China: Reaction or overreaction?

Posted by Gwen Robinson on Jan 27 10:22. 2 comments.

China’s credit-tightening moves continue to reverberate around the Asian region and further afield, despite some analysts’ views that the “China reaction” story is — well, an overreaction.

But “overreaction” More…

China’s credit-tightening moves continue to reverberate around the Asian region and further afield, despite some analysts’ views that the “China reaction” story is — well, an overreaction.

But “overreaction” is a hard word to say in Japanese.

This note from RBS Securities Japan on Tuesday sums up a widely-held view in Tokyo that responses to recent Japan-centric events, like the Bank of Japan’s monetary policy meeting and S&P’s switch to a negative outlook for the country, have been somewhat overshadowed by concerns about China:

JGBs REACT MORE TO CHINA THAN BoJ

Markets: Futures added 30 sen to 139.38. JGB market reversed its course in the afternoon primarily on sudden selloff in the Nikkei (-187ppts, or-1.8%) which was likely driven by further China credit tightening worries. The market traded very quietly in the morning, awaiting the BoJ MPM [monetary policy meeting]. However, the BoJ had limited impact. Instead, all attention was directed to weak equities…

And speaking of Japanese equities, this is from Reuters on Wednesday:

The benchmark Nikkei fell 73.20 points to 10,252.08, its lowest close since December 21. It fell 1.8 per cent the previous day, hurt as the yen rose broadly after China implemented a previously ordered increase in reserve requirements for some banks.

But some analysts take a very different view.

For example, a recent post on FT Alphaville about “China reaction overreaction” featured comments by Monument Securities’ Marc Ostwald on how the a small 4bps rise in the Chinese 3-month Bill rate to 1.36 per cent produced a much stronger reaction in offshore markets than onshore Chinese markets.

Ultimately, Ostwald says, this serves as a reminder that the “tail will not wag the dog in terms of PBoC rate policy, and therefore noisy Anglo Saxon market over reaction needs to be treated with care”.

Still, as Bloomberg reports on Wednesday, some big Chinese banks are moving firmly and speedily to halt lending — even as Reuters reports that ICBC, China’s biggest bank, confirmed on Wednesday that it would not halt new lending for now.

The big fear, though, as John Authers notes in Wednesday’s Short View column, is that the Chinese — not regional markets and investors — will overreact.

Given last year’s growth in Chinese bank loans, which roughly doubled, worries about a credit bubble seem reasonable — and credit-tightening measures would appear a good idea.

But if the Chinese do overreact amid growing bubble-phobia, they could inadvertently engineer a recession. And in light of Auther’s assertion that the “axis of worry” is now shifting to Asia, that would be all the region needs right now.

Related links:
Time for the tin hat? - FT Alphaville
That extra 8.20 (+50bps) in China – FT Alphaville
China seeks to curtail bank-lending binge – FT
China’s targeted lending policy - Money-supply

Hoenig the hawk

Posted by Paul Murphy on Jan 27 21:59. 1 comment.

As expected, the Fed’s zero rate strategy holds for now, but for the first time in a year there was a dissenting voter: Thomas M. Hoenig…

Statement (our emphasis):
Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. More…

As expected, the Fed’s zero rate strategy holds for now, but for the first time in a year there was a dissenting voter: Thomas M. Hoenig…

Statement (our emphasis):

Information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating. Household spending is expanding at a moderate rate but remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software appears to be picking up, but investment in structures is still contracting and employers remain reluctant to add to payrolls. Firms have brought inventory stocks into better alignment with sales. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. In order to promote a smooth transition in markets, the Committee is gradually slowing the pace of these purchases, and it anticipates that these transactions will be executed by the end of the first quarter. The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.

In light of improved functioning of financial markets, the Federal Reserve will be closing the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility on February 1, as previously announced. In addition, the temporary liquidity swap arrangements between the Federal Reserve and other central banks will expire on February 1. The Federal Reserve is in the process of winding down its Term Auction Facility: $50 billion in 28-day credit will be offered on February 8 and $25 billion in 28-day credit wil be offered at the final auction on March 8. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30 for loans backed by new-issue commercial mortgage-backed securities and March 31 for loans backed by all other types of collateral. The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted.

Related links:
Exit strategy – FT Alphaville
Federal Reserve warned on interest rates – FT

Port-ugal in the storm

Posted by Tracy Alloway on Jan 28 10:22. 11 comments.

Is Portugal the next of the porcine-acronym peripheral eurozone countries to send jitters through the market?

Like Greece, the Iberian nation has racked up its fair share of foreign investment in recent years. More…

Is Portugal the next of the porcine-acronym peripheral eurozone countries to send jitters through the market?

Like Greece, the Iberian nation has racked up its fair share of foreign investment in recent years. This chart, from Deutsche Bank’s fixed income team and focused on foreign bank holdings of Greek government debt, is worth reprising:

Portugal submitted a draft of its 2010 budget to parliament on Tuesday. The proposed fiscal-tightening was quite modest for the year, while the budget deficit for 2009 was revised from a previously estimated 8 per cent of GDP to a new estimate of 9.3 per cent. Ouch.

And the result — two warning shots from ratings agencies Fitch and Moody’s.

Fitch’s statement came out on Wednesday:

LISBON, Jan 27 (Reuters) – A downgrade for Portugal’s credit rating is “more likely than not” after its 2009 budget deficit was worse than expected, Fitch Ratings said on Wednesday, prompting the government to ask ratings agencies not to rush to judgement on any downgrade decisions.

With European financial markets weighed down by worries over how Greece can dig itself out of a funding crisis, investors are eyeing Portugal and the euro zone’s other heavily-indebted peripheral countries for signs of whether they could be next.

Douglas Renwick, associate director with Fitch Ratings told Reuters on Wednesday the agency maintains a negative outlook on the country’s credit ratings after the government put its 2009 deficit estimate at 9.3 percent of gross domestic product.

Moody’s statement, meanwhile, was released on Thursday morning.

