan Balance") and "fair value" of assets supporting it. After the loan gets repaid, the Fed and AIG split the proceeds on the collateral sales, with the Fed keeping lion's share of the proceeds as profit.

Maiden Lane I and II ($mm, source: NY Fed)

But there is one little problem. Liquidation of these assets is challenging, to put it mildly. The Fed has been focused on Maiden Lane II, which is easier to sell. The assets are mostly subprime and Alt-A mortgages, with a bit of option ARM sprinkled in.

Maiden Lane II ($bn, Source: NY Fed)

These assets are ugly, but even this wonderful stuff could be sold if the price is right - mostly because these pools of loans can be analyzed. The Fed started selling early last year, but these sales were visibly pressuring the ABS/RMBS markets. As the ABX (CDS on senior tranche of asset backed securities index) price chart shows, ABS assets were declining in price in the first half of 2011. The Fed decided to stop in June after the sales impact spilled over into other credit markets such as HY corporate credit.

ABX (synthetic ABS) senior tranche price (Bloomberg)

Since then the Fed tried utilizing a form of Dutch Auction by inviting only the dealers who knew how to place this paper without disturbing the market (via large global client networks). In spite of the criticism for keeping the process limited to the biggest dealers, the process seemed to have been successful so far.
Bloomberg: The New York Fed was criticized for damaging credit markets with the regular sales, and halted them in June after disposing of about $10 billion in face value of the assets. It resumed the sales on Jan. 19, when it unloaded about $7 billion of assets in one block to Credit Suisse, after receiving an unsolicited bid for the securities from Goldman Sachs. Only Barclays and Bank of America were invited to also participate in that auction. Goldman Sachs won the auction for $6.2 billion of bonds this week after Credit Suisse placed an unsolicited bid for the assets. Barclays, Morgan Stanley (MS) and RBS Securities Inc. were also included in that sale. Barclays presented the second- highest offer in both auctions this year, according to a person familiar with the process.
Maiden Lane II balances have come down sharply as the result of these sales. (Note that under the new Volcker Rule, these sales could not be accomplished.)

Fed's assets of AIG rescue facilities (Source: The Fed)

Yet Maiden Lane (ML) III balances continue to remain high, and based on the valuation (table above), that's where the real "juice" is. The coverage ratio (ratio of assets to loan amount) is over 180%.

Coverage ratio for Maiden Lane III (Source: NY Fed)

So why not focus on selling these assets first? The answer has to do with the types of assets held in ML III  - the asset mix is just slightly different from ML II. As a bit of background, ML-III assets were acquired by the Fed via the settlement of AIG's CDS it has written. Unfortunately unlike the Treasury's settlement in the cases of GM and particularly Chrysler, where debt holders took a huge haircut, this earlier settlement was a bit more generous. With some negotiation the Fed could have acquired these at a discount and would have an opportunity to make even more later. The assets on which the CDS was written were tranches (mostly "senior") of CDOs and they now sit on Fed's balance sheet.

Maiden Lane III ($bn, Source: NY Fed)

Subprime and Alt-A mortgages have been a problem in ML-II, but at least investors understand them and at the right price these assets can be placed. That's why ML-II is nearly unwound. But when it comes to the CDO tranches of ML-III, it's a whole other story. There is little appetite for structured credit these days among institutional investors. Therefore even dealers with the best client networks will have a tough time absorbing this paper. Indeed the Fed could make good money on this, but it may take years and strong credit markets to unwind this portfolio at a profit (particularly at current marks). However the Fed better move fast because under the Volcker Rule, the dealers can no longer hold this much inventory (unless they get a special exception), and these sales will stop altogether.

German people zero in on TARGET2 imbalances; may derail ESM increases

Let's for a moment continue with the topic of Google Search trends. One trend in particular indicates that the German people are becoming increasingly aware of and likely concerned with TARGET2 imbalances. The chart below shows a spike in global searches for the word "TARGET2". The bulk of those searches are coming from Germany, particularly from Hesse (likely dominated by searches out of Frankfurt).

