Europe finally agreed on a solution to the Greek question, sort of. European leaders persuaded banks holding Greek debt to accept 50% haircuts and have given banks until next June to raise capital. Banks will raise capital from private sources if they are able and from government sources, if necessary. This is not, we repeat not, a Greek default. Greece is not haircutting investors. European banks are voluntarily accepting a 50% haircut. Investors not agreeing to a voluntary haircut will receive 100% of par for their Greek debt at maturity, if Greece is solvent at the time. Among those NOT participating in the haircut is the IMF. The result is not a 50% reduction in debt for Greece, but according to sources on the street, something closer to 20%.
I mentioned earlier in this piece that this was sort of a final solution. We say sort of because there are details which need to be worked out. For instance, European officials agreed to expand the size of the EFSF to $1.4 trillion, but there are no details as to who is adding what capital to the program. Banks have been told to recapitalize, from private sources if possible and from government sources if necessary. Specifics of how banks may be able to receive public recapitalization and what restrictions may be put on such banks (dividend cuts, pay restrictions, core asset, etc.) have yet to be worked out. The way it stands is that banks which are unable to raise sufficient capital in the open market must first tap their national governments and only approach the EFSF as a last resort. Banks have until June 2012 to recapitalize. No word of what action might be taken, should a bank run into difficulties prior to raising sufficient capital.
The threat of contagion persists. It is possible that public pressure could force the governments of Portugal, Spain and Italy to request haircuts of some degree. Given the size of the Spanish and, especially, the Italian government bond market, even small haircuts to the sovereign debt issued by the European periphery’s two largest members could significantly affect banks and necessitate even more capital raising.
The EU did win not-specific support for the expansion of the EFSF from both Japan and China. China’s Premier Hu Jintao told Chinese television that he hoped measures taken in Europe will stabilize markets.
Which banks might need recapitalization? The Wall Street Journal reported that British and Irish banks will probably not need recapitalizations. However, banks in Germany, France and remaining periphery nations will probably need additional capital. Bloomberg News is reporting that French Banks BNP Paribas and Societe Generale (the two largest banks in France) are hastening cuts in their trading books (believed to be a combined $1.5 trillion, to avoid having to raise capital. French banks have already scaled back dollar-funded lending operations for items such as aircraft. Now BNP Paribas and Societe Generale are reluctantly shrinking their trading and derivative businesses. One European fund manager told Bloomberg News:
“It’s a striking sin of pride. They all want to keep their rankings, but French banks risk not having the necessary capitalization.”
European banks may find it increasingly difficult to shed assets at anything close to their fair values. As one London analyst told Bloomberg News:
“Everybody is trying to reduce risk-weighted assets as soon as possible. They’ve already all started, but they’ll probably find it harder than expected because the environment is clearly getting tougher.”
When a crowd tries to escape from a burning building via one door, some people get burned.
Already the holes in the deal are letting light in. For one, this does nothing for Greece. Oh sure, it reduces the country’s debt load for awhile, but unless Greece stops its profligate ways, its debt load will rise. However, since Greece can only obtain financing from the EU, it will default. It is nearly impossible for Greece to avoid a default. The contagion then spreads to Portugal. If it ever makes it as far as Italy, watch out. Italy has the third largest government bond market in the world. Just a10% haircut on Italian debt would cause turmoil among European banks.
Europe is a mess. Officials do not know how to pay for the “solution” or even or how the haircuts will be acknowledged. Meanwhile Europe hurtles toward recession. The rescue is nothing of the sort. Greece may end up leaving the euro (but not the EU) and devalue its way out of its mess. It is Greece’s only hope.
The bond markets are already telling us the bloom is off the Greek rose. Italy had to pay higher interest rates with its 10-year yield topping 6.00% on Friday. Spreads of periphery debt widened versus German bunds and money flowed back into U.S. treasuries.
I would advise investors not to be sucked in by stock jockey pundits and look at the situation for what it is. The periphery is an unsustainable mess. Common and preferred dividends are likely going away for awhile. If you must invest in Europe, be at a senior level on corporate capital structures. If not, invest in the U.S., at least we can keep printing money. :o
Sunday, October 30, 2011
Wednesday, October 19, 2011
Europe to Your Ears
Housing Starts rose more than expected on the strength of multi-family construction, such as apartments and condominiums as an increasing number of Americans choose renting over home purchases. This was the strongest read for multi-family construction since October 2008. Building Permits fell to a five-month low as a glut of existing homes, a backlog of foreclosures and real estate values, which continue to decline, weigh heavily on the home building industry. Moody’s analyst Aaron Smith told Bloomberg News prior to the report:
“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”
This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.
As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.
Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:
“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”
Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.
Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.
CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.
This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?
Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.
How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.
Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.
Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.
Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.
Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.
