Thursday, May 31, 2012

Is Canada facing a housing bubble?

As discussed before, risk management, whether in banking or among regulators and consumers tends to "fight the last war". The "riskiest" asset class in people's minds is generally the one that got the most attention in the previous down cycle.

In the 2007 recession, the US residential property market was the hardest hit among the various asset classes. As a reaction to that event, lenders in the US are being fairly conservative in providing residential mortgages. Home buyers on the other hand are in no rush to buy properties. The risks associated with real estate markets are still on everyone's mind and will probably be for some time. That type of risk aversion keeps asset bubbles from forming.

Canada on the other hand did not experience the same level of housing bubble nor the correction that followed as did  the US (see chart below). Therefore housing in Canada does not tend to conjure up the same connotation of risk as it does in the US. At least not yet.

Canadian home prices have been growing quite rapidly, particularly as compared to the US. Some may argue that this is justified because Canada's unemployment rate is lower. 8.1% in the US vs. 7.4% in Canada. Is that enough to justify such a divergence in housing prices, particularly when the GDP growth rates in the two countries is fairly similar?

In addition, construction in Canada is booming. The chart below compares construction jobs as a percentage of total jobs for the US and for Canada. The divergence is quite striking.

Source: Bloomberg

Canadians have also been growing household debt levels. The chart below, though a bit dated, includes mortgage debt (total debt as percentage of net worth).

Canadian consumer credit plus mortgage debt as % of household net worth

Economists are becoming concerned.
Edmonton Journal: -  ...OECD economist Peter Jarrett ... described the housing market as the “biggest story in Canada.” Home prices, which corrected about 10% during the recession, have surged again, “making household balance sheets look increasingly fragile, he said.
Given the global economic backdrop, and in particular the sharp correction in energy prices to which Canada is highly exposed, the risks of a Canadian housing correction are rising. Watch the BBC video below to get a feel for the situation on the ground.

India's GDP growth hits a wall

Concerns about India's growth that were reflected in the sharp decline of the rupee (see this post) turned out to be quite justified. India's GDP is in free-fall - with growth well below the levels of 2008-09 global recession. One could argue that 5% is still respectable when it comes to GDP growth. Not for India.

India's GDP growth
Reuters: - India's economic growth slumped to its lowest level in nine years in the first three months of 2012, marking a dramatic slide in the fortunes of a country whose economy was boasting nearly double-digit growth before the global recession.

"Urgent and bold steps are immediately needed to prevent the economy from descending into a full blown crisis. This must be averted at all costs," said Rajiv Kumar, secretary-general of the Federation of Indian Chambers of Commerce and Industry.

The economy grew 5.3 percent in the last quarter from a year earlier, a sharp slowdown from 9.2 percent growth in the last quarter of the previous year, government data showed. Finance Minister Pranab Mukherjee blamed the poor performance of the manufacturing sector, which shrank 0.3 percent from a year earlier, for the slowdown.

More China stimulus coming

The ISI Group believes that more China stimulus is on the way, as the nation is facing a real slowdown. The measures taken so far have been relatively insignificant, particularly as a percentage of total GDP (chart below). The difference this time vs. 2009-10 is that the central government wants to control the stimulus process as opposed to allowing regional governments to run with it. And the central government’s approach has been far more measured.

Another reason further stimulus may be on the way is simply because the bank reserve ratio requirement (RRR) cuts – the most visible monetary action this year - have been ineffective due to low demand for loans.

Source: ISI Group

US equities holding up well

US equities have been quite resilient in the face of this global retrenchment. Here are two comparisons that indicate that while the US market is not isolated from the global turmoil, it is certainly less vulnerable.

1. The S&P500 vs. the MSCI World index (US vs. global equities).

2. The S&P500 vs. the CRB Commodities Index. Commodities tend to reflect demand driven by global economic growth (recently dominated by emerging markets).

It remains to be seen whether this outperformance persists going forward. But for now large cap US stocks have been a de facto "safe-haven" in the global markets.

Wednesday, May 30, 2012

Italy's recession is becoming severe

There is basically no good economic news coming out of Europe these days. And the news out of Italy has been particularly sad. A couple of nasty earthquakes that recently hit Italy have killed a number of people and damaged factories, adding to an already bleak economic picture. On top of that the government had to increase gasoline taxes to pay for the reconstruction.
FT: - Italy has started counting the cost of two devastating earthquakes in the northern industrial region of Emilia-Romagna.

The government has come under attack for responding by levying a tax of two euro cents on a litre of fuel to help finance reconstruction.
This latest blow to Italy’s economy in the midst of a double-dip recession follows estimates by Confindustria that industrial output in May has fallen by 0.6 per cent over April and is now 22.1 per cent down on the peak reached in early 2008.

