Saturday, June 29, 2013

New threats to China's property bubble

In late 2011 many were expecting China's property bubble to burst. It looked as though housing prices had peaked and signs of stress were beginning to appear (see discussion). But the correction turned out to be quite shallow and in spite of China's government's multiple attempts to arrest housing price appreciation (and partially succeeding - see post), house prices went on rising.

Source: JPMorgan

With real rates on deposits remaining in negative territory for years, there were few places to turn for wealthy savers. Property became one of the primary vehicles to put away excess cash to escape inflationary pressures. Moreover, municipal governments made large sums of money selling land to developers, while banks ("encouraged" by municipalities) have been happily lending. And in many cases lenders and developers have set up arrangements that are a bit closer than "arms length" (see discussion). Except for ordinary families who got shut out of the housing markets, everyone benefited from this rally.

Housing investment as percentage of GDP has been growing unabated, and in recent years started approaching levels that other nations experienced at the height of their property bubbles.

Source: Credit Suisse

Now, based on the house price to wage ratio compiled by the IMF, China's large cities have the most expensive real estate in the world. Beijing is particularly expensive, as party officials deploy their "hard-earned" cash.

Source: Credit Suisse

And while Western economists debate if China's property market is truly a bubble, major Chinese developers are openly admitting it.
South China Morning Post: - China Vanke [one of the largest developers in China] chairman Wang Shi said the mainland's property market faces the risk of a "bubble", reiterating concerns the developer raised three months ago.

The bubble is not "light", Wang said at a conference in Shanghai yesterday. "If the bubble lasts, it will be dangerous."

Home prices have been increasing even as the government in March stepped up a three-year campaign to cool the market.

The measures have included raising down-payment and mortgage requirements, imposing a property tax for the first time in Shanghai and Chongqing, and enacting purchase restrictions in about 40 cities. New home prices jumped 6.9 per cent in May, the most since they reversed declines in December, SouFun Holdings, the mainland's biggest real estate website owner, said.
But bubbles can last for a long time. Are there indications that this market may have peaked? Two key economic developments point to rising risks to this multi-year housing rally.

1. Real rates on deposits have turned positive in China recently, which will reduce incentives to use property markets as a savings tool. If rich savers make more on interest than they lose to inflation, they are less inclined to look for alternatives to bank deposits.

Source: Credit Suisse

2. The recent madness in China's money markets and PBoC's "delayed reaction" to tight monetary conditions (see discussion) could potentially spill over into the broader credit markets, resulting in increased lending rates and tighter credit conditions in general. That's not great news for property markets.
JPMorgan: - We expect liquidity conditions to ease in July, but in the near term, there is a risk that the tough line taken by the PBOC will create an artificial liquidity squeeze and cause an increase in the lending rate to the real sector (the SHIBOR rate also increased significantly, to 5.4%), putting further pressure on already-weak economic activity. In our view, the PBOC should reintroduce reverse-repo [injecting liquidity] operations very soon to calm the panic in the interbank market.
These threats to China's property markets, combined with weakness in manufacturing, do not bode well for China's near term growth prospects.
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Friday, June 28, 2013

Anglo Irish Bank back in the news

As promised in the previous post on Ireland, here is an interesting e-mail from a reader discussing some of the facts around the Irish banking system bailout - particularly as it relates to Anglo Irish Bank:
The Irish Independent newspaper carries recordings of two bank employees, John Bowe and Peter Fitzgerald, discussing the finances of the insolvent bank Anglo Irish Bank (rebranded as IBRC : Irish Bank Resolution Corporation). Both men held senior positions at Anglo at the time.

In September 2008, Anglo requested a meeting with the then Minister for Finance Brian Lenihan requesting a government bailout to solve their “liquidity problem”.

The other Irish banks also lobbied Lenihan and this led to the creation of the Bank Guarantee indemnifying all of the Irish retail bank liabilities to the value of €450 billion.

The Guarantee’s introduction caused consternation in Ireland, UK and throughout the Eurozone because it saw deposit flight from the UK banks to Irish banks (Alistair Darling at the time had strong words with Lenihan).

Anglo claimed that its problems were temporary and that it needed bridging liquidity when in fact the bank was gravely insolvent.

Anglo’s accumulated reserves and shareholder funds were eviscerated, with questions arising about loans to directors, an alleged Guiness-type share support scheme and a bizarre cash where deposits from other Irish banks were put on deposit at Anglo at their balance sheet date to artificially boost their deposit balance for reporting purposes (see link). 
Anglo Irish Bank would eventually receive funding totalling €30 billion before being rebranded in July 2011 to the name IBRC : Irish Bank Resolution Corporation.

A series of promissory notes were created to cover the cost of €30 billion cost of refinancing, all funded by the hard pressed Irish taxpayer IBRC was subsequently liquidated in March 2013 (see discussion).

The Irish Independent newspaper claims to have a lot of tapes which it intends to publish here. The conversations that were taped using the banks recording system were recorded a few weeks prior to the Anglo meeting with Brian Lenihan in September 2008. 
You will hear the Anglo bankers talking about how they told the Irish Central Bank about what it (ICB) needed to do to save the Irish banking system, by saving Anglo.

It is explosive stuff and the contents of these tapes has led to a lot of public anger about the bailing of this insolvent bank.
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After sticking it to Ireland a few years back, EU "fixes" the bank bailout plan

Ireland was the one country in the Eurozone "periphery" that seemed to be bucking the trend (see post). Many had hoped that the nation will be able to withstand the Eurozone recession due to its strong trade balance. Exports were really humming until global growth stalled last year (see post). Ireland's trade balance turned negative again and does not seem to be recovering. Furthermore, domestic demand is now weakening.