And while the rating agency didn’t say anything explicit about a downgrade, they do have some interesting words on the debt affordability of a country like Portugal, as the eurozone’s economic recovery exposes discrepencies between members:

As other Eurozone members are likely to register more robust recoveries, there also is a risk that interest rates in the single currency area may rise faster than would be appropriate for Portugal. Given that the Portuguese government is no longer in the low-debt category and the challenges it faces ensuring sustained deficit reduction, the rating agency adds that higher interest costs also pose concerns about Portugal’s debt affordability going forward. Moody’s rating decisions for all countries are driven by this factor along with the rating agency’s assessment of debt reversibility and debt finance-ability.

“Finance-ability — at a cost — is not in question for the foreseeable future for a Eurozone country such as Portugal, or even for Greece, which is rated 3 notches lower at A2,” says Mr. Thomas. However, how far debt affordability will deteriorate and how reversible are questions that underlie the negative outlook on Portugal’s Aa2 rating. As a result, only a transparent and credible plan for deficit reduction will be sufficient to stabilise the rating where it currently stands.”

Related links:
If I had a pound, peseta, drachma or a deutsche-mark… – FT Alphaville
The sovereign debt premium – FT Alphaville
Can the eurozone survive economic recovery? – Martin Feldstein

Is negative convexity the new Bernanke conundrum?

Posted by Tracy Alloway on Jan 28 12:56. 5 comments.

Negative convexity is something which has been mentioned on this blog before.

It sounds dramatic, not to mention nerdy, but bear with us because it is something which is actually quite interesting — and something which is, More…

Negative convexity is something which has been mentioned on this blog before.

It sounds dramatic, not to mention nerdy, but bear with us because it is something which is actually quite interesting — and something which is, once again, rearing its head in connection with the Federal Reserve.

From Bruce Krasting:

The Atlanta Fed put out a report on the status of the Fed’s purchases of MBS. The report confirms that 91% of the anticipated $1.25 Trillion of paper has been bought. This leaves about $110b of buying power left for the Fed. There is only nine weeks left until the anticipated time that this program will end. This implies an average of only $10b of intervention per week. The most recent purchase was for $16B. Look for that weekly number to fall pretty quickly from now on.

Now look at the following graph. If you print this out and check with a ruler (I did) you will see that the lowest point on the brown shaded area is 1,200 and the upper band is at 2,400 (1,200 total). The legend states that brown are both Agency Bonds and MBS. From the report you get those numbers to be Bonds = $175B and MBS = $1.14T, for a total of $1.31T. Significantly higher ($110b) than you might have expected looking at the graph. There is a simple reason for the apparent discrepancy. It is called Negative Convexity.

Unlike most bonds, which have positive convexity, mortgage bonds are said to have negative convexity since since they tend not to rise in price as much as a normal bond as interest rates decrease.

That’s because in low-interest rate environments — like now — homeowners have a tendency to prepay their mortgages; refinancing them to take advantage of the lower rates. When this happens MBS investors get a return on principal faster than they expected and they’re left to reinvest in a lower yield environment.

The pre-payment rate for the Fed’s MBS portfolio is an unknown, but Krasting has asked a mortgage-rate type to give an estimate of how quickly he thinks the Fed’s portfolio might have been been shrinking due to those prepayments. Here’s what he got back:

From this professional you get a pretty good estimate of the prepay as being 10%. That would come to $110B. This estimate goes a long way toward explaining the discrepancy between what the Fed has purchased and what the principal balance is that they currently own.

Some thoughts on this phenomenon:

-My friend suggests that going forward the prepay could be as much as 20% PA. Well that would mean something in the order of $250B over the next year. That would, by itself, be a very deflationary force. It is too big a number. It would be happening at a very bad time. Pure economics would suggest that the supply of available mortgage credit would fall sharply as a result. The Fed does not need to do repos to suck up excess reserves. They just have to collect the prepays that are coming.

-If you buy into this you have to assume that the amount of prepays in the current month will be approximately $18b (1.1T * 20% / 12). The Fed is buying $16b a week or $64b a month. So in January the net is only $46B. Follow this dotted line and you will see that by early March the purchases net of prepays will be a negative number. This will be the starting date of the true reversal of the QE process. March is much sooner than people are thinking it will occur.

-The Fed will make Net purchases totaling $1.25T. But they will never have a portfolio of that amount. It has to be less. By the numbers they will end March with approximately 1.14 – 1.16 Trillion. And the portfolio will be shrinking by $20B per month thereafter.

This is a scary thought. This could well be the basis of a back door, Sneaky Pete “QE 2.0 Lite”. If the intention were to purchase and maintain a portfolio size of $1.25T they would have to make additional purchases of $100B and continue the buys on a monthly basis of approximately $20B. This would not be a change of policy (ahem). It would be refining and maintaining the existing policy.

We’re not sure about some of those assertions. But we do think the prepayment issue throws up another problem for the Fed — one very much closer to home.

If prepayments speed up in low-interest rate scenarios, the exact opposite happens in higher-interest rate or inflationary ones. Having snapped up some $1,250bn worth of MBS, the Fed could be left to finance a significant proportion of those mortgages at interest rates higher than their yield.

In other words, if interest rates were to increase, or inflation were to pick up, the Fed would still be financing those mortgages at a cost which exceeds the yield the central bank is earning on them.

Deutsche Bank analysts put it succinctly last year:

In other words, the Fed effectively has an asset-liability mismatch. This mismatch might diminish the Fed’s ability to control inflation in the long run, as it might have to keep creating money, even if the right policy would otherwise have been to shrink the money supply.

Related links:
Hoenig the hawk – FT Alphaville
Negative convexity at the Fed – FT Alphaville
The Fed’s asset-liability mismatch – FT Alphaville

Teun’s tightening tactics

Posted by Tracy Alloway on Jan 25 14:08. 2 comments.

Teun Draaisma’s latest is a veritable treatise of tightening threats.