The government’s decision to raise tariffs on petrol and diesel – already among the most expensive in Europe – was widely condemned by consumer associations and politicians on both left and right. They said the extra costs would hit spending and drive the economy deeper into recession.
Italy's double-dip recession is indeed becoming severe - even before the impact of these devastating events and the hike in gasoline taxes. Here are some of the latest economic trends.

1. Industrial orders have hit a wall as corporations cut back. Ultimately that is hurting jobs.

Italy's industrial orders YoY

2. Consumer confidence is now below the levels of 2008/2009 recession.

Italy consumer confidence

3. That is translating into a severe decline in retail sales (record year over year drop).

Italy Retail PMI(source: Markit Partners)
Markit: - The Italian retail sector remained in contraction during May, with sales again falling sharply in spite of widespread discounting. Cost pressures meanwhile grew from April’s recent low on the back of rising transport costs [remember this is before the gasoline tax hike], thereby adding more pressure to margins. Consequently, firms shed staff at a marked and accelerated rate that was the steepest since data were first compiled in January 2004.
And now the European Commission is telling Italy to "remedy" its weak growth (which is now more of a rapid contraction).
Europolitics: - Italy has been warned by the European Commission to remedy persistently low growth and address its high public debt in its upcoming budgets. In a 30 May report that forms part of the EU’s stepped-up screening system for national budgets, the Commission has urged Rome to crack down on tax evasion and free up the jobs market for younger people and women. “Italy is faced with the twin challenges of a very high public debt and persistently low growth,” the Commission’s report says. “These challenges long pre-date the global financial crisis and largely explain investors’ mounting concerns with the sustainability of Italy’s public debt in an environment characterised by high risk aversion.” Italy’s public debt of 120% of GDP is the second highest in the EU after Greece.
No matter how many reports the EC writes, there is nothing that can pull Italy out of this recession in the near term. The situation will get a great deal worse before it gets better. And the EU needs to come to terms with it sooner rather than later.

Let's thank our friends in Spain for making this summer driving season cheaper

Spain's spreads once again hit new records today (10yr spread to Germany is now 5.37% - as the countdown continues). But the one positive outcome of the Eurozone crisis is a sharp decline in US gasoline prices. In fact the spike that started at the beginning of this year has pretty much been reversed.

NYMEX gasoline futures
So for those of us who have to do some serious driving this summer, let's not forget to thank our Spanish friends for making it that much cheaper.

Gold is just another commodity, until it's not

Gold has been selling off recently with copper and other commodities on the back of the rapidly strengthening US dollar and demand uncertainties (particularly from emerging markets).

US dollar against currency basket (DXY)

But the tricky thing about gold is that it's just another commodity until it's not... We saw an example of that this morning as things started looking scary across financial markets.  The 2-year German bond traded at negative yield for the first time as flight of capital accelerated (someone was willing to pay the German government to hold on to their euros for 2 years!).

Current 2-year bund yield (3 days, intraday)

And as one would expect in such an environment, gold suddenly decoupled from copper. The sentiment quickly shifted from global demand uncertainty for commodities to urgent flight to safety. And gold became the beneficiary of this sentiment shift.

Gold futures vs. copper futures (3 days, intraday)

Eurozone contagion spreads to emerging markets

Emerging markets currencies are under pressure again. In particular the rupee is getting slammed - now above R56 per $1. The Eurozone-based risk aversion as well as India's economic uncertainties are driving investors into dollars.
The Economic Times: - The rupee fell for a second successive session on Wednesday to near a record low, as oil importers ramped up demand for the greenback ahead of the end of the month, while global risk assets were hit by worries about Spain.

Though global cues are providing the trigger, traders said the rupee was also being weighed down by deep concerns about India's fiscal and economic challenges, and doubts about slowing policy reforms.
INR per $1
Other Asian currencies have taken a beating as well.
Bloomberg/BW: - All of the 10 most-traded currencies in Asia excluding the yen are headed for monthly declines as exchange data show international investors pulled $7.7 billion from South Korean, Taiwanese and Indonesian stocks during the period.
Even China is allowing the renminbi to weaken in order to support its exporters. This is a reversal of the long-standing appreciation policy, and should get some US politicians riled up.

CNY (renminbi) per $1
The Russian ruble and the Mexican peso are also weakening as oil prices decline sharply (both nations are big oil producers). BRL remains relatively stable (near recent lows) on the back of Brazilian government's recent intervention. It is unclear what if anything other governments will choose to do about their weakening currencies.

This depreciation in emerging markets currencies shows that the Eurozone contagion is spreading globally as risk aversion grips global investors.

China may be looking to immigration to ease labor shortages

Global demographic projections show divergence in labor force growth among world's major economies. We know that Japan's labor force is on a steady decline. The US labor force is expected to increase at a fairly constant pace, supporting a re-emerging manufacturing base.