Source: Barclays Capital

As a result Ireland's GDP contracted and the nation followed the rest of the Eurozone into a recession - just over 3 years after the Great Recession.

Source: Barclays Capital

Given Ireland's high government debt to GDP ratio (Ireland ranks third in the Eurozone after Greece and Italy), this is bad news. The hope was that the government can manage down its leverage as the GDP grows, but that's not how things turned out.

Source: Tradingeconomics
Unlike most of the other Eurozone nations whose debt to GDP trajectory was much more gradual, Ireland's ratio shot up rapidly in a matter of 4 years.  What makes Ireland somewhat unique in the Eurozone is that this debt spike is directly related to Ireland's bank bailout. The sad part is that Ireland's EU "friends" had a great deal to do with this. Here is why.

In the last couple of days the EU reached an agreement on dealing with failed banks.
The Express: - The European Union has today agreed to force investors and wealthy savers to share the costs of future bank failures, moving closer to drawing a line under years of taxpayer-funded bailouts that have prompted public outrage.

After seven hours of late-night talks, finance ministers from the bloc's 27 countries emerged with a blueprint to close or salvage banks in trouble.

The plan stipulates that shareholders, bondholders and depositors with more than 100,000 euros should share the burden of saving a bank.
If Ireland were allowed to implement anything resembling this provision during the financial crisis, its debt to GDP would never have reached anything close to the current levels.

During the financial crisis a great deal of the unsecured debt of Irish banks was held by the UK's and the Eurozone's banks. And neither the EU nor the ECB wanted to haircut these bonds. In order to "keep the peace" in the EU banking system, these bonds were not written down, forcing the Irish government to make the bondholders whole. It had no resources to do so and was forced to borrow tremendous amounts in order to cover these obligations. As losses on property portfolios inherited by the government mounted, so did the government debt (government guarantee had to cover increasingly larger losses). The austerity drive generated by this high government debt caused unemployment to spike and destroyed domestic demand. It may be a decade or longer before the nation fully recovers. Now that Ireland had paid the high price for covering its banks' obligations, the EU is about to implement the rules to force haircuts on unsecured creditors - something they refused to do for Ireland just a few years ago.

The next post will contain an email from a reader describing some of the ugly facts around the bailout of the Irish banking system.
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Thursday, June 27, 2013

Freddie's lawsuit over LIBOR manipulation may be an uphill battle

Here is some old news from Dec 19th, 2012:
The Telegraph: - America's two largest mortgage lenders could have lost more than $3bn (£1.85bn) as a result of banks’ alleged manipulation of Libor.
And then there was this on March 19, 2013:
WSJ: - Freddie Mac sued more than a dozen of the world's biggest banks for alleged manipulation of interest rates, in the first government-backed private litigation over the rate-rigging scandal.
When it comes to the LIBOR scandal, it was never a question of guilt (see discussion). The issue has always been around methods for estimating damages. What should the LIBOR rate have been if it wasn't manipulated?

The Office of Inspector General of the Federal Housing Finance Agency had a good idea. Why not use the Fed's measure of deposit rates as the benchmark. The Fed publishes these rates daily under "Selected Interest Rates (Daily) - H.15, Eurodollar deposits (London)" (here) and it is supposed to measure the same thing as LIBOR. The difference between the two indices is that the Fed's measure is a broader sampling of banks vs. LIBOR, which is compiled by the British Bankers Association. Also since no contracts are priced using the Fed's calculation, there would be no reason for anyone to attempt to manipulate it (see memo from the Inspector General below).

By comparing the two indices, one would presumably be able to determine the damages based on the LIBOR linked portfolio (LIBOR-linked mortgages for example) held by Fannie and Freddie during the period in question. The portfolio should have received more interest income than it did.

So far so good? Maybe the proud owners of Fannie and Freddie (the US taxpayers) would be able to recoup some damages. Unfortunately it's going to be an uphill battle for a couple of reasons:

1. Banks reporting to the BBA are larger on average than those in the Fed's sample list. The banks will argue that their borrowing costs - and therefore LIBOR - during the crisis would have been lower because of their size, even without the manipulation. Furthermore, the "quotes" from smaller banks are even less reliable, given they had zero access to the unsecured interbank market. That argument puts the amount of damages in question because it is no longer just based on the difference between the two indices. In reality the big banks were quite stressed, and LIBOR should have been higher, but without some actual interbank transactions, good luck trying to prove it. 

2. According to the Fed, it gets it's deposit rates from "Bloomberg and CTRB ICAP Fixed Income & Money Market Products". ICAP is an interdealer broker who is supposed to see transaction flow and provide market data to subscribers. It's a well respected source of pricing data, but is it reliable enough to hold up in court? Once again it's going to be difficult, given ICAP's current dilemma:
WSJ: - A top executive at brokerage firm ICAP knew of an arrangement with UBS that U.S. and British regulators allege was part of a scheme to rig benchmark interest rates, according to people familiar with the matter.

The ICAP executive, David Casterton, was included on emails between ICAP and UBS officials in 2007 as they negotiated a deal that regulators say was designed to compensate ICAP brokers for helping UBS traders manipulate the London interbank offered rate, or Libor, these people say. Mr. Casterton ultimately signed off on the arrangement, they say.

British regulators have described the arrangement, which they say involved UBS making quarterly payments to ICAP allegedly to reward brokers for helping rig Libor, as "corrupt." The Swiss bank admitted wrongdoing when it settled Libor-rigging charges with U.S. and British authorities last December.
This doesn't make the banks any less liable for LIBOR manipulation, but given the source, a good lawyer will focus on the reliability of the Fed's measure as the benchmark. With enough doubt introduced, the banks will then claim that the damages due to the actual LIBOR manipulation are significantly lower than what could be determined from the difference between the two indices. In the end, the taxpayers are likely to get some money back, but these issues will make the actual payout significantly smaller.