In it, Morgan Stanley’s chief European strategist warns of the impending switch from stimulus-overload to stimulus-withdrawal — something he’s mentioned before but, More…

Teun Draaisma’s latest is a veritable treatise of tightening threats.

In it, Morgan Stanley’s chief European strategist warns of the impending switch from stimulus-overload to stimulus-withdrawal — something he’s mentioned before but, we guess, is imminently more imminent this time around:

Sell into strength, as authorities have switched from “all out stimulus” to “let’s start some stimulus withdrawal”. Tightening measures are coming in thick and fast around the world. We always thought that the start of tightening was not the first Fed rate hike, but could be many other things including higher taxes, less spending, more regulation, Chinese/Asian tightening, or Fed language change. Recent initiatives include Obama’s banking initiatives, and several Asian tightening measures. In the next few months this theme is set to intensify, and we expect positive payrolls, a Fed language change, and the start of QE withdrawal. This willingness of authorities to move away from crisis mode is an important change and means that the tightening phase in the broad sense of the word has now started. Thus, indeed, 2010 is shaping up to be like 1994 and 2004, as we expected. The start of tightening is hardly ever the end of the growth cycle, and normally the accompanying dip needs to be bought, but it typically is a serious double-digit dip lasting 2 quarters or more. The sector rotation has of course already started in October-2009 and is set to continue. As a result we move 2% from equities to bonds in our asset allocation, going to +5% cash, -2% UW equities, -3% UW bonds. We think short-term strength is quite possible, and we have not quite gotten an outright sell signal on our MTIs either, but the 6 month risk-reward of being long is worsening, and we recommend to sell into strength. Our 12 month MSCI Europe target of 1030 implies 6% downside.

The idea then is to get out of the cheap things — the kind of stuff we saw rally in the dash for trash — and switch into `strength,’ that is, high-quality, reliable-growth stocks, plus bonds and cash.

You can see the reasoning in the below charts.

We are, Draaisma says, on the verge of saying goodbye to the sweet spot, that happy place where recovering economic growth coincides with very loose fiscal and monetary policies, and about to enter that world of correction-inducing tightening:

Related links:
The defining feature of 2010 will be… – FT Alphaville
You are now leaving the Twilight Zone – FT Alphaville
Six months of the sweet spot, DB says – FT Alphaville

Big year for European sovereign bonds

Posted by Gwen Robinson on Jan 26 09:01. Comment.

With national deficits soaring around the world and the recent panic over Greece’s economic crisis, it has been clear for some time that 2010 is shaping up as a big year for sovereign bond issues.

Nowhere more so than in Europe. More…

With national deficits soaring around the world and the recent panic over Greece’s economic crisis, it has been clear for some time that 2010 is shaping up as a big year for sovereign bond issues.

Nowhere more so than in Europe.

Now, Fitch Ratings has put a figure on it, estimating in a new report that European states will need to borrow €2,200bn ($3,100bn) from capital markets this year to finance their budget deficits.

The projected borrowing is a 3.7 per cent increase on the €2,120bn raised in 2009, says Fitch, as governments continue to issue sovereign bonds and short-term bills.

This record issuance, in turn, will put pressure on public finances amid rising yields and volatility.

And, as Fitch notes, short-term sovereign debt issuance — which has to be rolled over once every three or six months — will raise refinancing risks for European governments, leaving them increasingly at the mercy of bond markets.

An expected surge in issuance of short-term Treasury bills in France, Germany, Spain and Portugal increases the market risk facing these countries — notably exposure to interest rate shocks, adds Fitch.

Overall, among Europe’s top issuers this year, France will be the biggest, raising an estimated €454bn. Then comes Italy at €393bn, Germany at €386bn and the UK at €279bn.

As a percentage of GDP, borrowing is expected to be the largest in Italy, Belgium, France and Ireland — at about 25 per cent.

The year is likely to see greater volatility as the liquidity premium enjoyed by sovereign issuers diminishes amid hastening recovery — and that, says Fitch, means a material risk of a rise in government funding costs as yields rise. The agency continues:

“Combined with concerns over the medium-term fiscal and inflation outlook, this will likely cause government bond yields to rise, potentially quite sharply.”

On the bright side, high-grade sovereigns are unlikely to have problems accessing markets, though they will have to pay higher rates, according to Fitch.

And separately, on another happy but related note: if there are any concerns about investor uptake for this tidal wave of European sovereign issues, just look to Greece.

As the FT reports on Tuesday:

International alarm over Greece’s debt crisis abated on Monday when investors flocked to buy the government’s first bond issue of the year, an indication that it may run into less trouble than anticipated in meeting its short-term financing needs.

Investors placed about €20bn ($28bn) in orders for the five-year, fixed-rate bond, four times more than the government had reckoned on. However, in a sign that Greece is being made to pay for years of fiscal profligacy, the bond carried a record high interest rate spread relative to the rate for German bonds, the eurozone’s benchmark.

The message seems to be, give them enough incentive and investors will overcome anything — even fear of a Greek implosion.

Related links:
The sovereign debt premium – FT Alphaville
D-day for Greece – FT Alphaville
That lack of Greek contagion - FT Alphaville
Eurozone shows its strength in a crisis – FT

S&P fires warning shot at Japan

Posted by Neil Hume on Jan 26 09:19. 1 comment.

Probably not a huge surprise, given the nation’s bloated finances but Tuesday’s threat by S&P to cut Japan’s credit rating unless it gets its house in order still makes for interesting reading. Especially in the UK, More…

Probably not a huge surprise, given the nation’s bloated finances but Tuesday’s threat by S&P to cut Japan’s credit rating unless it gets its house in order still makes for interesting reading. Especially in the UK, and particularly if you are a Conservative MP who expects to be in government after the next election.

The full statement from S&P, which sounds none-too-happy with Japan’s new budget consolidation plan.

Standard & Poor’s Ratings Services today revised to negative from stable its outlook on the ‘AA’ long-term rating on Japan. At the same time, we affirmed our ‘AA’ long-term and ‘A-1+’ short-term local and foreign currency sovereign credit ratings on Japan.