China's labor force on the other hand has been rising until recently but has now peaked and is expected to decline going forward.

Source: DB; click to enlarge

The one-child policy has had a profound impact on China's demographics, resulting in a "top-heavy" population age structure (not as bad as Japan, but certainly visible). What's more, it caused a gender imbalance among the younger generations. Traditional families faced with one-child limitation, "chose" to have boys - something China is desperately trying to correct.

Source: DB; click to enlarge

Clearly this decline in labor force is inconsistent with the 7-8% GDP growth targeted by Beijing. This is particularly difficult given China's "labor-intensive" massive manufacturing base. To deal with this issue, China is looking for creative solutions. One of them is immigration - something that allowed the US for example to maintain growth for generations. And who is willing to come to China to work in a factory? The North Koreans of course. - China is issuing work visas for 20,000 North Koreans so they can work in three northeastern provinces of Jilin, Liaoning and Heilongjiang. The move comes amid a crackdown on illegal North Korean migrants who typically drift into menial jobs, but a diplomatic source in Seoul said the three Chinese provinces now decided to legally hire 20,000 North Koreans for jobs there in a bid to ease a labor shortage.
To achieve this targeted growth over time, immigration may become Beijing's core policy, opening its borders to North Korea as well as other impoverished nations. It may be the only way to plug the generational holes created by the one-child policy and ease the growing labor shortages.

Tuesday, May 29, 2012

Spain vs. Portugal - the countdown to zero

On April 1st, 2011, Portugal's 10-year spread to Germany went above 5% for the first time. Two weeks later Portugal formalized its request for assistance from the EU/IMF.

Yesterday, Spain's 10-year spread to Germany exceeded 5%.

The chart below compares Spain's and Portugal's 10-year spread, aligning the charts at the point when the spreads first crossed the 5% level. The x-axis is the number of days until Portugal's request for rescue funds, covering the full year prior to the event. If history is any indication - and these spread paths have been quite similar so far - there isn't much time left for Spain.

US pensions' equity holdings the highest among OECD nations

US pension funds are still heavily invested in equities - close to 50% of assets. In fact US pensions have the highest concentration of equities among all OECD nations.

Source: DB (click to enlarge)

This is somewhat troubling, particularly for defined benefits corporate pensions. That's because there are risks of a feedback loop. When equities decline, pension funds become underfunded, forcing some companies to inject cash into their pension accounts. And that in turn may add to the declines in equity prices.

But no worries. Corporations are shifting to defined contributions plans, letting their employees take this equity risk. And for the remaining defined benefits plans, the pension managers will use corporate bonds to discount pension liabilities - the wider the spread, the lower the "present value" of what they owe to future retirees.

Good luck with your retirement plans.

The spike in ratings downgrades is driven by banks

Fitch has been on a downgrade "war path" recently. The latest downgrade vs upgrade statistics are showing a "mini spike" in the number of downgrades. It's not nearly as bad as the 2008/2009 cycle, but is clearly visible. This spike is coming entirely from rating actions in the developed markets.

Drilling down further reveals what is actually driving the downgrades. The chart below compares the rating actions for industrials versus financials. Clearly Fitch has been aggressive in downgrading banks.

Source: Fitch; click to enlarge

The equity market seems to agree with this assessment. Financials have underperformed considerably over the past year (covering the period of these downgrades).

Financials (white) vs. the SP500 (green) performance over the past year

The other rating agencies have also been active in downgrading financials - particularly last year. At this rate it is only a matter of time before many banking institutions will lose their investment grade standing. It will be interesting to see how the high yield and the crossover markets handle this inflow of new names.

When it comes to credit, Greece is already out of the Eurozone

Following up on an earlier discussion that shows extraordinarily tight liquidity conditions in Greece, we are starting to see further evidence of "credit isolation".
Capital Economics: - Recently, the problem of tight credit conditions have been exacerbated by domestic and foreign firms becoming more unwilling to sell goods to Greek customers unless they are paid for up front. In other words, credit risk is stopping some transactions from taking place. What’s more, some foreign buyers of Greek goods and services are delaying payment, in case Greece exits and the size of their bill (in euro-terms) drops.
Greek refiners continue to purchase Iranian crude because Iran is the only nation willing to provide these firms credit to finance crude purchases until this oil is refined.

Such behavior is quite similar to the way suppliers and customers treat a company that is about to file. This is all at the time when Greek banks are unable to step in to deal with this isolation. New domestic lending has pretty much halted, as existing loans roll off.

Total loans outstanding to Greek citizens from Greek banks
(excluding loans to government, EUR millions, source: BoG)

That isolation is translating into collapse in growth. The latest Greek GDP forecast by Capital Economics is quite sobering.