“Through the volatility, the trend in starts appears to have picked up, though the level is still historically low. Multifamily activity is trending higher as the shift from homeownership to renting boosts demand for rental units and brings down vacancy rates.”
This does little to help single family home owners who have seen their home values tumble from their bubble peaks. At the risk of sounding like a broken record (for those of you who remember records), housing cannot recover until the excess supply of homes is absorbed. Accomplishing this is becoming increasingly difficult as the U.S. economy seems to have hit cruising speed at a modest pace, lending standards remain tight (but closer to traditional standards) and changes to demographics have young adults choosing to rent in urban settings while eschewing the suburban McMansions of older generations.
As has been the case for the past several years, CPI has, to a large extent, decoupled from PPI as producers remain unable or unwilling to pass, or fully pass, price increase on to consumers. Inflation, as measured by CPI, increased at its slowest pace in three months. This lends credence to the Fed’s view that inflation pressures could moderate in the coming months. It is also a signal the businesses may be losing pricing power or are concerned that consumer demand may slacken and are working to maintain or increase their market share.
Core CPI MoM rose by the smallest amount (0.1%) since last March. Moody’s Senior Economist Ryan Sweet stated:
“Inflation is playing out according to the Fed’s script. The economy is sluggish and businesses are very hesitant to pass on higher input costs to consumers. Consumers are very price sensitive right now.”
Leading the way toward slower inflation were the biggest drop in clothing prices since 1998, lower prices for both new and used vehicles and the smallest increase in rents in four months.
Late yesterday, the markets were startled by a report by The Guardian newspaper that France and Germany had ostensibly agreed to a deal to infuse three-trillion euros into the EFSF as part of a solution to the European sovereign debt crisis. Shortly thereafter European officials, including German Chancellor Angela Merkel, refused to confirm that The Guardian’s story was accurate. However, information leaking out to the financial press indicates that The Guardian’s report may have an air of truth about it.
CNBC reported (yeah, we know it’s CNBC) that EU officials are close to a deal in which France and Germany would contribute three-trillion euros to the EFSF which would act as an insurance plan for banks. The plan would have banks take more aggressive haircuts on Greek debt (specifics were not given, but the prior haircut amount most recently discussed was 50%) and banks would recapitalize with private money instead of government funds, Investors would theoretically be comforted by the three-trillion euro insurance fund waiting in the wings should a bank need more capital or is unable to raise sufficient capital on its own from private sources.
This sounds encouraging. Indeed, the markets were encouraged when the possibility of the three-trillion insurance fund was announced late yesterday, but whether or not it works in practice remains to be seen. The question becomes: Will investors infuse capital in banks in which European governments do not have a stake with only an insurance fund sitting on the sidelines?
Such an approach was discussed in the U.S. in the fall of 2008. However, financial institutions needing to recapitalize only did so after the U.S. government bought a state in those troubled banks. In other words, investors wanted governments to have skin in the game before they committed their own capital.
How the banks are recapitalized carries implications for investors in preferreds issued by European banks. If banks can recapitalized without government (taxpayer) assistance, preferred dividends for those banks may continue unabated. However, banks needing direct government investments could be forced to suspend dividends as per last week’s suggestion by the European Commission. We favor large domestic banks over their European counterparts.
Will the proposed three-trillion euro insurance fund calm the markets and solve the European sovereign debt crisis? That question can only be answered by market participants. Not necessarily those who are currently moving the equity and fixed income markets, but by those who will decide whether or not to commit their capital in the form of common equity investments in European banks. One thing is for sure, European officials had better agree on a solution very soon as reports coming out of Greece today are pointing to a disorderly outcome in more ways than one.
Moody’s downgraded Spain by two notches to A1, and keeps it on negative outlook, citing vulnerabilities from high levels of debt in the Spanish banking and corporate sectors. Earlier on Tuesday, S&P downgraded 24 Italian banks and financial firms. Spanish media reports a new European bank stress test could apply haircuts of up to 20% on Spanish sovereign debt.
Speaking of banks, have readers looked past what appear to be encouraging headlines and really analyzed earnings? If you have, you would have noticed a recurring trend. The biggest profit gains have been from banks marking down their outstanding debt. This accepted accounting practice assumes banks could retire their outstanding public debt below par value or at a lower price than in the same quarter a year ago because it can be purchased at a discount or at lower prices in the open market. Of course the reason it is trading at a discount or lower prices from the same period a year ago is because current bank financing costs are higher, making such debt repurchases unlikely. Accounting gains are usually brushed aside by market participants. Another trend has been sharp declines in investment banking revenues as banks adjust to new financial regulations which nearly eliminate proprietary trading.