Office of Inspector General - Federal Housing Finance Agency Memo on LIBOR Manipulation (source: WSJ)
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Wednesday, June 26, 2013

Massive decline in euro area's excess reserves is not an indication of improved lending

The decline in euro area banks' excess reserves has been quite spectacular. Excess reserve levels are back to 2011 levels.

Source: ECB
Some are attributing this to banks "no longer hoarding cash" and therefore lending. That's nonsense. This decline in excess reserves was a direct result of banks reducing their borrowing from the Eurosystem. The combination of the MRO, the LTRO, and the MLF loans from the ECB has been falling.

Source: ECB

Why are banks paying off their loans? Some have found alternative sources of funding in the private markets (repo or secured bonds for example), but a great number of Eurozone banks are simply deleveraging. As they reduce their assets, they don't need to borrow as much. Sadly, this deleveraging has resulted in extraordinarily weak loan growth, both to households,

YoY growth in loans to Eurozone households (source: ECB)
... and to corporations.

YoY growth in loans to Eurozone non-financial companies (source: ECB)

While there are some signs of economic improvements in certain parts of the Eurozone, the deleveraging of the banking system and nonexistent loan growth does not bode well for a near-term recovery.
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Missed that 3.5% mortgage rate? That's OK, there is always the 5/1 ARM

In the past two days the 30-year conventional mortgage rate broke above 4.5% - roughly a 2-year high. Many economists argue that in spite of this spike, we are still some two percent below the pre-recession rates. Of course the economy (including availability of credit and employment) was arguably stronger before the recession than it is now. And it's not necessarily the level but the speed of the spike that worries some:  over 120 bp rate hike in less than two months.

There is another dynamic taking place in the mortgage universe. The treasury yield curve has steepened (see post), resulting in the adjustable rate mortgage (ARM) rates lagging the 15 and the 30Yr rates quite dramatically (30Yr to 5/1 ARM spread went from some 40bp to 150bp).

Source: Mortgage News Daily

Now apparently a growing number of homebuyers who are nearing a house purchase are turning to mortgages with teaser rates as well as to 5yr ARMs. Having become accustomed to mortgage rates declining for years, many have been waiting for rates to turn around and now want that last month's mortgage rate. And often the only way to get there on the monthly payments is to shift down the yield curve. This is a bit alarming because in 5 years rates could spike further and these borrowers would be in trouble.
CNBC: - "Funny, people are rushing into higher-risk loans to save deals as rates spike. What happens in five years when their rate starts adjusting upward 2 percent per year? They blow up!" said Mark Hanson, a California-based mortgage and housing analyst.
Of course in 3-5 years they will be able to flip that house. Sounds familiar?
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Bursting Bernanke's bubble

The last time we discussed the Credit Suisse Global Risk Appetite Index, it was headed for "euphoria" (see this post from May 21). Around May 22 something changed, and it was all downhill from there.

Source: Credit Suisse

It was Bernanke's first hawkish statement.
May 22; Bernanke: - We’re trying to make an assessment of whether or not we have seen real and sustainable progress in the labor market outlook. If we see continued improvement and we have confidence that that is going to be sustained, then we could in -- in the next few meetings -- we could take a step down in our pace of purchases.
Intentionally or not, the Chairman burst the market bubble just before it hit "euphoria". It was clear that the Fed was becoming concerned about froth forming in fixed income markets (Bernanke spoke about it - see this post). It was time to end it.

The unfortunate outcome of this action however is that it remains unclear whether the economy would have been better off if QE3 was never launched at all. The next 12 months will be filled with uncertainties about the exit timing, rising rates, and shaky credit markets. Anecdotal evidence suggests that some banks are becoming jittery about growing their balance sheets in this environment. As a result, loan growth is already slowing. That can't be good for business growth and hiring. When the dust settles, the economy may end up being in worse shape than it would have been if the Fed left it alone in August of 2012.
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Tuesday, June 25, 2013

Munis dumped below market levels via ETFs

Muni ETFs have taken tremendous hits in the last few days. SPDR New York and California municipal bond ETFs in particular have underperformed the overall muni market.

Source: Ycharts

Surprisingly these NY and CA ETFs now trade with a 4-5% discount to NAV (ETFs' value is lower than the value of the underlying portfolio). That discount explains a portion of the underperformance (the index ETF discount is about 1%). But these are not closed-end funds and over time the ETF discount should disappear. Given this is not driven by credit concerns (for now), one could make money going long these state ETFs and shorting the overall index or treasuries to "lock in" the discount.

It's just amazing to see investors dumping munis indiscriminately, even if they end up selling below market levels (via ETFs at discount to NAV). Many of the higher rated (particularly longer dated) munis yield more than the equivalent treasuries on a pre-tax basis. The fear of fixed income product is outweighing the attractiveness of post-tax yields.

From an economic perspective, this is bad news for municipal finance. Several muni bond issuances have already been delayed, given the nasty volatility. Just when some had hoped that employment at the state level may have stabilized, the increased cost of funding will now create additional headwinds.

Source: U.S. Bureau of Labor Statistics
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The Fed's accounting magic makes mark to market losses disappear

We are getting a number of questions related to the Federal Reserve experiencing a major loss on its securities holdings due to the sharp correction in bonds over the past couple of weeks. How big is the loss and how will it impact everything from the central bank's capitalization to distribution of income to the US treasury? The answer is that while the mark to market loss on the Fed's $3.2 trillion of securities holdings is massive (here is the full portfolio in detail), it will never be recorded on the bank's financial statements unless the Fed begins to sell the portfolio. Currently it has no plans to do so.