Source: Capital Economics
Capital Economics: - ...we still think that, regardless of the election result, Greece will probably leave the euro-zone by the end of the year.

Monday, May 28, 2012

Global addiction to government stimulus

It is quite sad to see just how dependent the global economy and markets have become on government stimulus and bailouts. Here are just a couple of examples:

1. Asia's markets and commodities are up tonight (after a major and prolonged correction) on speculation of China's new stimulus:
Bloomberg: - Asia stocks reversed losses and oil gained on speculation China will take steps to boost growth in the world’s second-largest economy. The euro traded near a 22- month low as Europe’s banks seek more financial support.
“There are expectations China will introduce more stimulus to boost the economy and there’s optimism the economy will recover in the second half,” said Mao Sheng, an analyst for Huaxi Securities Co. in Chengdu. “External factors such as Europe woes are still dragging on the market.”
2. As discussed earlier today, Spanish banks are now fully expecting a bailout:
Bloomberg (this article is actually quite scary): - Spanish banks are masking their full exposure to soured property loans while they continue to prop up insolvent “zombie” developers, leading to credit-rating downgrades and plummeting share prices.

Spain is trying to clean up its banks, requiring lenders to set aside more for possible losses on loans deemed performing to developers like Metrovacesa SA, which hasn’t completed a project in more than a year and has none under way. While that represents about 30 billion euros ($38 billion) of increased provisions, it’s not enough because many of the loans said to be performing aren’t, said Mikel Echavarren, chairman of Irea, a Madrid-based finance company specializing in real estate.  ...  
[Bloomberg is now finally touching on Ireland-style bailout for Spain discussed here back in April]
Markets in the US are still hoping for QE3, even though such a program may no longer be effective and may even end up doing more harm than good. The Eurozone is praying that the ECB will do another round of 3-year LTRO so that banks can buy more of their nations' sovereign debt. And Japan is in a permanent state of QE.

Global markets are now so addicted to government stimulus, it is often difficult to imagine stability without it. The question now is what would it take to break this dependence and is it even possible.

The market to Spain: recapitalize the banks or face funding problems

Spain's banking system and regional debt problems are now becoming the key driver behind the risk aversion sweeping  the Eurozone. The German current 3-month bill yield is now firmly in the negative territory. People are paying the German government to hold on to their euros.

German current 3-month bill yield

Spanish authorities continue to deny there is a problem. It's all because of the euro...
Reuters: - Prime Minister Mariano Rajoy pinned the blame for the rising borrowing costs on concern about the future of the euro.
... while the denial of the inevitable continues.
He again ruled out seeking outside aid to revive a banking sector laid low by a property boom that has long since bust.
And now the nation's ability to meet its near-term funding requirements are being questioned.
Reuters: - Spain's trump card is that it has issued well over half the debt it needs to this year, in the first five months.

But that advantage is being eroded.

The government said last week its highly indebted regions faced 36 billion euros of debt refinancing bills this year, way above the previously stated 8 billion. Catalonia said it was running out of options and needed central government help.

A plan to recapitalize Bankia with Spanish government bonds, which the bank could then use as collateral to get cash from the ECB, could add to the government's refinancing problems.

Spain's Treasury insisted it would repay debt maturing without problems.

"We are in a very strong position (to meet debt maturing shortly)," said Ignacio Fernandez Palomero, deputy director of public debt at the Treasury, pointing to redemptions in July and October, when Spain has big amounts due.

Spain's central government and regions need to refinance 117.5 billion euros of debt by the end of the year, while funding a deficit worth 52 billion euros.
Not a problem...  Except the market doesn't buy it.

The euros going into German bills are coming out of Spain, as the country's 5- and 10-year spread to Germany as well as the 5-years CDS hit new records today.

Spain 10y spread to Germany

What's even more concerning is the change in the sovereign spread curve shape. The chart below shows Spanish bond spreads to German bonds by maturity - now and a month ago.

Spanish bond spread (to Germany) curve

The shorter tenors (3-5yr) have widened out more than the longer tenors as the spread curve becomes steeper in the short end and inverted in the longer end. The market is pricing in a higher probability of default closer in time - as usually happens with distressed names. A similar situation is developing in the CDS curve.

Spain CDS spread curve (green is now, yellow is 1m ago)

The 5-year CDS is now implying 44% probability of default in the next 5 years, assuming a 50 cent on the euro recovery (the probability drops for the same spread if the expected recovery is lower).

The market is now saying to Spain: recapitalize your banks or your funding situation becomes untenable.
"The events at Bankia will reinforce the view that the upcoming external review should identify a significant recapitalization need for the Spanish banking system," analysts at Nomura said in a note, putting a recapitalization of the whole sector at between 50 and 60 billion euros, with the main listed banks requiring an additional 16 billion euros.