Google search relative statistics for "TARGET2" 

The debate on the issue has sharpened as the public is becoming inpatient with the demands (at least from the German perspective) the currency union is placing on them. As one German newspaper points out, it is rare that an abstract ECB payment mechanism has attracted so much attention.
Frankfurter Allgemeine: Selten hat ein abstrakter Notenbankmechanismus in Deutschland so viel Aufmerksamkeit erregt wie die Target2-Salden des Eurosystems. Insbesondere Ifo-Präsident Hans-Werner Sinn schlägt Alarm. Ulrich Bindseil von der EZB widerspricht ihm fundamental.
The unease of the German people, many of whom perceive TARGET2 as a "backdoor" bailout, may end up derailing the Eurozone's ability to scale ESM to the desired levels.
MSN: Germany, however, has taken a tough public line on limiting public funds used for bailouts. A government official close to Chancellor Angela Merkel insisted on Sunday that there is already enough money pledged for the euro-zone's rescue fund, known as the European Stability Mechanism. Berlin has said it sees no need to combine the ESM with a temporary fund, the European Financial Stability Fund. "The German government's position is unchanged: we see no need to increase the upper limit of the ESM," said the official in Berlin.

Google search indicates a shift in public sentiment on sources of risk

It is remarkable just how quickly public sentiment can turn, particularly in the US. These shifts in focus often drive financial markets, with sources of fear changing rapidly. As discussed before, the Google search statistics are an excellent way to track this inflection in sentiment. The chart below shows Google News searches for the words "Greece" and "gas prices" in the US. The public and to a large extent the markets have dismissed the Greece related risks, focusing instead on Iran, oil, and gasoline prices. These results are corroborated by this informal survey. Oil and gasoline prices have risen not only due to the Iran situation, but also due to expectations of increased demand driven by a perception of stabilization in the Eurozone (which may not be warranted at this stage).

Relative search frequency on Google News for the words "Greece" and "gas prices" in the US

Risks in the Eurozone continue to persist, with Greece not yet a done deal. The Germans are so fed up with the situation, there is a possibility of a political backlash. Never underestimate the Eurozone leadership's ability to bring risk back to the table.
Reuters: Germany appears to be playing for time. It faces a critical vote on Monday to win support in the German parliament for Greece's second rescue package. Many Bundestag members are skeptical that Greece can meet tough fiscal conditions required to bring its public debt down to 120 percent of GDP by 2020.

Similar votes are scheduled in the Netherlands and Finland next week. Germany also wants to see whether enough investors sign up for Greece's debt swap, which Athens wants to complete by March 12, a euro zone official said.

"Most euro zone countries are ready to move now, but I am afraid that Germany will need more time to agree to the increase, mainly to be able to better manage the Bundestag," one euro zone official said.
The less the public and the markets are focused on these Eurozone issues (not fully pricing in the risks), the more risky the situation becomes. As the perception of risk shifts away from the Eurozone (as the chart above shows), the potential for a surprise increases. Financial markets do not respond well to negative surprises.

Saturday, February 25, 2012

LTRO programs' impact on sovereign bond purchases by banks (past and present)

In the past years the LTRO programs by the ECB (in addition to little or no capital requirements) resulted in banks purchasing substantial amounts of sovereign debt (see chart). All this LTRO liquidity encouraged certain Eurozone nations to take advantage of low rates driven by demand for sovereign paper from banks. In some cases the artificially low rates allowed these nations to borrow irresponsibly (sounds familiar?)

The Eurozone leadership and the ECB have been trying to restart debt purchases by banks to keep the financing flowing. So far the 3-year LTRO facility seemed to have only a limited effect on sovereign bond purchases by EU banks, though it may have helped stem the accelerating bond sales. It remains to be seen how much impact LTRO-II (the second 3-year facility from the ECB) will have on bond purchases in the next couple of months.

Source: Credit Suisse

Update: See this post for a superb chronology (and background) of the LTRO program.

Is the Fed informally targeting mortgage rates?