The outlook change reflects our view that the Japanese government’s diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures.

At a forecasted 100% of GDP at fiscal year-end March 31, 2010, Japan’s net general government debt burden is among the highest for rated sovereigns. Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than we had previously expected.

Combined with other social policies that are not likely to raise medium-term trend growth and with persistent deflationary pressures, we forecast that Japan’s net general government debt to GDP will peak at 115% of GDP over the next several years.

The affirmation of the ‘AA’ sovereign ratings on Japan rests on the country’s strong net external asset position, the yen’s status as a reserve currency, the financial system’s resiliency throughout the recent global recession, and the economy’s diversification.

We believe that these strengths will keep the government’s rating in the ‘AA’ category, even if further fiscal consolidation leads to a one notch downgrade. A strong net external asset position and the yen’s key international currency position provide ample external liquidity and good access to global capital markets.

Japan is the world’s largest net external creditor in absolute terms with projected net assets of an estimated 309% of current account receipts at the end of 2009. The country’s current gold and foreign exchange reserves of over US$1 trillion are second only to China’s. Standard & Poor’s expects Japan’s net external assets to rise further in the coming years due to continued current account surpluses.

The ratings on Japan could fall by one notch if economic data remain weak and measures to boost medium-term growth are not forthcoming, given the country’s high government debt burden and its weak demographic profile.

Standard & Poor’s will be looking for signs of government policy toward fiscal consolidation in the update of its medium-term fiscal plan, due to be released in the first half of 2010. Additional policy initiatives may also be revealed after the upper house elections in July. If on the other hand we conclude that government policies, either on the fiscal side or structural reform side, will moderate the government’s debt trajectory, the ratings could stabilize at the current levels.

The market reaction is so far muted. The yen has gained broadly this morning and that’s down to China’s decision to implement a planned increase in required reserves at some banks.

Related links:
Japan’s ratings outlook cut on lack of Hatoyama plan – Bloomberg
Japan’s JGB dilemmas – FT Alphaville
Japan’s godzillion-yen stimulus spree – FT Alphaville

That European funding problem, charted

Posted by Tracy Alloway on Jan 26 09:35. 4 comments.

Here’s the kernel of Fitch Ratings’ report on European government borrowing:

The thing to focus on here is really the green bit — the short-term debt — a lot of which rather exposes governments to things like interest rate shocks. More…

Here’s the kernel of Fitch Ratings’ report on European government borrowing:

The thing to focus on here is really the green bit — the short-term debt — a lot of which rather exposes governments to things like interest rate shocks. It’s also what’s responsible for pushing this year’s overall funding requirement, of €2,200bn, higher than 2009’s level of €2,120bn.

There’s a bit more detail on the short-term debt issue in the below table:

Remember that the short-term debt will need to be rolled over sometime this year, so immediate funding requirements for 2010 look heaviest in places like France, Germany and Italy.

Scariest of all — the Fitch estimates don’t take into account anything unexpected.

Things like, err, bank failures:

Note that for 2010, Fitch has assumed no below‐the‐line operations (eg bank recapitalisation) and no change in governments’ cash balances (eg no pre‐funding of future expenditure).

Full report in the Long Room.

Related links:
The sovereign debt premium – FT Alphaville
The sovereign ‘Northern Rock’ funding model – FT Alphaville
Treasury ΣTCHings – FT Alphaville

The sands of Greek bond issuance

Posted by Izabella Kaminska on Jan 26 10:15. Comment.

Greece’s new sovereign five-year issue received unexpectedly high demand in initial price talk on Monday.

The bond gets officially priced mid week, and on that matter Standard Chartered published an interesting view on Tuesday: More…

Greece’s new sovereign five-year issue received unexpectedly high demand in initial price talk on Monday.

The bond gets officially priced mid week, and on that matter Standard Chartered published an interesting view on Tuesday:

The large yield concession built in before the deal seems to be gradually contracting, but it is crucial for Greece to receive substantial demand for this deal, which is expected to be priced by mid-week (Tuesday or Wednesday).

Greece is not yet on the path to default; scenarios of imminent Greek default are based on rather unrealistic assumptions. True, Greece will have to issue close to EUR 50bn in 2010, but it still benefits from the relatively high average maturity of its debt – around eight years – which minimises rollover risk for now.

Duration, at 4.2 years, suggests some exposure to jumps in short-term rates, but large jumps are unlikely for now given the current European Central Bank (ECB) stance.

In other words, an emphasis on short-term debt over the past year has probably resulted in a cheap source of funding for Greece as the share of debt with an average maturity of less than one year increased. Were Greece to maintain its commitment and to implement the first steps of its ambitious SGP programme, we would expect the market reaction to be positive. It is clear, however, that nervousness towards sovereign issuers – especially those with low fiscal credibility – is increasing. While we remain long Greece vs. Bunds in the medium run, we expect the path to a narrower spread to be volatile.

In other words, despite Greece’s fiscal festering, in terms of timing in the bond markets, the country has played its hourglass rotations perfectly.

It’s what you might call the Goldilocks approach to issuance — not too long, not too short. Just right.

Related links:
The European funding problem, charted – FT Alphaville
A big year for European sovereign bonds – FT Alphaville
Austrian CDStrudel – FT Alphaville

Greed & Fear and David Stockman on where it all went wrong

Posted by Gwen Robinson on Jan 26 10:30. 3 comments.

CLSA’s Christopher Wood in an extra edition of his weekly Greed & Fear newsletter highlights a timely criticism of the US approach to fixing the financial system by David Stockman, Ronald Reagan’s former director of the Office of Management and Budget. More…

CLSA’s Christopher Wood in an extra edition of his weekly Greed & Fear newsletter highlights a timely criticism of the US approach to fixing the financial system by David Stockman, Ronald Reagan’s former director of the Office of Management and Budget.

In a harsh comment article originally published in the International Herald Tribune last week, Stockman lashes out at bankers, regulators – particularly the Fed – and just about everyone outside of the Reagan administration.