Nomura said only BBVA, Santander and Sabadell would not need to strengthen their capital, while the government would need to clean up smaller lenders it has already propped up, such as Banco de Valencia, Novacaixagalicia and Catalunya Caixa.

"Given the current economic and political uncertainties facing the euro zone, this could see additional pressure on Spain to consider using external funds for the bank recapitalization," Nomura said.
Spanish bank bailout now seems inevitable..

Rate swaps have an embedded option to sue the bank

This happened in the US and is now happening globally. Municipalities, corporations, and even sovereign states who put on "hedges" against rising interest rates are suing banks because their hedges lost money. Let's see, you put on a position that will make money if rates rise, what do you think happens if rates fall?

10-year EUR swap rate
But that's OK because many organizations always have the option to sue the banks to recover these losses.
Bloomberg: - Unitech Ltd., an Indian property developer, accused Deutsche Bank AG of selling it an interest- rate swap that wasn’t suitable and wasn’t properly explained, according to a London lawsuit over a $150 million loan deal.
That's right, the hedge wasn't explained well. It's way too complicated. If interest rates rise, Unitech's property development funding costs go up and the swap makes them money to offset those incremental costs. If rates go down and funding costs decrease, the swap loses money and Unitech loses the savings from lower funding costs.

Or maybe they don't have to give up those savings after all - because they can just play dumb and default on the swap payments.
Unitech filed a counterclaim in May arguing Deutsche Bank was negligent to sell an unsuitable hedging agreement, and owed damages that canceled out its debt, according to court documents. Germany’s biggest bank had earlier sued Unitech saying a unit of the company owes $11 million under the swap contract and has missed payments.
Deutsche Bank “knew, or must have appreciated, that it was likely to make significant amounts of money” from the contract at Unitech’s expense, the Indian company said in its lawsuit. 
Of course Deutsche Bank knew that rates will go down. They always know which way rates are going.
Interest-rate swaps that turned out to be costly for customers and profitable for banks have led to hundreds of lawsuits and an investigation by the U.K. Financial Services Authority into how they were sold. Unitech’s suit is one of the largest to reach the U.K. courts. The issue has affected bank customers from British seaside cafes to municipal governments including Milan in Italy and Jefferson County, Alabama.
Banks make a spread on swaps they transact with clients. In general they offset the rate risk with futures, bonds, or swaps in the other direction (usually some combination of these). A typical swaps desk is indifferent to the detection of rates. That means if the client loses money, doesn't mean the bank makes that same amount of money, because the bank is rate neutral. Unless of course the client refuses to pay.

This option to sue really comes in handy. Here is some investment advice: if you have a stock portfolio, hedge it with some S&P500 futures. If these futures make you money when your portfolio tanks, you've limited your losses. But if the futures lose money when the portfolio rallies, just sue the Chicago Mercantile Exchange. Wait, that might be a bit tough to do. Instead of futures, just enter into an equity index swap with some bank, and then sue it in some "friendly" jurisdiction. Just claim it wasn't well explained to you.

These swap sales people at banks need to be re-educated. They should only offer cancellable swaps to most clients. Such swaps allow a client to cancel the transactions if rates go against them. Cancellable swaps are clearly more expensive than the "vanilla" type because of that embedded option to cancel. But since many organizations already have a free embedded option to sue, the cancellable product is the way to go (see quick overview below).

Cancellable swap

All the subscribers to the housing Armageddon theories, just look at the data - the US housing market is beginning to recover

The US housing's bubble and its spectacular end left a indelible mark on people's view of residential property markets. Sadly the idea of a "permanent" US housing market decline has been drummed into the heads of numerous, often well educated and otherwise open-minded people. Hoards of angry bloggers keep spewing the same line over and over again - housing prices will fall "forever" because of the shadow inventory, etc., etc. People, including many in academia, would deny a housing market improvement even if it stared them in the face. Positive housing news cause many to experience what psychologists call "cognitive dissonance", as they desperately attempt to rationalize away the data that doesn't conform to their views.

The housing market bottom has to come some time, and as predicted at the beginning of the year (which really angered some of the folks described above), 2012 seems to be that year. Nobody is talking about a recovery of prices to the bubble years or even a robust growth in housing. We all know the issues. But on average across the US, home price declines have stopped.

Multiple data points are now suggesting that is indeed the case. A sudden spike in the FHFA housing price index is one of those points. A 1.8% monthly increase in March is the largest monthly move in recent years.