Guest post by TheDealer

There is no direct evidence for this, but folks on trading floors are saying the Fed may be trying to smack down 30-year fixed mortgage rate. The average rate is still near historical lows.

30 year fixed mortgage rate (source:

But it seems every time the rate pops up from the lows, a series of Operation Twist trades takes place.  Here is what happened to the treasury curve Friday - some visible flattening action.

Friday's change in treasury yields by maturity

Call me crazy but I don't think this is a coincidence.

Friday, February 24, 2012

Greek CDS settlement auction is ‘lifeguards swim only’

The probability of the Greek CDS credit event (trigger) is now quite high. Once the ISDA committee makes their determination (and with CAC, they have to call it an event), the CDS settlement begins. Modern CDS are cash settled rather than via "physical". In the past the protection buyer often delivered the defaulted bond (usually could be any eligible pari passu bond from that name) in return for par payment from the protection seller. These days the settlement is done via auction of the defaulted bonds that is used to determine the bond "recovery value". That means if you hold a Greek bond and also hold protection you may still have some basis risk.

If your bond is worth say €30 and you also hold the CDS, you would expect the total value of the position to be around par. Suppose you want to hold on to your bonds (post-PSI) instead of delivering them into the auction. If the auction ends up with a recovery value of €32, the CDS will only pay you €68 (instead of 70), and now you end up with €98 instead of par. There is some basis risk between where your bond is marked and where the CDS recovery is established. That's why in preparation for the auction, some investors are using "recovery locks" - swaps that pay the difference between the expected and and the actual recovery levels once the auction is completed.

IFR has a great write-up on the topic:
Recovery locks only tend to trade in the run-up to a CDS auction. Some traders prefer to use these instruments to cover their residual risk in order to avoid volatility in the CDS market going into an auction. Five-year CDS on Greece has also pushed out over the last week by four points to 72 upfront to take into account the higher than expected haircut in the so-called private sector involvement programme that sees investors agreeing to swap existing bonds for new paper.
As discussed earlier, the markets are already pricing in the CDS trigger.
IFR: William Porter, head of credit strategy at Credit Suisse, said the market was already showing general signs of winding down. “The market is liquidating even now at the margin – the open interest is going down, and CDS is priced to an immediate event. You’re effectively conducting the early stages of the auction now,” he said.
Here is the expected timeline for the settlement. The bonds used in the auction to determine recovery will likely be the new, "post-PSI" Greek bonds.
IFR: ...the debt swap will take place on March 12, at which point the CACs will be exercised writing down bonds to 46.5% of face value, and CDS will be triggered. Domestic law bonds should therefore be exchanged for “new” Greek paper before a CDS auction is held, which have traditionally taken at least a week to organise following a credit event decision by the DC [ISDA committee]. As a result, these new bonds should be deliverable into the auction.
This settlement pertains to the Greek law bonds, while there is still uncertainty around €18.5bn of the UK law ("international") bonds. Other uncertainties remain as well, mostly associated with the actual process, given this unusual CDS settlement (vs. say corporate CDS whose settlement is commonplace.) By the time we get to Portugal or Ireland, everyone will be an expert.
IFR: “These auctions are not ‘adults swim only’, they’re ‘lifeguards swim only’ – the market is still learning as we go along. I think the Greek auction will be orderly, but the chance that something really strange might happen can never be entirely ruled out,” Porter said.

First signs of US "austerity"?

Here are the charts for the US private and public employment. Is the US headed for austerity (the way the Eurozone periphery is) and doing it under the current administration? This should get some people really excited...

Source: ISI Group

Source: ISI Group

The euro recoupling with "risk assets" again

The euro is once again trading with "risk assets". The chart below compares EUR-USD with the CRB Commodity Index. During the Eurozone-related periods of stress, the euro decoupled from commodities to the down-side (red arrows), but returned back to track the commodity index. Since the beginning of this year, the two have been moving in tandem again.

UER-USD vs. the CRB Commodity Index (Bloomberg)

It is still unclear just how much the impending Eurozone recession will impact global growth. As the focus shifts from the Eurozone toward those global risks (that will impact commodity prices), the euro will trade as just another "risk asset". For now.