To be sure, says Stockman, “the most direct way to cure the banking system’s ills would be to return to a rational monetary policy based on sensible interest rates, an end to frantic monetisation of federal debt and a stable exchange value for the dollar”. He concludes:

But Ben Bernanke, the Fed chairman, and his posse are not likely to go there, believing as they do that central banking is about micromanaging aggregate demand — asset bubbles and a flagging dollar be damned. Still, there can be no doubt that taxing big bank liabilities will cause there to be less of them. And that’s a start.

Wood agrees with Stockman’s every word but quotes just two sentences.

“The US economy desperately needs less of our bloated, unproductive and increasingly parasitic banking system … The banking system has become an agent of destruction for the gross domestic product and of impoverishment for the middle class.”

As for the market consequences of Obama’s new policy initiative to curb banks’ size and activities:

“It has clearly increased the risk that the Wall Street correction begins before the S&P500 reaches the 1200 level”, notes Wood. Still, investors who want to hedge their long Asian and emerging market exposure should continue to remain underweight or short the large Western financial stocks, he adds.

While noting that some famous investors are long these stocks because of the easy profits now being generated by the significant steepening of yield curves, Wood remains bearish on these stocks in the medium term. He explains:

This is, first, because the yield curve is likely to flatten in due course when investors realise the recovery in the West is not normal and government bond yields, as a consequence, decline.

Second, he says, bulls on big bank stocks in America and Europe have been underestimating the regulatory reaction which is coming – “which at a very minimum is likely to mean structurally lower returns on equity. This is because they are experts on finance, not politics”.

Finally, just to show he is in crackingly cynical form, Wood concludes:

Remember that if something is too big to fail it is too big to exist. That is something Joe Sixpack can understand even it remains a point hard to grasp for the sophisticates in New York and Washington and the rest of the Davos Crowd.

Related links:
The background to the Volcker rule – FT Alphaville
‘Volcker rule’ takes bankers by surprise – FT
Obama and Wall Street in depth – FT

The trials of Papaconstantinou

Posted by Izabella Kaminska on Jan 26 10:46. 1 comment.

While Greece may have side-stepped immediate funding catastrophe with its successfully placed five-year bond issue, that’s not to say there aren’t further trials for the sovereign issuer down the road. More…

While Greece may have side-stepped immediate funding catastrophe with its successfully placed five-year bond issue, that’s not to say there aren’t further trials for the sovereign issuer down the road.

For example, here are some of the challenges facing Greek finance minister Georges Papaconstantinou in the not-too-distant future, according to Barclays Capital:

10 February: National strike. The strike’s intensity and politicians’ reactions may provide a first impression about the government’s ability to implement fiscal reforms.

16 February: EU Council officially reacts to Greece’s 2010 budget (after hearing assessments by EU Commission as well as ECB).

March: Greek Parliament to vote on Tax law and details of spending cuts.

April-June: EU assessment on Greece’s budget implementation and decision whether stricter recommendations (not yet “sanctions”) are taken under the “Excessive Deficit Procedure” (EDP). EU will undertake assessments on the implementation of fiscal measures very 3-6 months. In parallel, the Greek Treasury faces the first large redemptions of the year in April and May and is likely to issue in advance of these dates.

January 2011: ECB is expected to return to regular collateral procedure. This implies that Greece would need an A- rating from at least one of the agencies. Currently Moody’s has Greece still two notches above the critical threshold, but under negative outlook.

And if that wasn’t enough, here’s the decision labyrinth Papaconstantinou faces in terms of Greece’s fiscal adjustment, also courtesy of Barclays Capital:

Related links:
That European funding problem, charted – FT Alphaville
The sovereign debt premium – FT Alphaville
The sovereign ‘Northern Rock’ funding model – FT Alphaville
Treasury ΣTCHings – FT Alphaville

Chinese Decision on Rates Seen as ‘Turning Point’

By KEITH BRADSHER Jan. 7 (International Herald Tribune) -- HONG KONG — China’scentral bank raised a key interest rate slightly on Thursday forthe first time in nearly five months, a move that economistsinterpreted as the beginning of a broader move to tightenmonetary policy and forestall inflation.
After breaking stride a year ago during the global economicslowdown, the Chinese economy resumed galloping growth lastsummer. Government investments, real estate construction andconsumer spending are all rising briskly thanks to a surge inlending by government-controlled banks.
Even exports have begun to recover despite continuedeconomic weakness in the European Union and the United States,China’s two biggest overseas markets.
Raising interest rates may help discourage speculativeinvestments by Chinese companies and individuals in real estateand other realms. China’s dilemma is that higher rates may alsoprompt overseas investors to redouble their efforts to push moneyinto China despite the country’s stringent capital controls.
The People’s Bank of China announced Thursday that the yieldfrom its weekly sale of three-month central bank bills had inchedup to 1.3684 percent. The yield had been stuck at 1.362 percentsince August.
An increase of less than 0.05 of a percentage point mightsound small, but economists said it was a harbinger of furtherinterest rate increases to come. They cited expectations thatconsumer and producer prices will rise in the months ahead,particularly compared to low price levels a year ago, when demandslumped in China as well as the rest of the world.
“It is a turning point,” said Ben Simpfendorfer, aneconomist in the Hong Kong offices of the Royal Bank of Scotland.“There is a convergence of events that will lead to higherrates.” Central banks around the world have a history of takingsmall steps at first when they begin raising interest rates aftera long period of keeping rates low in response to an economicdownturn. Because China does not have a well-developed bondtrading market, the yields on weekly sales of central bank billsare widely watched as a barometer of the central bank’sintentions.
The central bank bills are mainly sold to banks, which payrenminbi that the central bank then effectively takes out ofcirculation.
Weekly sales of central bank bills are part of whateconomists describe as “sterilization” of China’s massivecurrency market intervention: The central bank prints vast sums of renminbi, issues them in exchange for dollars that go into theforeign exchange reserves, then claws back the renminbi from themarket through a series of measures that include the sale of central bank bills.
The goal of sterilization is to keep inflation under control in China while keeping the renminbi weak relative to other currencies. This helps keep exports competitive overseas andpreserve employment in China.
China’s foreign-exchange regulators have redoubled theirefforts in the past two months to prevent inflows of so-calledhot money — capital that moves on a short notice to any countryproviding better returns. Such funds often enter China inviolation at least of the spirit of the country’s foreignexchange controls, although not necessarily the letter of theregulations. With the exception of investments that bring the transfer ofscarce technologies or management expertise, China has adwindling need for foreign capital. A domestic savings rate ofclose to 40 percent has made ample money available for newprojects. The central bank is already buying over $300 billion a yearworth of foreign currencies, mainly U.S. dollars, to keep China’sown currency, the renminbi, weak against the dollar and preservethe formidable competitiveness of Chinese exports in foreignmarkets. So the central bank has had little appetite to buy evenmore foreign currency so as to allow foreigners to invest inChina’s growth while preventing the renminbi from appreciating.
Click here to see the story as it appeared on the New York Timesweb site.
Copyright 2010 The New York Times Company
-0- Jan/07/2010 11:00 GMT