While private institutions in the US usually follow Generally Accepted Accounting Principles (GAAP) for their financial reporting, the Federal Reserve Banks do not. Instead their financials are prepared using the Financial Accounting Manual for Federal Reserve Banks - a set of accounting rules just for the Fed. And when it comes to securities holdings, the method of accounting is "straight-line amortization" rather than "fair value".
FRB: - The primary difference between the accounting principles and practices in the Financial Accounting Manual and GAAP is the presentation of all System Open Market Account securities holdings at amortized cost rather than the fair value presentation required by GAAP. Treasury securities, government-sponsored enterprise (GSE) debt securities, Federal agency and GSE mortgage-backed securities, and investments denominated in foreign currencies comprising the SOMA [System Open Market Account Holdings (the bond holdings)] are recorded at cost on a settlement-date basis rather than the trade-date basis required by GAAP. The cost basis of Treasury securities, GSE debt securities, and foreign government debt instruments is adjusted for amortization of premiums or accretion of discounts on a straight-line basis. Amortized cost more appropriately reflects the Reserve Banks' securities holdings given the System's unique responsibility to conduct monetary policy. Accounting for these securities on a settlement-date basis more appropriately reflects the timing of the transactions' effects on the quantity of reserves in the banking system. Although the application of fair value measurements to the securities holdings may result in values substantially above or below their carrying values, these unrealized changes in value have no direct effect on the quantity of reserves available to the banking system or on the prospects for future Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio may involve transactions that result in gains or losses when holdings are sold prior to maturity. Decisions regarding securities and foreign currency transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, fair values, earnings, and gains or losses resulting from the sale of such securities and currencies are incidental to the open market operations and do not motivate decisions related to policy or open market activities.
Here is roughly how this works. If the Fed buys a 10-year bond with a 3% coupon at $105, it will record a gain of $3 per year on the coupon and a loss of 50 cents ($5 dollar premium amortized over 10 years) per year. It will therefore pay a dividend of $2.5 per year (less operating expenses) to the US Treasury on this bond. If the Fed buys the same bond at a discount, say at $95, the net income per year would be $3.50 because the $5 discount would be accreted over 10 years.

So if the Fed's bond purchase was originally priced at $105 and is now at $99, the Fed will record $2.5 of income this year rather than the $3 loss it would report under "fair value" accounting ($3 coupon - $6 mark to market loss). Unless the bond is sold (or defaults), the loss will never appear on the financial statements. That's the privilege of being part of the Federal Reserve System.
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Monday, June 24, 2013

Good explanation for tight interbank liquidity conditions in China - finally

Someone sent us a quote from JPMorgan that finally explains the origins of the tight interbank liquidity conditions in China. It's roughly what analysts have been suggesting.
JPMorgan: - ... there is an additional reason for the tight liquidity, in the form of a crackdown on illegal bond trading by regulators. In recent years, wealth management products (WMP) have become an important channel for Chinese banks to attract deposits. Most wealth management products are short-maturity (65% are below 3 months, and 20% range from 3-6 months). The maturity dates of such products are usually at the quarter-end, to meet regulatory requirements on loan-to-deposit ratios. Due to competition in providing high returns for WMP, banks were forced to buy high-yielding bonds with 1-5-year maturities to serve as underlying of the WMP. Examples of such bonds are lowly rated credit papers with poor liquidity, or non-standard securities such as discounted bills and bank loans. This resulted in a term mismatch between the maturity of WMP and their underlying asset. To avoid any squeeze from this mismatch upon maturity of the WMP, small banks started to engage in a kind of sale-and-buyback operation of the underlying bonds, consisting of two steps. In step 1, bonds were sold before quarter-end in a “fake” sale to a friendly counterparty, with the aim to obtain cash to pay back the maturing WMP. In a second phase of the trade, the bond was then bought back using cash from new WMP issues. But in May the regulator banned this practice, as part of a general clampdown of the abuses in the WPM market. Part of the interest rate squeeze we are observing today is due to the difficulty in liquidating the (illiquid) underlying bonds before the maturity date of WMP at June-end. The demand for cash has therefore risen significantly, at least from the small banks. Note that China’s larger banks do not have problems accessing liquidity, but that primarily the small banks are suffering.
As discussed earlier, it is clear that the PBoC does not have a good handle on banks' risk-based capital and the smaller banks in China have been playing the game of regulatory capital arbitrage. This is similar to US banks using off-balance-sheet vehicles funded with commercial paper to "convert" long-dated illiquid assets into short term (less than 365 days) exposure.
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Shape of the yield curve adjustment impacted by bond buying pattern

Here is how the treasury curve shifted over the past two months (through today).

The obvious question is why has the sell-off been most acute in the 7-10yr range (the 7-year yield has increased by 90bp)? And why have the bonds in the 20-year range been a bit more stable. The answer has to do with the Fed's buying patterns.

Source: NY Fed

Maturities where the Fed has been most active are the ones which are more vulnerable to this correction. Those are the bonds whose prices the Fed has been supporting (aside from treasury bills that are now used as safe-haven). As the support diminishes, the bond pricing adjusts to post-QE levels. (Note that the bucketing used by the Fed doesn't match the bond maturities in the first chart precisely and the pattern is obviously not exact - yet the relationship is still visible). This tells us that a great deal of the fixed income pricing to date has been determined by the monetary expansion rather than the fundamentals of the markets.
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When it comes to the latest PBoC policy, Mr. Mobius knows best

The PBoC acted to calm China's interbank markets this morning, somewhat stabilizing liquidity and short-term rates.