Those believing the Fed is on hold for the next 3 years will be in for a rude awakening

Misconceptions still persist that the Fed is on hold with respect to rates until at least late 2014.
WSJ (Feb 16th): ... They said after their last meeting in January they expect to keep rates at "exceptionally" low levels until late 2014.
The markets would disagree. The Fed Funds futures have the first rate hike (25bp) centered around August of next year and the second hike (to 50bp) on July of 2014.

Fed Funds Futures (implied rate) expected rate hike dates

The market has completely reversed the Fed's announcement on January 25th. In fact the expectations for the first hike are now even earlier than they were before the Fed's statement.

Fed Funds Futures  (implied rate) expectations of rate hike shifted to an earlier date than was priced in before the Fed's announcement

The market is fully ignoring the FOMC's prolonged zero rate forecast. If Bernanke tried to lower short-term rate expectations by the announcement, he failed miserably (though it's possible that was not his intent), as the rate expectations are now even higher than prior to the announcement. Why is the market pricing in higher short-term rates (an early rate hike)? The answer has to do with relatively strong economic data coming out of the US and rising commodity prices. All of this is driving up inflation expectations. The chart below shows TIPS implied 2-year forward inflation expectation now comfortably above 2%, the Fed's inflation target.

TIPS implied 2-year forward (breakeven) inflation expectation

The market is prepared for the first rate hike in about 16 months, possibly sooner. Those who are becoming complacent believing the Fed is on hold for the next 3 years will be in for a rude awakening.

Thursday, February 23, 2012

Portugal missing a quarter of their funding needs from the official debt/GDP ratio

Portugal’s general government debt is now at 107.2% of the GDP. According to BNP Paribas, this figure does not include half of the State-owned enterprise (SOE) debt. They estimate that some EUR 15bn is missing. Not a big number from the perspective of the US, but for Portugal it's a chunk of change. In fact it's a quarter of the nation's funding needs for the next three years.

SOE debt included and not included in the Debt/GDP calculation (source: BNP Paribas)

The question is what will happen when they do include the SOE debt and/or Portugal's GDP tanks more than estimated (a fairly likely scenario). It is important to remember that Portugal will need to come to the markets in 2013. With an increased debt/GDP ratio, the private markets may be completely closed to Portugal and the nation will likely need to extend its current EU/IMF loan (which is now some 20% of total government debt).
BNP Paribas Research: And as the funding needs of the SOEs are set to amount to EUR 15bn over the next three years, at least some of this will have to be taken into account in calculating any extended financing programme. The total market funding needs of the Portuguese government to 2015 are around EUR 45bn as things stand. If the financing needs of the out-of-calculation SOEs are taken into account, this could rise to more than EUR 60bn.

Why CLO managers continue to struggle

By all accounts the CLO business should be going well. Some $3.3 billion of new CLO deals have been done this year already as compared to $4.4 billion for the whole of Q4 of 2011. Seems like a significant amount but this volume is actually quite light relative to historical levels (see chart).

In fact CLO managers are finding it tough to do business these days. Here are some reasons why they continue to struggle:

1. In order to execute a CLO deal, a manager needs to have a portfolio of loans ready to go. Most stock traders would say, so what, just buy it in the market. But corporate loan liquidity is quite poor, and to accumulate (“ramp”) say $200mm of loans in order to launch a new deal could take months (weeks if you are lucky). This process is made particularly difficult because loan “issuance” (origination of new corporate loans by banks) has been rather slow (see chart). There is practically no LBO activity and the merger activity has slowed down. These are the typical transactions that require corporate loans - the rest is mostly refinancing of existing debt. There simply isn’t enough of new supply hitting the market, making it tough for CLO managers to build portfolios.