BarCap’s funding findings

Posted by Tracy Alloway on Jan 05 12:18. 1 comment.

The last of our Barclays Capital’s European bank special is a funding finale.

This is, of course, something which has been mentioned before.

The withdrawal of cheap central bank liquidity, a wall of short-term debt that will need to be refinanced and the continued weakness in the securitisation market, More…

The last of our Barclays Capital’s European bank special is a funding finale.

This is, of course, something which has been mentioned before.

The withdrawal of cheap central bank liquidity, a wall of short-term debt that will need to be refinanced and the continued weakness in the securitisation market, mean it’s very much expected that banks will experience a hike in funding costs in the coming years.

And while BarCap sees the additional burden as “manageable” they are talking pretty big numbers:

Banks spent the last decade radically shortening the maturity profile of their senior unsecured bond funding – from around six years to nearer half that today. This runs against prudent management as well as forthcoming regulation. We estimate that in the next three years, c€850bn will need to be re-financed at longer, more expensive maturities. Massive central bank liquidity support (c€875bn in Europe) will also be progressively withdrawn and replaced by funding at higher commercial rates, adding to these pressures.

(For an illustration of the funding issue, click here to view a few of the Barclays charts).

The interesting point, which Barclays highlights. is the potential discrepancy between maturity profiles and funding costs of banks. To wit, the below chart, showing their estimate of banks’ residual bond maturity (that is, assuming they don’t issue any new ones):

You can see there’s a rather wide range, consequently producing some very different funding requirements.

BNP Paribas, for instance, has the second-longest maturity on its remaining bonds of nine years. That means, according to BarCap, that to replace the €16bn of maturing bonds over 2010-12 and to ensure a blended average maturity of 6.3 years requires the bank to issue new bonds with an average 5.2 years maturity.

By contrast, for SocGen, the residual maturity of its issued bonds is just one year, which means that replacing its €8.6bn of maturing bonds over the 2010-12 periods would require new issues to have a longer, more expensive, maturity of 8.8 years.

And that’s just the maturity, funding costs between weak and strong banks also vary significantly obviously. The difference between the 10 narrowest and 10 widest bank CDS spreads, for instance, is now at about 100bps. That’s lower than the 250bps it was at the height of the crisis, but still very much above its pre crisis norm of 10bps or so.

Overall, BarCap estimates an overall impact on post tax profits of €7bn, or about 6 per cent of its net profit forecast for 2012. But within that, the numbers vary very much by bank.

About a third (HSBC, NBG, Standard Chartered), for instance, see almost no impact, while another third (Bank of Ireland, Alpha Bank, BankInter, etc.) see their earnings impacted by over 15 per cent.

Back to BarCap:

That, we believe, is the key message. The forthcoming normalisation of funding is likely to result in a range of strategic and financial responses across the sector.

The good news is that quality is actually starting to count in the bank debt market:

At the same time, we will see greater divergence in bank funding costs than before . . . For the first time in more than a decade, there is a major strategic advantage from being a well funded, “strong” name in the debt market.

But ironically, at the potential expense of that other issue covered by BarCap on Tuesday — Too Big To Fail:

In practice, weaker banks don’t always need to accept higher funding costs: they can shrink. But that’s the point; weak banks will struggle to execute their strategic goals if they are unable to get sufficient funding at economical terms. This will only be accentuated as banks look to replace the c€875bn of central bank funding. Ironically, just as some of Europe’s biggest banks might be impacted by “too big to fail” regulations, those same large, wellfunded banks – HSBC, BNP Paribas, BBVA and the like – may well have the funding base that allows them to grow bigger at the expense of their weaker rivals.

Related links:
Banks don’t just have an asset problem, says Moody’s - FT Alphaville
Banks face hike in funding costs – FT
BarCap calculates the cost of `Too Big to Fail’ – FT Alphaville
BarCap’s `credit surprise’ snapback – FT Alphaville

BarCap’s ‘credit surprise’ snapback

Posted by Tracy Alloway on Jan 05 10:11. 3 comments.

A portion of Barclays Capital’s 351-page European bank bonanza published on Tuesday, discusses the possibility of a “credit quality surprise” in 2010. That is, a decline in the number of non-performing loans (NPL), More…

A portion of Barclays Capital’s 351-page European bank bonanza published on Tuesday, discusses the possibility of a “credit quality surprise” in 2010. That is, a decline in the number of non-performing loans (NPL), and subsequently, impairment charges taken by the region’s banks.

As the analysts, led by Simon Samuels and Mike Harrison, put it:

Reviewing the Q309 [European bank] results transcripts, the almost uniform view of management is that credit costs will “plateau” at these elevated levels. Yet that rarely happens. Since 1980 the average change each year in impairments provisions is +/-50% so “plateauing” is – at least statistically – unlikely.