Although it is very unlikely that any of the large U.S. financial institutions have difficulty servicing their debts, the best values on a risk-to-reward basis may exist in the bonds issued by banks with large traditional banking businesses, as well as regional banks located outside the most troubled real estate markets. Subordinated notes issued by banks offer yields which rival many high yield bonds, but more moderate investors can pick up attractive yields in senior bank debt. The sweetest spot on the bank and finance credit curve is in the 5-year to 10-year range, but good values can be found in 15-year step ups and short-term buyers can find good value in bank debt in the two-year to three-year area of the curve. Also, $1,000 par senior notes offer better values than their long-term $25-par brethren, especially those with coupons below 7.00% which are unlikely to be called at their first scheduled call date, if ever.
Sunday, October 16, 2011
The Undead Economy
Recent economic data indicates that the economy is not quite dead. However, it is not quite alive either. Consumer spending picked up in August, but recent measures of consumer confidence indicate that consumers are remaining jittery. Home prices remain depressed and the existing neglected stock of homes decomposing in the field. The unemployment rate remains at a disturbing 9.1%, but that only counts people who applied for jobs during the past four weeks. The real unemployment / underemployment rate (the U6 report from the Labor Department) stands at 16.5%. Meanwhile policy makers point figures at one another and youthful protesters being encouraged by celebrities, who believe that they have earned their millions in a manner the deem to be respectable, to demonize people who have made large sums of money in other ways, and by political opportunists.
Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.
Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.
Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.
We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.
Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:
“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.
We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.
Meanwhile EU officials fiddle while Greece burns, but what the heck, the Greeks are fiddling faster than anyone. Defaults and hits to the banks are coming. Major capital raises and possible bank dividend cuts are coming. A European recession is on the way and emerging economies are beginning to slow. Unfortunately, the fiscal policy response has been embarrassingly poor. All we can come up with is tax the rich, more regulation, demonization and schemes to spend on big union infrastructure programs. It would be better to help boost the private sector by simplifying regulations and the tax code as well as changing forthcoming healthcare rules from an overreaching plan to ration care into a scheme to make care more affordable and therefore more available.
Meanwhile the Fed does what it can to keep money accessible and affordable. However, it cannot force firms and households to borrow and spend. The U.S economy will trudge along. This will have implications for the fixed income markets. Interest rate products (U.S. treasuries and Agency senior notes) will see yields fall. Some credit products, such as high grade bonds from the industrial, energy, telecom and utility sectors should see yields move lower with U.S. treasuries. However, high grade bank, finance and insurance bonds could see credit spreads widen and yields remain about where they are or even rise, somewhat. High yield is another story.
Higher benchmarks could mean higher yields in high grade corporate bonds. This could begin to pull investors up the credit quality scale. If sufficiently attractive returns are available in A-rated paper, investors may move up from BBB-rated bonds. BB investors may move to BBB and B and CCC investors may move to BB. The result could be significantly wider credit spreads for the very bottom of the high yield universe. Wider spreads and higher U.S. treasury benchmark yields could make it difficult, if not impossible for very-low-rated companies to refinance debt. As we said yesterday, the best risk versus reward values in high yield reside in BB-rated paper five years and shorter.
We have just experienced the best of the golden age for high yield debt. While there could be further upside for very-low-rated bonds in the near term, should the economy regain some traction while the Fed leaves policy very accommodative, your potential downside far outweighs your upside due to the current environment of low benchmark yields and relatively narrow credit spreads.
Although we have been vocal about the richness of the high yield markets for several months, we are not alone. Today’s Wall Street Journal “Credit Markets” column discusses high yield fund managers lightening up on their high yield corporate bond exposure:
“After riding a two-year rally in U.S. "junk" bonds, some high-yield bond-fund managers are looking elsewhere for returns.”
“Some fund managers said they are worried that U.S. companies selling below-investment-grade, or junk, bonds aren't compensating investors enough for the risk, especially as the economy slows. So, they are putting more money into other assets they consider better value and less risky, such as corporate debt in Europe or emerging markets, commercial mortgage-backed securities and convertible bonds.”
We would use caution when investing in the asset classes mentioned in the article (it is almost impossible for retail investors to invest in Commercial MBS) and European and EM debt are aggressive ideas, but even the fund managers believe that high yield corporates may be getting a little rich. Again, high yield bonds are most appropriate for aggressive investors and the best values on a risk versus reward basis tend to lie five years and in on the curve among BB-rated companies.
We have received questions regarding finding relative values in the preferred markets. Currently, preferreds are trading with tight spreads to bonds issued by respective companies. Investors may wish to consider swapping out of preferreds (which tend to have long maturities or are perpetual and are very subordinate on corporate capital structures) and consider purchasing bonds (particularly senior note, although there are attractive subordinate notes) in the 7-year to 15-year area of the curve. One can earn attractive returns, lower duration and, in most instances, climb several rungs on the capital structure.
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