FHFA housing price index MoM SA

Our friends at ISI Group are continuing to see more recent improvements in April and May in their house price survey. That is in spite of otherwise jittery economic conditions in the US and the mess in Europe. Of course year over year the index is still down - we are not expecting any miracles here. But on a month-over month basis, the trend is unmistakable. This and other housing indices will be up from current levels this time next year.
ISI Group: - House prices are continuing to improve in may. ISI's house price survey, which covers over 40 residential real estate agents around the country, continued to improve this week, suggesting existing house prices, which surged in April, improved further in May.

Source: ISI Group

There are other indicators pointing to improvements, such as the stabilization in lumber prices in spite of the recent sharp drop in commodity prices.

Perhaps the best data point would be to hear it from the people on the ground - the realtors. The National Association of Realtors maintains a tremendous database and has done a thorough job in monitoring the health of the housing market. Their latest results indicate that distressed sales are beginning to taper off, the number of first time buyers is increasing, and prices are stabilizing.
NAR: - Lawrence Yun, NAR chief economist, said the housing recovery is underway. “It is no longer just the investors who are taking advantage of high affordability conditions. A return of normal home buying for occupancy is helping home sales across all price points, and now the recovery appears to be extending to home prices,” he said. “The general downtrend in both listed and shadow inventory has shifted from a buyers’ market to one that is much more balanced, but in some areas it has become a seller’s market.”

Here is the video.

Sunday, May 27, 2012

German taxpayers face re-denomination loss from TARGET2

As the risks of Greek exit from the EMU increased, the mainstream financial media began to pay attention to growing TARGET2 issues within the Eurosystem. A recent Bloomberg article did a good job in describing the situation. But strangely, rather than referring to it as TARGET2 - the technical term, they called it the German "bailout" (although they've written about the topic before).
Bloomberg: - Here’s how it worked. When German banks pulled money out of Greece, the other national central banks of the euro area collectively offset the outflow with loans to the Greek central bank. These loans appeared on the balance sheet of the Bundesbank, Germany’s central bank, as claims on the rest of the euro area. This mechanism, designed to keep the currency area’s accounts in balance, made it easier for the German banks to exit their positions.

Now for the tricky part: As opposed to the claims of the private banks, the Bundesbank’s claims were only partly the responsibility of Germany. If Greece reneged on its debt, the losses would be shared among all euro-area countries, according to their shareholding in the ECB. Germany’s stake would be about 28 percent. 
Let's help Bloomberg with the explanation here. To start with, this is the "tricky part" - it's actually fairly straightforward. The arrows point to the direction of claims.

And here is how the Bundesbank claims grew. Bundesbank refers to it as "BBK01.EU8148: External position of the Bundesbank since the beginning of EMU / Claims within the Eurosystem / Other claims (net)".  For those who have trouble finding it on the newly redesigned Bundesbank website, you can plot it using Bloomberg charts here (just extend the period to 5 years to see the full effect).

Bundesbank "other claims" on the Eurosystem

But Bloomberg has yet to take that extra step and describe what would actually happen with these claims should a periphery nation exit. The exit would simply result in a re-denomination of some claims and would look like this:

There is no other way to do this. As loans to Greek banks become drachma denominated, so will the claim on the Bank of Greece (BoG), with the central bank separating from the Eurosystem. The Eurosystem was never designed for an exit of a central bank, so this process would need to be cobbled together on the fly - sort of the way the Greek restructuring was done. The "exercise" may potentially set up a process for other nations exiting the EMU.

In this scenario the Eurosystem's asset (claim on the BoG) is denominated in drachma and the liability in euros. The resulting P&L from the drachma devaluation will hit the books of the ECB and will need to be shared by the remaining Eurozone partners (of which Germany is 28%). So as the Bloomberg article points out, even if Germany avoided a massive direct bailout of Greece and other periphery nations, this "backdoor bailout" exposure will sill end up on the doorstep of German (and other core nations')  taxpayers.
Bloomberg: - In short, over the last couple of years, much of the risk sitting on German banks’ balance sheets shifted to the taxpayers of the entire currency union.

It’s hard to quantify exactly how much Germany has benefited from its European bailout. One indicator would be the amount German banks pulled out of other euro-area countries since the crisis began. According to the BIS, they yanked $353 billion from December 2009 to the end of 2011 (the latest data available). Another would be the increase in the Bundesbank’s claims on other euro-area central banks. That amounts to 466 billion euros ($590 billion) from December 2009 through April 2012, though it would also reflect non-German depositors moving their money into German banks.

By comparison, Greece has received a total of about 340 billion euros in official loans to recapitalize its banks, replace fleeing capital, restructure its debts and help its government make ends meet. Only about 15 billion euros of that has come directly from Germany. The rest is all from the ECB, the EU and the International Monetary Fund.