So if 2010 doesn’t see impairments “plateau”, do they go up or down from here? Most of the early signs indicate a move down is more likely. Whilst non-performing loans (NPLs) are still rising, the pace of new formation has slowed sharply, from €35bn in Q209 down to €15bn in Q309. Driving this are signs of stabilisation in asset prices and a slowdown in the pace of increase in unemployment across Europe. Things are still getting worse, but at a noticeably slower pace. It is not clear if we are at a turning point, but we appear to be moving towards one.

But, when that turning point does eventually come, BarCap says, it will probably happen very quickly:

One thing that our analysis does make clear, however, is that when credit quality does finally start to improve, it rarely improves slowly. Analysing all recessions for all European banks since 1980 shows that – on average – one year after impairment losses have peaked they have fallen 45% and after two years they are down over 60%. If 2010 and 2011 were such “snap back” years, then the sector upgrade would be 80% and 20% respectively.

You can see this rather dramatic `snap back’ you can see in the below charts. The first shows impairment charges for Swedish banks, which peaked during the Swedish Banking Crisis in 1992 at circa 6 per cent, but then fell within two years to just 2 per cent. Within four years they were back down to pre-crisis levels.

The second, is from BarCap’s head of asset allocation, Tim Bond, who’s developed a predictive model for the US credit cycle (where, apparently, there’s more data available). It also forecasts a rather sharp snapback in terms of impairment charges for US banks post the current financial crisis:

So in sum, BarCap sees “a growing possibility that credit costs start to fall in 2010″. It’s also assessed the potential for such impairment reversals happening at European banks, identifying five that are “likely” or “might” see such a snapback. You can view the results here.

But, we should note, BarCap’s whole thesis comes with a rather large caveat:

However, risks remain; the IMF believes that European banks have been slow to recognise losses, residential asset prices in Europe remain very expensive relative to the (now corrected) US market and European banks – especially Swedish, Greek and Austrian – have meaningful exposure to several “Very High Risk” countries identified by the Bank for International Settlements (BIS). So whilst we recognise the potential for impairment losses to come down more than forecast, we also remain mindful of the potential for unexpected shocks. Ultimately, much will depend on the economic environment in 2010, but if economic surprises remain on the upside, so impairments could surprise on the downside, possibly meaningfully.

Related links:
BarCap calculates the cost of “Too Big Too Fail” – FT Alphaville
Banks’ coverage ratio capers, cont. – FT Alphaville
Spanish banking crises, then and now – FT Alphaville

BarCap calculates the cost of ‘Too Big Too Fail’

Posted by Tracy Alloway on Jan 05 09:24. 7 comments.

Barclays has done a number on European banks. On Tuesday morning it has published a full 351 pages worth of research, in six separate notes, as it started coverage of the sector with the team it poached from Citigroup. More…

Barclays has done a number on European banks. On Tuesday morning it has published a full 351 pages worth of research, in six separate notes, as it started coverage of the sector with the team it poached from Citigroup.

FT Alphaville will be picking out some highlights — to begin with, the notion of ‘Too Big Too Fail’ (TBTF).

Here’s what the BarCap analysts, led by Simon Samuels and Mike Harrison, say:

Banks have not always been this big. Indeed, as recently as 1990 none of the top 25 banks in the world boasted a balance sheet larger than their host country’s GDP (indeed, bar UBS, they were all less than one quarter of their host country GDP). By 2007 – on the eve of the financial crisis – this had totally changed . . .

Total balance sheet is not the only measure of size, but it is an important one. Eventually, if banks get too big, then national governments – as the ultimate guarantor of the system – lack credibility. This was exactly what happened to Iceland in 2008, and presumably would have happened to Ireland were it not a Eurozone member. Other measures – such as employment within financial services – show a similar pattern with the proportion of the working population in Europe employed in financial services rising from 10% in 1990 to 15% today. However sliced, banks have got bigger.

“So what?” you might ask. On one level, it is a perfectly reasonably question. It is not that long ago that the prevailing mantra was that bigger banks were safer. Moreover, there was hardly a detectable size-related pattern to the banks that “failed” in this crisis. Universal and narrow banks, large and small banks all ended up being rescued by either their governments or their competitors.

Whilst banks may have got bigger relative to the wider economy, it is not at all clear that bigger banks are more vulnerable. Indeed, to put the point another way – it could be argued that smaller, more narrowly defined institutions are more vulnerable to failure (see later).

That, however, misses the crucial point – namely that an industry that has been forced to rely to an unprecedented extent on its taxpayer base (capital injections for some banks, funding and funding guarantees for all banks) must expect those taxpayers in turn to demand widespread restructuring. The taxpayer cry is simple – “this must never happen again” . . . A number of major economies have either committed and/or distributed a significant percentage of their GDP as part of the rescue of the global banking sector. And it is for that reason that the debate over the cost to the taxpayer of failure – especially for those banks deemed TBTF – has now emerged.

And the TBTF response could take three forms, according to Barclays.

First, you could force banks to get smaller, though the analysts say a simple screening by size would not have predicted bank failures in the recent financial crisis.

Second, you could try to make banks “fail proof” by improving their solvency or liquidity (i.e. boosting their capital or requiring them to hold more liquid assets, be more self-funded, etc.).

Third, you could try to implement some sort of “controlled failure” procedure (the idea of living wills etc.).

Barclays’ biggest point though, is that regulatory proposals will be felt by banks deemed TBTF.

The BarCap analysts have accordingly come up with a list of 20 European banks they think could be considered TBTF by virtue of their size, interconnectedness or just identification by regulators as systemically important.

The results are below, click to enlarge.

In addition to identifying those 20 TBTF banks, Barclays also shows the impact of them having to carry additional regulatory capital above the sector average (currently Core Tier 1 of 8 per cent for 2011).

So for instance, if Allied Irish were to increase its Barclays-forecast 2011 Equity Tier 1 level of 3.3 per cent, to 5.3 per cent, it would need additional capital equivalent to a whopping 603 per cent of its current market value. Yowzers.

