Over There

Fitch announced it was downgrading the hybrid securities (preferreds) of eight European financial institutions. They are:

Lloyds Banking Group Plc, Royal Bank of Scotland Group Plc, ING Groep NV, Dexia Group, ABN Amro Holding NV, SNS Bank, Fortis Bank Nederland, and France's BPCE

The reason for the downgrade is that European regulators may order the aforementioned institutions to halt dividend payments. The European Commission has ordered Bayerische Landes Bank and Anglo-Irish bank to halt dividend payments for because the received assistance.

These actions should not come as a complete surprise to my readers. On March 28, 2009 I wrote the following:

"Following my piece on foreign bank leverage, a reader responded with information that a certain German bank had leverage of over 50 time as of last autumn. I have heard similar stories about a number of European institutions, but have been unable to verify actual numbers. I am often asked about other shoes to drop. One large shoe could be the European banks. That may be a sector that all but speculative investors should avoid."


However, I am ashamed of my actions in recent weeks. During the course of my professional duties, I have taken many buy orders from financial advisers for preferreds issued by ING, RBS and ABN AMRO. In the past I would have warned advisers against such purchases. However, I have been pressured by my superiors not to express an official opinion on such matters. Thanks to my management, many advisers and their clients purchased these preferreds not knowing that they were still in danger or believed them too big to not pay dividends. All banks still owing money to their respective government's are in jeopardy of not paying dividends.

It's Just Another Day

After yesterday's weaker than expected 10-year auction I was wondering if foreign investors were losing their taste for long-dated treasuries. Then I began to think (always dangerous thing). The auction took place prior to the FOMC statement, a statement in which the Fed stated that inflation is expected to remain subdued. If the Fed had made its statement before the 10-year auction it is quite possible that the auction would have attracted more interest.

Another factor which encouraged investors to extend out on the curve were today's poor Initial Jobless Claims and Advance Retail Sales reports. Backing out the Cash for Clunkers influenced auto sales data and retail sales fell 0.6%. Even with the help of gasoline sales, retail sales came in at -0.4%. No one has yet explained to me how the consumer (who has accounted for 70% of U.S. economic activity) is going to lift this economy off of the financial ocean floor without jobs and without irresponsible leverage and lending practices? The answer is that the consumer is not leading us out of this. Slow positive growth will settle in once the benefits of inventory replacement is over.


Better late than never Mr. Gross. Pimco announced that is sees value in bonds in the utility, large bank and finance and energy sectors. This means that PIMCO has already acted and has gone long these sectors. Fund managers always tell you what to do after they have acted for their clients. I have been advocating such bonds for months.

Bloomberg News reported:

Yield premiums have now returned to about what they were before the collapse of Lehman Brothers Holdings Inc. in September, Curtis A. Mewbourne, a managing director and portfolio manager at Newport Beach, California-based Pimco, said in a research report today. While systemic risk has subsided and investors have re-entered the market, economic and business conditions are "significantly worse" than in the third quarter of last year, Mewbourne said.

Mr Mewbourne went on to say: "Yield spreads for high-quality investment grade corporate bonds are still wide relative to historical levels, and we think attractive risk-adjusted value still exists in certain areas of this market," he said. "There is a clear disconnect between financial markets and underlying fundamentals."

I would agree with that but would caution investors against expecting financial sector bonds from moving much tighter than the widest of their historical spread ranges. I would also caution against expecting spreads tightening anywhere near levels seen during the middle of the past decade. Increased debt loads, softer earnings and more cautious investors will keep spreads somewhat wide, but somewhat more narrow than today's levels.

Curve Balls and Change-Ups

I stand corrected. The 10-year auction was weaker than expected. Concerns about the deficit, $15 billion of 30-year bonds coming due tomorrow and a very strong 3-year note auction were the culprits. Keep mind however, at $23 billion, this was the largest 10-year auction ever.



Fed Funds rate was unchanged. The Fed sees conditions warranting excessive policy continuing, but a leveling off and stabilization of conditions. It sees modest growth (because of inventory replacement) and resource slack keeping inflation under control. Fed will purchase up to a total of 1.25 trillion Agency MBS and $200 billion agency debt by year end. The FOMC stated that it could end treasury purchases as soon as October.

The reality is that the Fed sees what most of us see. The worst is probably over, there will be a pop to economic growth, but that is a correction on the downside overshoot. Growth that follows will be below historic levels (probably 1.5% to 2.0% area).

What will happen to treasury yields. As I have said for some time, they will move gradually and modestly higher. Growth, debt issuance and dollar printing will force long-term interest rates higher. Foreign investors will moderate the pace and extent of long-term interest rate rise, but not prevent it from happening. Economic growth will be slower than what has been typical in recent cycles as the consumer cannot return to previous spending levels with out a return to prior, irresponsible levels of leverage.

One must now look at the corporate bond and preferred markets. Sectors such as industrials, telecom and utilities may be fairly valued spread wise. This means that their yields could follow treasury yields higher. In the financial arena, the large ex-TARP banks are almost fairly valued. Their bonds and preferreds should be purchased for income. The weaker large banks are also fairly valued given their glow-in-the-dark assets. The best preferred values lie in National City (guaranteed by PNC) and Countrywide (guaranteed by BAC). Note: Merrill trust preferreds ARE NOT guaranteed by BAC. High yield bonds are fairly to over valued given fundamentals and projected defaults.

Fixed income investors should continue to ladder or barbell. Ladders should oveweight the belly of the curve while barbells should overweight the short end of the curve. Neither barbells nor ladders should extend past the 10-year area of the curve.