The PBoC made a vague statement over the weekend regarding its monetary policy.
PBoC (translation/paraphrasing): - The PBoC meeting stressed the need to conscientiously implement the Party's recent economic directives, to pay close attention to the latest international and domestic economic and financial developments and changes in international capital flows, to continue to implement prudent monetary policy, and make efforts to enhance policy to be more proactive with targeted, flexible, appropriate and timely fine-tuning. The meeting stressed sound macro-prudential policy framework, the integrated use of various monetary policy tools to strengthen and improve liquidity management, guidance on monetary credit, and steady growth of social financing. These goals should be achieved by maintaining the stability and continuity of macroeconomic policies, while optimizing allocation of financial resources,... and effectively supporting the restructuring, transformation and upgrading of the economy. This will ultimately help serve the real economy, job growth, and financial risk mitigation.
What does this mean? It seems the PBoC has been trying to avoid adding incremental liquidity in order to help facilitate the "restructuring" of the economy, while fine-tuning liquidity when needed. Most central bank watchers would agree that creating a liquidity crunch however is a bizarre way of implementing economic restructuring.

Raising short term rates may serve two purposes and China is unlikely to be interested in either. One would be to slow economic growth, which China clearly doesn't need. And even if it did, it would want to target a gradual increase, not the mad volatility shown in the chart above. The second reason to raise short-term rates is to defend the currency (something Brazil may end up doing). But China's massive foreign reserves would make that task fairly simple without having to take liquidity out of the market.

The central bank is trying to reduce growth in shadow banking and "speculation" using this blunt monetary tool. That will end up tightening credit conditions for regular bank lending as well (see discussion). A far more efficient way of achieving this goal is by increasing bank capital requirements for "wealth management products" as well as  on- and off-balance sheet undesirable risk taking. A simple way to implement such policy would be through stress testing requirements, forcing banks to have higher capital ratios. That would reduce unwanted risk taking without killing general lending. But that's not what the PBoC is doing.

What this tells us is that China doesn't have a good handle on risk-based capital needs for the nation's banks and resorts to liquidity "starvation" to stem growth in shadow banking. Somewhat surprisingly, Mark Mobius believes the PBoC is doing the right thing. His view is that since the banking system is state-owned, it can be recapitalized (bailed out) at any time. Let the PBoC shock the system and see how things ultimately shake out.
CNBC: - While China's housing market problems are similar in scale to those faced during the U.S. subprime mortgage bubble and its banks are rife with bad loans, it won't lead to another Lehman-style crash, Franklin Templeton's Mark Mobius told CNBC on Monday.

Mobius said the similarities could not be denied but since Chinese banks are owned by the government, they will not be allowed to fail.
Sounds like a dangerous strategy. But clearly Mr. Mobius knows best and it is all going to work out in the end. Is that why China's stock market tanked 5% overnight?

Shanghai SE Composite Index (source: CNNMoney)

Sunday, June 23, 2013

New fears grip Egypt's investors

Egypt's economy remains in a precarious state. As if the pressure on emerging markets is not enough, the planned anti-government protest could end up involving the military and potentially destabilizing the nation.
CBS: - Egypt's army chief warned on Sunday that the military is ready to intervene to stop the nation from entering a "dark tunnel" of internal conflict.

Gen. Abdel-Fattah el-Sissi spoke a week ahead of mass protests planned by opponents of Islamist President Mohammed Morsi. There are fears the demonstrations calling for Morsi's ouster will descend into violence after some of the president's hard-line supporters vowed to "smash" them. Others declared protesters were infidels who deserve to be killed.

El-Sissi's comments were his first in public on the planned June 30 protests. Made to officers during a seminar, they reflected the military's frustration with the rule of Morsi, Egypt's first freely elected president who completes one year in office on June 30.
Given the recent history of violent protests in Egypt, this could end up being quite ugly. In spite of the central bank's attempts to maintain currency stability, the Egyptian pound broke through 7.0, hitting a new record low.

USD/EGP (source:

Beyond the anticipated political protests, sectarian violence is threatening to become a problem.
Aljazeera: - Sunni Muslim villagers have killed four Shia Muslim men in Egypt after accusing them of trying to spread their version of Islam, according to security officials.

The four were beaten to death on Sunday in Giza province, near the capital Cairo, in one of the most serious sectarian incidents in Egypt in recent months.

The Health Ministry confirmed the death toll, adding that scores of Shias were seriously injured in the attack.

About 3,000 angry villagers, including ultraconservative Sunni Salafists, surrounded the house of Hassan Shehata, a Shia leader, threatening to set it on fire if 34 Shias inside did not leave the village before the end of the day, according to the officials.
The stock market is down some 17% for the year as investors fear escalation.

Egypt's stock market index (source:

It remains to be seen if the army will indeed intervene on a large scale during the protests or if this is a form of posturing.  June 30th is a week away.
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From rotation to panic - a turning point?

The latest report from the ISI Group called the recent outflows from bond funds "a bit of a panic". Indeed after years of growth, the drop in fixed income funds' AUM is nothing short of spectacular.

Source: ISI Group

Some insist that this is more of a "rotation" than a panic. A possible way to settle the argument is by looking at the Credit Suisse Risk Appetite Index. One of its components is the Fixed Income Risk Appetite sub-index, which in fact just entered the "panic" mode for the first time since 2011.