By contrast, banks like Credit Suisse and UBS would be relatively unaffected by such a measure, since they’ve already, in the words of BarCap, experienced a process of “massive deleveraging that the Swiss regulator has already forced upon them – which has taken their core capital ratios 400bps higher than the industry – precisely in recognition of their TBTF status.”

A point aptly summed up by the below chart (riffs of which, we’ve seen before):

Related links:
The problem is not TBTF, but TDTR - Naked Capitalism
All hail the Basel banking regime change – FT Alphaville
Banks too big to (excessively) bonus, FSA says – FT Alphaville

Sovereign debt crises 2010, an RBS sapling

Posted by Tracy Alloway on Jan 04 16:44. 3 comments.

What is the `Tree of Truth’?

According to RBS, it is a Binary Recursive Tree Approach aimed at selecting explanatory variables and critical threshold levels that best discriminate between sovereign debt crisis and non-sovereign debt crisis states. More…

What is the `Tree of Truth’?

According to RBS, it is a Binary Recursive Tree Approach aimed at selecting explanatory variables and critical threshold levels that best discriminate between sovereign debt crisis and non-sovereign debt crisis states.

In basic terms it’s a flow chart, showing which countries in Central Eastern Europe, the Middle East and Africa, the bank (using criteria from a 2005 IMF working paper by Nouriel Roubini and Paulo Manasse) thinks are potentially vulnerable to a sovereign debt crisis.

And RBS has just updated its Tree of Truth chart for 2010.

The result is below, click to enlarge.

If you want to compare and contrast with the 2009 version, created in June, the chart is here.

We can tell you that the model identified 14 economies at risk in 2010, compared with 13 for 2009. In the words of RBS’s CEEMEA specialists Tim Ash, Imran Ahmad and David Petit-Colin, that means that “… despite the general improvement in global sentiment, the analysis suggests a more lasting impact from problems faced by the global economy over the past year or so.”

Specifically, Hungary, having dropped off the list of vulnerable credits in CEEMEA in 2009, re-enters in 2010, along with Romania. Having added some new states to the model mix for 2010, RBS also identifies Bahrain, Iceland, Lebanon and the UAE as crisis-prone this year.

The majority of at-risk states are still, however, within emerging Europe.

Here are some select excerpts:

* The results are broadly in line with current market risk perceptions as in recent years Emerging Europe has generally suffered from wide current account deficits and excessive foreign borrowing and hence large external financing requirements/relative to FX reserve positions. Rigid exchange rate regimes, predominant through the region, add an extra vulnerability, suggesting a very hard landing for these economies, with pass thru to banking sectors via rising [nonperforming loans].

* None of the major EM economies in Asia and Latin America surveyed appear vulnerable to crisis as per the IMF definition/methodology. The latter two regions’ much better external financing positions, particularly reflect the maintenance of current account surpluses and relatively light external debt burden while the accumulation of healthy stocks of FX reserves during the “good years” provide an added degree of insulation.

* The analysis clearly has its limits as it only reveals “ability to pay”. As recent debt crises (e.g. Argentina and Ecuador) in Latin America and perhaps even Dubai in CEEMEA, in particular, have shown, “willingness to pay” is also critically important, but difficult to model. Countries could perhaps use the “cover” of the global crisis to manage their external liabilities lower by restructuring liabilities.

Full paper in the usual place.

(H/T the FT’s Chris Flood)

Related links:
`Rules of Thumb’ for Sovereign Debt Crises - IMF working paper
Moody’s sees sovereign states a suffering – FT Alphaville

MergerMarket’s M&A rankings

Posted by Paul Murphy on Jan 04 16:35. Comment.

Investment banks like these things — and when the latest deal league tables show Goldman Sachs being knocked off the top spot by Morgan Stanley we can treat it as bona fide news.

From MergerMarket, More…

Investment banks like these things — and when the latest deal league tables show Goldman Sachs being knocked off the top spot by Morgan Stanley we can treat it as bona fide news.

From MergerMarket, an FT sister company…

We should add, however, that MOST only head the 2009 list because of this…

The full 37 page Mergermarket report can be found here.

Related links:
Brief respite from brickbats – Reuters DealZone

Delinquent CMBS, the `C’ stands for climbing

Posted by Tracy Alloway on Jan 04 15:43. Comment.

Behold, what looks to be the biggest monthly increase in delinquent CMBS in 2009 (so far).

Realpoint has released its CMBS delinquency report for November 2009.

With the exception of June 2009, More…

Behold, what looks to be the biggest monthly increase in delinquent CMBS in 2009 (so far).

Realpoint has released its CMBS delinquency report for November 2009.

With the exception of June 2009, when the temporary late payment status of some General Growth Property loans helped push total delinquent CMBS to $28.85bn, it looks like November saw the biggest monthly gain over the last year — rising $5.38bn to $37.93bn.

That’s a delinquency rate of 4.706 per cent, up from the 4.013 per cent posted in October.

About $3.5bn of that increase was caused by a single loan — the Extended Stay Hotel LLC loan from the WBC07ESH transaction. Still, the ratings agency expects that loan to continue to be delinquent “in the near-term” and thinks the overall delinquency rate will rise to between 5 and 6 per cent in Q1 2010.

The good news though: Realpoint thinks the various government programmes put in place to bolster the commercial real estate sector (the Talf, CRE loan workouts, etc.) might yet make an impact:

On the other hand, as three new issue deals have closed in the past two months and more new issuance is expected to come to market in 2010, some of the delinquency growth we have experienced month-over-month in 2009 may yet be offset somewhat by any new issuance’s speed to market in 2010. In addition, liquidations of severely distressed defaulted loans have picked up speed in the latter half of 2009, while modifications and forbearance at the loan level continue to be discussed between borrowers and special servicers that may also result in a delinquency “leveling-off” period.

Related links:
US CMBS delinquencies hit 4.5 per cent, Moody’s says – FT Alphaville
All roads lead to retranching in CRE crunch – FT Alphaville