Another confirmation of run on Spanish banks

There have been some questions about the veracity of the ISI data shown in the post labeled "Run on banks in Spain is very real". As a confirmation of those results we provide the latest data from the ECB. The chart below shows quarter over quarter changes in total deposits by the "real economy" (excluding deposits by banks with each other) at German and Spanish banks. The data is through Q1 of this year. Given the record spreads of Spanish to German bonds was saw on Friday, does anyone believe this situation has improved since the end of the first quarter?

"non-MFI" stands for Non - Monetary and Financial Institutions -
these are deposits by corporations, households, etc.
(source: ECB)

Is the rise in US consumer confidence another sign of decoupling?

Friday we saw more evidence of a potential divergence between the US and the EU economic trends (see this post by Cullen Roche for more on the topic).
NYTimes: - Consumer sentiment rose to its highest level in more than four years in May as Americans stayed positive about the job market, while higher-income households were optimistic about wage increases, a survey released on Friday showed.

The survey, the Thomson Reuters/University of Michigan’s index on consumer sentiment, rose to 79.3 from 76.4 in April, topping forecasts for 77.8 and an initial May reading at the same level.

The reading, the final one for May, was the highest level since October 2007.
US vs. EU consumer confidence indicators

Unlike with the earlier signs of decoupling, the US equity markets remained skeptical and ended lower on the day. There are a couple of reasons for this:

1. The Eurozone problems are becoming so severe, it is now harder to see how the US could fully decouple.

2. The US consumer sentiment has been known to shift  rapidly.
NYTimes: - “Unfortunately, consumer confidence is still extremely vulnerable to a reversal, as occurred in the past two years,” the director of the survey, Richard T. Curtin, said in a statement.
Interestingly, the US consumer confidence indicator trend seems to have also diverged from the consumer sentiment in China. China's consumer survey results have been fairly volatile recently and more data will be needed to establish a trend. Given the impact of the US consumer on the economy and China's goal of increasing domestic spending, these relative trends will be tracked closely in the coming months.

US vs. China consumer confidence indicators

Saturday, May 26, 2012

Bail-in provisions will exacerbate run on banks, drive German asset inflation

This Sober Look post discusses the reality of unsecured EU bank bonds that are expected to have zero recovery due to the so-called "bail-in" provisions. Should a bank were to become "insolvent", these provisions will allow the regulators to force orderly defaults, subordinating these bonds behind any government bailout funds. But because most bank assets that would have value in a liquidation are already pledged (particularly in the periphery) to the ECB under the LTRO programs, there will be nothing to recover under these unsecured claims. Unsecured bank bonds have basically become equity with no up-side. The provisions will essentially put an end to most EU banks' ability to issue anything but covered bonds.
FT: - Sweeping reforms to shift the burden of rescuing failing banks from taxpayers to bondholders are to be unveiled by the European Commission, despite fears it will further rattle nervous bank investors.

When a bank is deemed to be failing, regulators will win extensive powers to write down non-guaranteed deposits and senior unsecured bondholders, according to draft proposals obtained by the Financial Times.

While the broad thrust of EU bank resolution reforms are well known, its publication has been delayed for more than a year over fears the so-called “bail-in” tools would make it even harder and more expensive for banks to raise money.
What's more, large depositors such as corporations, trusts, pensions, asset managers, insurance firms, etc. will have to view their cash at banks as unsecured lending to these institutions.

Within the euro area these bail-in provisions will simply drive bank clients to move balances to German banks and into German government paper, further exacerbating TARGET2 imbalances and run on periphery banks. This flight of capital is even starting to drive German asset price inflation.
Pimco: Evidence so far points to accelerating asset price inflation in Germany rather than consumer price inflation. Capital flight and their “safe haven” status have inflated the prices of German government bonds. Concerned about the stability of the euro, Germany’s savers are shifting their money into real estate. German residential house prices and rents rose by 4.7% last year, the fastest increase since 1993’s reunification boom. So far, Germans are not leveraging to buy houses. Growth in German mortgages is paltry at just 1.2% per annum according to the ECB as of December 2011, but in our view all ingredients for a debt-financed house price boom are there. Distrust in the euro is rising, German households’ debt level is low, as are interest rates and unemployment. The ECB’s monetary policy is too loose for Germany’s domestic conditions, just as it was too loose for Spain and Ireland in the early years of monetary union when Germany’s economy was weak.

Not to worry - BOJ will buy the JGBs that girl bands and sumo wrestlers haven't sold

AFP: - Japan's cash-strapped government is turning to wildly popular music group AKB48 to help it sell government bonds, as interest in the low-yield paper wanes, reports said Friday.

The all-female pop group will headline a summer campaign for "reconstruction bonds" aimed at financing projects in regions hammered by last year's quake-tsunami disaster, the Wall Street Journal said, citing an unnamed source.