Source: Credit Suisse

However, those who prefer the contrarian view of the markets will appreciate the following quote.
Credit Suisse: - A break into "panic" territory has historically been a strong signal for a turning point in the bond market, indicating that the market has become very oversold in the short run. Since the start of the index in 1995, there have been seven such signals. Six out of seven times that translated into longer-dated US bonds outperforming bills over a period of 3-6 months. In recent years, panic deeps have on average become shorter and shallower, resulting in even stronger signals.
The fundamental explanation here is that a sudden rate shock we've had can't be great for the economy. And any visible sign of renewed US economic weakness could delay the Fed's "taper", creating a bid for bonds.
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Emerging markets for sale

Floating emerging markets currencies have been under tremendous pressure over the past month, as active investors move out.  Slowing growth, political instability, and weaker demand for natural resources have all contributed to the sharp declines. Rising rates in the US have not helped the situation either, making the dollar more attractive on a relative basis.

Not to be outdone, the Australian dollar - which is sometimes used as a proxy currency for China - is also down 6.4% over the same period. Many Emerging markets currencies have not seen these levels since the financial crisis. The Indian rupee touched another all-time low of 59.57 to the dollar. As discussed earlier, Brazil has been hit the hardest. The situation would have been considerably worse if the governments didn't actively intervene in the currency markets.

Nations with pegged currencies are also not immune to flight of capital. Argentina for example is experiencing tremendous pressure on foreign reserves.
Credit Suisse: - [Argentina's] central bank’s reserves remain under pressure. Gross foreign reserves have declined $5.0bn ytd to $38.3bn, compared to a $0.1bn increase over the same period in 2012. ... Reserves could fall by nearly $8.0bn this year. ... Any additional increase in reserves related to the tax amnesty program carried out in 3Q (perhaps $2.0-3.0bn) will likely be temporary and counterbalanced by external debt payments. Overall, we expect more controls to target deteriorating external imbalances, but reserves could still fall to $35.5bn by year-end and by another $5.0bn in 2014.
Anecdotal evidence suggests that China is also becoming concerned about capital flight. As a data point, the stock market is down some 10% over the past month. Some have even proposed that the high short-term rates in China (see post) is an attempt to "punish" those trying to short the currency (high rates and difficulties borrowing would make it hard to stay short the yuan).

Whatever the case, active investors are dumping emerging markets equities and bonds with the intensity not seen since the financial crisis.
JPMorgan: - EM bonds have been at the center of the flight from carry and illiquidity. EM local markets lost 1.5% FX-hedged, and almost 4% in USD terms Thursday, the former a record, the latter the worst day since October 2008. EM bond funds continue to see outflows, if more from hard currency than local currency funds. FX weakness is tilting risks toward tighter monetary policy to support the currency is some markets, and this week we penciled in another 50bp of hikes in Brazil. We maintain a short duration stance in EM, with position squaring likely still not done.
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Steepening yield curve benefits banks, but major headwinds remain

The treasury curve has steepened materially over the past few weeks, driven by Bernanke's seemingly hawkish statements. One group of companies that will benefit from this adjustment is the banking sector.

In fact bank shares have been outperforming the broader market by a significant margin - over 6% in the past couple of months.

The reason is simple. Given the short end of the curve has not budged, banks will continue to pay next to nothing on deposits. But they can now charge much higher rates on new term loans they make. That spread increase (net interest income) will flow right into equity and juice up bank dividends. Bank shareholders and executives should thank Bernanke for this "gift".

But there are headwinds appearing on the horizon for the banking sector that may negate some of these gains. Here are a few examples:

1. A portion of bank revenue has been generated from mortgage refinancing in the past couple of years. But that game is over (see post) and the refi fee revenue will no longer be there. We'll let our friends who analyze bank shares quantify that number, but it can't be immaterial.

2. With rates rising, loan demand in the corporate sector may in fact decline. We are already seeing evidence of that.

On top of reducing origination fees and asset growth for banks, this trend could easily result in slower economic growth, which has been quite fragile to begin with.

3. Treasury and agency securities make up about 10% of bank assets. Even though not all of these securities will get marked to market, the recent bond correction can't be good for the old P&L. Customer flows in fixed income departments of banks will also decline materially.

4. New regulatory pressures could create tremendous headwinds for the larger banks and could even result in dividends being shut off for years to come as banks are forced to build up capital.
Bloomberg: - U.S. regulators are considering doubling a minimum capital requirement for the largest banks, which could force some of them to halt dividend payments.

The standard would increase the amount of capital the lenders must hold to 6 percent of total assets, regardless of their risk, according to four people with knowledge of the talks. That’s twice the level set by global banking supervisors.
For those who think banks haven't been lending enough, just wait till such rules go into effect. We will see an outright credit contraction in the US.

Given these headwinds in the banking sector, one should be careful jumping on the bank shares bandwagon. There may be some nasty earnings surprises along the way. And with banks under pressure, those who are predicting the US GDP to grow at 2.5% or higher should go back to the drawing board.
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Dividend shares remain resilient

As expected, dividend-focused shares have underperformed in this rising rate environment. The chart below shows a couple of broad dividend index ETFs vs the S&P500 (SPY) over the past two months.

Source: Ycharts

Nevertheless on a year-to-date basis these same shares have performed about as well as the broader market. As discussed late last year (see this post), dividend shares never exhibited signs of a "crowded trade" and therefore were able to withstand this rate adjustment significantly better than fixed income products (see discussion).
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Saturday, June 22, 2013

Mortgage rates spike to two-year high. The refinancing gravy train has ended.

US 30yr mortgage rates spiked to a 2-year high on Friday (4.49%).

In the near term this spike may actually push some potential buyers who have been on the sidelines into purchasing a home. People are concerned that rates will rise even further, which may have the effect of increasing June/July sales (see this story).