New syndicated corporate loan volume  (source: LCD)

2. Prior to the issuance of the CLO tranches, managers need banks to provide a “warehouse” – a facility to finance the “seed” portfolio. The problem is that such facilities these days require 10-15% first loss commitment from the manager. Smaller managers may be required to post that amount as cash in order to obtain the warehouse facility. And that commitment is nearly impossible for some managers. That’s why most CLO issuers in recent years have been the bigger firms (such as private equity).

3. The “equity” tranche for new CLOs has prospective returns of 10-14%. This is due to the fact that senior tranches now require significant subordination by the rating agencies – who are being overly conservative to compensate for their "sins" of the past. Higher subordination makes the equity tranche larger and the returns lower. At these modest returns and given the negative connotation associated with any structured credit, equity tranches are hard to place (particularly with pensions and other institutional investors).

4. It may also become difficult to place the AAA tranches soon. The buyers of these tranches tend to be banks and the new regulations may make holding this paper uneconomical.

Because of these uncertainties, analysts are divided as to the expected size of total CLO issuance this year. Forecasts range from $12 to $25bn for the whole year. Back in 2007 that would have been a bad quarter.

A three year old chicken McNugget for only $200

Alright, in a market economy like the US there should be a market for absolutely everything of "value". And some items bought and sold will be stranger than others. Once in a while the item will be really strange - like this one. It's a three year old chicken McNugget with the likeness of President George Washington.

Source: Ebay
Ebay: Approximately 3 years ago, I treated my children to “99 cent McNugget Tuesday” and play time at our local McDonald’s. As I was cleaning up, I noticed one particular nugget and began to laugh. I picked it up for a closer look, and sure enough it was in the likeness of President George Washington. I decided to take it home and show my husband this hysterical find.

And it could be all yours for over $200 - but the price is still rising.

Certain European banks playing dangerous games with accounting rules

European banks are announcing new losses associated with the Greek bonds writedowns.
Bloomberg: RBS, Britain’s biggest government-owned lender, posted a wider-than-expected full-year loss after taking a sovereign-debt impairment of 1.1 billion pounds ($1.7 billion). Commerzbank, Germany’s second-biggest lender, booked a 700 million-euro ($1.1 billion) writedown on Greek debt in the fourth quarter. Credit Agricole, France’s third-largest bank, reported a quarterly loss after 220 million euros in impairments on Greek debt.
Dexia and the insurance firm Allianz also took losses. Greek bonds have been trading at some 25-30 cents on the euro for some time, so why are these banks taking losses now? It has to do with the wonderful international rules of “held to maturity” (HTM) accounting. Note that in spite of all the myths out there, this rule can be applied to bonds but not derivatives such as CDS. HTM bonds accrue interest (using what’s called Effective Interest Method) and are not marked to market. Impairment is supposed to take place when the value of the investment is deemed by the holder to be more than just temporary. That is if a bank believes it won’t be able to collect 100% of what is due to them under the contractual obligations, it should take a writedown on the bond. But some of these banks will now claim they didn't believe the impairment in Greek bonds is permanent, and that's why they didn't take the writedowns until the details of the Greek PSI have been announced.

Greek 5.2-7/34 government bond prices (Bloomberg)

Yes, this strange accounting rule gives European banks and other financial institutions a great deal of leeway. But for these banks to claim that Greek bonds were not impaired until the PSI deal was announced borders on accounting fraud. These writedows should have taken place months ago. What’s even more absurd is that Steven Hester who runs RBS (the UK “government agency”) is a former CFO of Credit Suisse First Boston (CSFB). He was in charge of, among other departments, product control and financial control, the groups responsible for portfolio valuation and accounting at CSFB. Having been a CFO through the Russian default crisis at CSFB should have made anyone an expert in bond "permanent impairment". Apparently Hester didn't learn his lessons. RBS must be as good with their accounting practices as they were with their risk management.

Fidelity Money Market Fund is yielding 1 basis point (yes, per year)

US money market funds continue to increase their use of secured lending for investments in Europe. The amount of repo lending in their portfolios has been growing.