AKB48, one of the world's highest-grossing acts with more than $200 million in CD and DVD sales last year, are a phenomenon in Japan and across Asia, with members appearing in commercials for everything from chocolate to mobile phones.

The debt campaign will see AKB48 -- comprising about 90 performers, ranging in age from early teens to mid-20s -- joined by sumo wrestling's champion Hakuho and female football star Homare Sawa, Japan's Jiji press agency reported.
See a more "colorful" version of this story from the Telegraph.

Buying government paper is being portrayed as a patriotic thing to do. These types of campaigns to push JGBs to Japan's population have been common in recent years. But with some 95% of bonds owned domestically and a rapidly aging population, selling long-term paper at yields of 90bp will become increasingly difficult - no matter how many girl bands or sumo wrestlers the government hires.

Some would argue that the central bank (BoJ) with its unlimited supply of yen can always step in and buy the government's massive amounts of rolling and new debt. That is Japan's Debt to GDP ratio can grow indefinitely. The rating agencies have simply been wrong to sound the alarm. And because Japan has been in a deflationary environment, printing more yen will do the nation some good.

In fact BoJ has been doing just that. The central bank has been engaged in a "perpetual QE" since the 2008 financial crisis. And that program has been accelerated this year, keeping long-term rates low.

BoJ JGBs held (units = 100MM yen; excludes shot-term bills, source BoJ)

Apparently that's not enough, as the governmental needs to sell more paper - above and beyond what the central bank, insurance firms, banks, pensions, and corporations have been buying. Clearly there is the reconstruction effort, after which the needs to sell large amounts of JGBs should subside.

Or maybe not. Debt to GDP ratio is expected to continue climbing at its current pace, exceeding 250% within the next few years. And that's assuming no change in interest rates. Should rates increase, the ratio's growth will begin to accelerate because the government would need to cover ever larger interest expenses.

Source: BNP Paribas

But for now BoJ will simply buy whatever the amounts the girl band campaigns are unable to sell. Deflation will be tamed, the yen will be weakened, the debt to GDP ratio growth will be ignored, and all will be well...

Friday, May 25, 2012

The inverted Eurepo curve spells trouble

Only one yield curve represents the pan-Eurozone interest rates implied by actual lending transactions. It's the Eurepo curve - rates at which short-term EUR lending is done on a secured basis (collateralized lending). Sovereign curves are specific to each nation, while Euribor does not represent any real transactions and is basically a figment of bankers' imaginations.

A month ago the Eurepo curve was upward sloping, as hopes of some sort of stabilization in the Eurozone later this year still existed. These hopes have now been dashed, with the curve becoming inverted in the short-end and flat at around 11bp out to one year. There is no active repo market beyond one year.

Eurepo curve: now and a month ago

This demonstrates lack of borrowers willing to tie up precious repo-eligible collateral beyond a month, while money market funds and other cash accounts are desperately trying to get any non-zero secured term yield. Inverted yield curves rarely spell good news - and the only news here is the onset of the Eurozone recession.

A chart of capital flight into Germany

As capital flight from the Eurozone periphery into Germany picks up pace, German government bond yields collapse to zero. The chart below tells it all.

Dallara: Grexit will bankrupt the ECB, cost a trillion euros

Some have suggested that the Sober Look half a trillion euro rough estimate cost of Greek exit from the Eurozone was exaggerated. Try something closer to a trillion. That's the cost estimate by the Institute of International Finance (IIF). What's more, the exit will render the ECB insolvent. Watch the Bloomberg interview with Charles Dallara, managing director of IIF (he represented the creditors in the Greek debt restructuring).

Spanish spreads hit new records as larger bank bailout expectations grow

As expectations of ever larger bank bailouts in Spain hit the market, both the 5-year and the 10-year Spanish government spread to Germany reached new records, with the 5-year spread exceeding the November high for the first time.

5yr Spain sovereign spread to Germany
10yr Spain sovereign spread to Germany - The board of Bankia, the large Spanish bank that was taken over by the government, met Friday to discuss a restructuring plan that will include a request for more state aid, bolstering calls for a coordinated relief blueprint for Europe’s fragile financial sector.

Trading in shares of Bankia, the country’s fourth-largest lender, were suspended Friday while its board determined how much new aid it needs. The bank’s shares have whipped about violently in recent weeks on fears it could succumb to the massive losses it has built up in the country’s collapsed real estate sector.
The bailouts were never built into the debt to GDP ratio projections. The debt levels have strayed from the target even before the additional support for the banking system became necessary. Nobody really believes that Bankia is an isolated case, raising the possibility that Spain would need to undertake an Ireland-style banking recapitalization. That may require external support from EFSF/IMF, which frightens existing bond holders as they continue to sell Spanish debt.
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