The longer term effect however is less clear. While 4.5% is low by historical standards, it certainly takes a portion of the population out of the housing market. Also the speed of the rate spike may have a negative impact on consumer sentiment. Monthly payments on a new mortgage have increased by 10% from just a month ago (roughly $100/month for a median house price).

One thing we can be confident of is that the wave of mortgage refinancing is over. Consumers have been putting extra cash into their pockets by refinancing multiple times in recent years. That gravy train just ended.
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Friday, June 21, 2013

Fixed income party is over - for now

This has been one of the worst months for fixed income assets in years. Active investors are dumping bonds of all types. Here is what the performance looks like over a period of a month (through today).

A great deal of this selling has been forced by ETFs. Lower valuations force the exchange of shares for the underlying securities, which are then sold into the market. Mutual funds are losing capital as well. Firms like BlackRock (BLK) have had an amazing run in recent years (see discussion), but the party is over. BLK is down 11.5% over the past month.
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As social unrest escalates, Brazil investors flee

The wide-spread social unrest across Brazil continues.
The Guardian: - Brazil's president, Dilma Rousseff, and key ministers are to hold an emergency
meeting on Friday following a night of protests that saw Rio de Janeiro and dozens of other cities echo with percussion grenades and swirl with teargas as riot police scattered the biggest demonstrations in more than two decades.

The protests were sparked last week by opposition to rising bus fares, but they have spread rapidly to encompass a range of grievances, as was evident from the placards. "Stop corruption. Change Brazil"; "Halt evictions"; "Come to the street. It's the only place we don't pay taxes"; "Government failure to understand education will lead to revolution". Rousseff's office said she had cancelled a trip to Japan next week.
Many are asking how is it that this "economic miracle" has generated so much anger. As discussed earlier (see post), Brazil's tremendous growth combined with the wealth of natural resources masked a number of problems. Taxes and corruption are of course a big part of the issue. Allocation of certain resources to high profile projects at the expense of healthcare and education is another. But as has been the case throughout history, social unrest is often triggered by rising prices - particularly on items that the average citizen cares about.

Source: The NY Times

Active investors have become increasingly jittery (both foreign and domestic). The real has dropped to 2.25 per dollar and the stock market continues to tank (down 22% year-to-date). What's particularly alarming however is the sell-off in government bonds. Even the short end of the curve has not been spared. The one-year note yield just rose above 10%. The concerns seem to be less about the government's ability to repay as they are about currency devaluation. Whatever the case, this is a troubling development that has the potential of spreading across other economies. The global capital markets are now even more susceptible to contagion than they were in 1997 during the Asian financial crisis.

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Thursday, June 20, 2013

Correlation between equities and treasuries turns positive

The last time short term correlation between treasuries and US equities turned positive was at the beginning of Fed's QE2 in 2010. At the time both equities and treasuries rallied in anticipation of the new stimulus. Now we are back to positive correlation, except this time the reverse is taking place (at least in terms of expectations). Treasuries no longer provide the hedge for equities portfolios that the markets have become accustomed to (see discussion). It may take another crisis to send the correlation back into negative territory.
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Update on China's funding situation: throwing out the baby with the bath water

China's short-term rates have now spiked to double digits while the PBoC continues to ignore the problem.
Reuters: - The weighted-average one-day bond repurchase rate reached 13.1 percent On Thursday morning, the highest level since Reuters' historical data series began.

A severe liquidity squeeze has hit China's interbank money market since early June, but the People's Bank of China has declined to aid the market with aggressive fund injections.

More media outfits have picked up the story.
NY Times: - “China’s interbank market is basically frozen — much like credit markets froze in the United States right after Lehman failed," said Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management. "Rates are being quoted, but no transactions are taking place.”
Numerous theories continue to circulate around the PBoC's rationale for letting the situation worsen. The prime candidate of course is the central bank's desire to tighten the various shadow banking programs and speculative market activities in order to "accelerate reform".

There has also been a suggestion that some in the private sector have been trying to repatriate currency into dollars. And by injecting liquidity, the PBoC would suddenly weaken the renminbi, which they want to avoid. Doesn't sound like likely scenario, but worth bringing up.

The danger here is that many so-called "wealth management" programs that banks have been running, have longer dated maturities and are funded with short-term money. Tightening the supply of short term money will make it harder to run these programs but will also expose some financial institutions to bankruptcy and even a broader potential panic. This is not substantially different from longer dated structured credit bonds in the US funded by commercial paper (ABCP) or via repo (Lehman for example) in 2007. We all know how that turned out.
NY Times: - To some extent, this is fundamentally a Ponzi scheme," Xiao Gang, then the chairman of the Bank of China, wrote in an opinion column in China Daily last October, referring to the mismatch between the maturity of wealth management products and the loans they pay for. "The music may stop when investors lose confidence and reduce their buying or withdraw" from the products, he wrote. Mr. Xiao now serves as the chairman of the China Securities Regulatory Commission.
During periods of booming economy the nation could potentially withstand such a shock to the banking system. But as we learned this morning, China's manufacturing is contracting again. By hitting the shadow banking system, the PBoC is tightening credit across the board - throwing out the baby with the bath water.

Manufacturing PMI (source: Markit)

Let's hope China is prepared for its own version of the Great Recession.
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Like it or not, you too have exposure to emerging markets

We've received an e-mail recently with the following question (paraphrased):
"I am a US-based retail investor. I have no positions in emerging markets - why should I care about places like Brazil [discussed here] or China [discussed here]?"
Here are two reasons (among others) that should get you interested in the events taking place in emerging markets - particularly the BRIC nations:

1. BRIC nations have been buyers of massive amounts of US treasuries. As their growth slows down and current account surplus declines, so will their purchases of US treasuries. The other large buyer of US treasuries just announced yesterday that their buying days may be over some time next year. What do you think happens to US interest rates? Mortgage rates? Dividend stock valuations?