Source: Fitch

This is good news from the perspective of the safety of US money funds, but if you need some place to park your cash (that is outside a bank), be prepared to get close to zero return. Between the the near-zero rates on repo and zero rates on treasury bills, there isn't much left after fees. As an example the Fidelity Money Market Fund (ticker: SPRXX) has made less than 1 basis point for the whole year. That's right, if you deposited $100,000 with SPRXX on 2/22/11 and took it out on 2/22/12, you would have made ten dollars ($9.50 to be exact).

SPRXX total return (Bloomberg)

Wednesday, February 22, 2012

Is bad timing the reason for hedge funds' underperformance?

The universe of hedge funds tracked by the Dow Jones/CS Hedge Fund Index has underperformed the SP500 by some 15% since the start of 2011. On a risk-adjusted basis the underperformance isn't as bad when one considers that a diversified pool of hedge funds is much less volatile than the equity index (as evidenced from the chart below). Nevertheless, this is a black eye for the hedge fund industry.

Is there a simple explanation for such a terrible performance relative to the overall markets? The folks at JPMorgan argue that it has to do with markets' correlations. Most hedge fund type strategies (macro excluded) according to them underperform during periods of high correlation.

Source: JPMorgan

This is not a very satisfying explanation because the underperformance continued even after correlations across and within asset classes came down this year. A more likely explanation is that hedge funds became extremely defensive, particularly in the late fall of last year. Many hedged their portfolios, increased cash positions (reduced balance sheet), or put on large short positions. They ended up participating in the market correction from late summer, possibly through October. But because they re-positioned their portfolios to be much more defensive (potentially at the worst time), they did not fully participate in the market rally that followed. This lag to the upside is quite visible in the first chart (above). Much of hedge funds' underperformance may therefore be simply a case of really bad timing.

Greek PSI outcomes tree: credit event probability at 93%

The CAC legislation has been put before the Greek Parliament.
Reuters: Greece said on Tuesday it would pass legislation that would allow it to enforce losses on bondholders who will not take part in a voluntary bond swap plan, also known as PSI, that forms part of its bailout plan.
The vote is set for tomorrow and is expected to pass. It will retroactively change the existing Greek bonds (only those under the Greek law, since a portion is under the UK law) and require two-thirds majority of the outstanding bonds to force the holdouts into taking a haircut (exchange for new bonds.) The ECB/NCBs will be excluded. Given this is an aggregate CAC (not issue by issue), the Greek banks and other "friends of Greece" holders should be able to form a two-thirds quorum (building a "blocking position" will be nearly impossible).

The BNP Paribas diagram below shows possible outcomes with the highlighted boxes representing the most likely scenario. This supports the view that the most likely outcome (as well as two others) will result in a CDS credit event (trigger) - as discussed earlier. Each final outcome on the tree has a precedent: Uruguay, Anglo Irish (bank), Northern Rock (UK lender), and finally Argentina. Only the "Uruguay scenario" does not end up triggering CDS.

Greek debt (PSI) event tree (source: BNP Paribas)

The Eurozone as a giant CDO

Here is an interesting way to think about the Eurozone credit risk. Credit Suisse views it as a giant CDO with the National Central Banks representing the tranches.

Source: Credit Suisse
For those who've seen a few CDO term sheets in their time, this sure looks real.

Healthcare expenses will overwhelm the US federal budget

If one had to point to a single factor that will end up being the most devastating to the US budget deficit, it would be the cost of healthcare in the US. The private cost of US healthcare is staggering, far exceeding anything seen elsewhere in the developed world.

Cost of healthcare as % of the GDP (source: Capital Economics)

But  if it's private, how would it impact the federal budget? The answer has to do with the aging US population as more baby boomers will be retiring over the next couple of decades:

US age demographics (Source: Credit Suisse)

With more retirees, that private healthcare spending in the first chart will be flowing into the public bucket,

as Medicaid and Medicare (including Affordable Care Act or whatever other forms that the US healthcare entitlements take) will be replacing private insurance for the aging population. That is why the CBO is forecasting the healthcare related expenditures ultimately dominating and overwhelming the US federal budget.

US federal spending as % of GDP (source: Capital Economics)
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