Source: Sandler O'Neill

2. Take a look at the US exports to BRIC nations over time as percentage to total exports. These nations' economic growth will have a direct and very real effect on US corporations (enjoy your CAT or BA shares while you can), jobs in the US, and the US economy as a whole.

Source: Bloomberg

So as an American investor, when you see the Indian rupee sell-off to record lows as panicked investors  move dollars out of the country (chart below), you should be concerned. Whether you like it or not, you have exposure to emerging markets.

USD/INR (Indian rupees per one dollar)
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Wednesday, June 19, 2013

China's central bank's inaction can have dire consequences - this is not a game

It is remarkable that China's central bank has been unable or unwilling to contain the spike in short-term rates, as the interbank liquidity squeeze continues. This is roughly the equivalent of the Fed not being able to control the fed funds rate. You can certainly have fluctuations, but within a couple of days a major central bank should be able to inject enough liquidity into the system to bring down rates - unless of course the central bank wants the rates higher.

Something is amiss here. China is risking a recession unless the PBoC can bring this under control. Both the repo and the SHIBOR rates have risen to new highs in the past few days.

Source: Reuters

1-week SHIBOR

Some have suggested that the PBoC is in fact trying to tighten liquidity in the financial system in order to put the brakes on the rapidly growing shadow banking sector (see discussion). While an admirable goal, creating a liquidity squeeze in the banking system and sending short term rates to multi-year highs is NOT the way to achieve that. This is especially scary in the face of an already "moderating" economic growth.
Reuters: - China's short-term funding costs surged on Wednesday, with the benchmark money market rate hitting a multi-year high, and authorities postponed the market's close by 30 minutes to give banks extra time to complete their borrowing.

The money market squeeze that began early this month has worsened this week, forcing banks and other financial institutions to trim non-essential businesses, such as wealth management and arbitrage, traders said.

That response may be welcomed by the central bank, which has adopted a hawkish stance towards market liquidity since May, partly to clamp down on an increase in risky shadow banking activities, traders said.
The interbank market decided to extend the trading time to 5 pm as many banks failed to obtain enough short-term money needed for business at the normal closing time of 4:30 pm, traders said.

Such trading extensions have occurred several times recently amid the acute squeeze, traders said. "Everybody is disappointed at the central bank's non-action," said a dealer at an Asian bank in Shanghai.
It's not clear if people fully appreciate the potential impact of this liquidity squeeze - including folks at the PBoC. This is not a game. These tight conditions and high rates over a longer period can easily derail lending activities across the country while potentially putting a number of financial institutions at risk and sending the economy into a tailspin. With the Eurozone still struggling in the aftermath of the crisis, let's see what a recession in China (12% of world's GDP) can do for global growth. Mr. Bernanke and company may need to go back to the drawing board very soon.
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Brazil feeling the heat: 3 reasons for the sell-off on Paulista Avenue

Continuing with the emerging markets underperformoance theme (see discussion), Brazil's stock market hit new post-recession lows today. We haven't seen the Bovespa index this low since the spring of 2009.

But Brazil's financial market correction is not limited to equities. The 10yr government bond yield rose to 11.43% today (chart below).


And the Brazilian Real (BRL) fell to 2.23 per dollar. As with equities, we haven't seen USD/BRL at these levels since the first half of 2009.

USD/BRL (Source: MarketWatch)

There are three key reasons for these violent market "adjustments".

1. Brazil's economy has been weakened by slowing global demand, particularly from China and the Eurozone. The nation's current account has been in the red for some time and is deteriorating.

The Economist: - FAILING to meet low expectations is becoming a habit for Brazil’s economy. Figures published on May 29th showed that in the first quarter of this year it grew by just 0.6% (2.4% annualised), well short of the recovery analysts had expected. For the first time in years the country is running a trade deficit. Its primary fiscal surplus (ie, before interest payments) is shrinking and government debt is growing. Other emerging economies are also cutting growth forecasts, as China slows and the euro zone slumps. But Brazil’s woes started earlier than most and seem to be home-grown. Inflation close to 6.5% despite low growth suggests domestic rigidities are the main problem, rather than weak foreign demand.
2. Brazil's economic weakness has generated a wave of social unrest. Over the past decade Brazil experienced tremendous growth, which ended up masking a number of structural and social issues. Now these issues are coming to the surface and spooking many investors.
Reuters: - After more than a week, the biggest series of protests to sweep Brazil in more than two decades continued in major capitals and moved into smaller cities. Focused at first in cities like Sao Paulo, Rio de Janeiro and the capital, Brasilia, demonstrations in more than 70 smaller cities were expected across the country on Thursday.

Wednesday's protests in Sao Paulo, the site of the most frequent marches, followed overnight demonstrations that led to looting and vandalism. Police arrested more than 63 people after protesters torched a police facility, tried to storm City Hall and broke windows and ransacked stores.
3. The Fed is now looking to slow the pace of massive amounts of stimulus being added to the system in the US each month.
Bernanke: - “If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,... We will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
As a result, rising rates have generated a broad "risk-off" market sentiment, with active investors dumping anything that feels risky. Brazil is high on that list.

When markets open across Asia and Europe tomorrow, expect to see some major adjustments among emerging markets in those areas as well. But Brazil, being squeezed from all sides, probably takes the cake for the worst financial markets turbulence among major emerging market economies - for now.
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