What to buy:

CDs are offer the best values on the very short part of the curve, callable agency bonds two to five years out and large bank and finance bonds from five to ten years out.

Strange Days Indeed

It is a strange day indeed when I agree with strategist Dick Bove', but it happened today. Mr. Bove', formerly of Ladenburg Thalmann, formerly of Punk Ziegel and now of Rochdale stunned the markets when he announced that bank stocks have not risen on substance and that will not do better in the second half of 2009. In fact, he later told Larry Kudlow that most banks, including some very large banks, will probably lose money in the second half of 2009.

This is big news because Mr. Bove' has been a bank cheerleader, specifically singing the praises of a bank which is now essentially nationalized. However, just when I thought Mr. Bove had returned to reality, he told Larry Kudlow that that his favorite bank pick was the one which is a ward of the state and has memoranda of understanding with both the Comptroller of the Currency and the FDIC (which mean that the bank;s management can't do much more than order lunch without the approval of its regulators.

Here is a bit of news for you all. If you really looked (I mean really looked) at the assets which are on the books of the two largest, most troubled banks, you would faint from the shock of how bad they are. In fact, if not for the government, one large bank would not be here. Some argue that with a steep yield curve and nearly 0.00% short term borrowing rates, banks can make money. They can, if they have enough qualified customers needing credit. Unfortunately, the demand for credit from those who should receive credit is not great enough for some banks to earn enough to offset the constant drain caused buy assets which rival Chernobyl in terms of radioactivity. So much for mark to market reform. Most toxic assets are held on balance sheets in the form of loans, not securities. Loans are not subject to marking to market when on bank balance sheets. Many, if not most, toxic loans on bank balance sheets have been marked little if at all.

I had previously warned the those looking for foreign investors to abandon U.S. treasuries that foreign central banks are committed to investing in dollars. Today's three-year treasury note auction was for a record $37B with record interest from foreign central banks. Expect strong foreign demand from foreign central banks in tomorrow's 10-year note auction and Thursday's 30-year bond auction.

I expect no surprises in tomorrows FOMC statement. It is status quo for now.

Foreigner

The market is firmly focused on this weeks U.S. treasury auctions and the FOMC meeting. Prices of U.S. treasuries rallied today on speculation that long-term bond yields have risen too far, too fast considering it is unlikely that the economy will generate inflationary pressures to warrant significantly higher long-term interest rates. The market is looking to this week's auctions and the FOMC statement for guidance.

Market participants were mostly in agreement that this week's 10-year treasury note and 30-year government bond auctions will be well-received by foreign investors. As I have stated before, foreign central banks and producers have a vested interest in buying treasuries. First: They want to support the dollar to keep their home currencies relatively week to make their goods affordable in the U.S. They also wish to keep our long-term borrowing costs low. I do not think that they will abandon the dollar any time soon.

This does not mean that long-term yields will never rise or that the dollar will not weaken. Both will happen to some extent. This makes U.S. companies with export potential attractive. The last time the dollar weakened, companies such as Caterpillar experienced rising overseas sales. If you think that developing countries will eventually be purchasing equipment to build modern infrastructure or improving agriculture, companies such as Cat and Deere could do well.

The U.S. consumer is likely to be less active than in recent recoveries. It could be U.S exports which help lead us out of the "Great Recession".

Note: I am on vacation next week. I will be publishing sporadically (if at all) for the next two weeks. Feel free to leave a message on this blog if you need assistance.

Turn and Turn and Turn

Today's employment data truly exhibited some encouraging signs. The unemployment rate unexpectedly declined to 9.4% from 9.5%. Average weekly hours came higher at 33.1 hours versus a prior 33.0. This was due to businesses replenishing depleted inventories and the restarting of shuttered auto plants (which made the numbers look better than what they were). Is this the beginning of the end? Probably not, but it could be the end of the beginning.

What should we expect over the next twelve months? The next two quarters should exhibit positive GDP growth as businesses rebuild their inventories. However, when that is over, we could see GDP flat line or remain moderately positive. Why won't it go straight up? A good portion of consumers will remain on the sideline. Actually, before the days of easy credit, these consumers had been on the sidelines. Economic growth cannot return to levels seen during the last bubble if a quarter of consumers are not consuming much above subsistence levels.

Is there a way to get these consumers back in the game? Yes, but that may do more harm than good in the long run. One way is to make credit available in way which is similar to what was done during the housing bubble. That is probably not a good idea. The other way is to increase employment. However, unless employment growth is due to fundamental economic expansion, the gain will be short-lived (I.E. the tech bubble). Government hiring won't do the trick either as that would result in higher taxes. Essentially, money would be taken from one consumer, in the form of taxes, and given to another consumer in the form of wages, but it is a zero-sum game. Worse even, it could result in two consumers being able to purchase inexpensive or small-ticket items instead of higher-priced, big ticket items. Last time I checked, the U.S. economy was more dependent on the sale of big-ticket items.

Growth will come, but we all need to manage our expectations. What we have here is what I call the great correction. Since the Paul Volker Fed, we have had shallow, short-lived recessions as the economy recovered from the malaise and policy mistakes of the 1960s and 1970s. With the Fed having to resort to quantitative easing and lending practices returning to more prudent standards that correction is done. Barring poor economic policy or mass insanity among lending officers, the U.S. economy should begin a gradual march higher, but don't discount the poor policy or insanity scenarios.

Assuming that prudence and sanity prevail, what will keep growth modest? Higher taxes (they are coming), anti-business legislation (it is being mentioned) and higher interest rates. The latter is inevitable. That will make credit more expensive for those who can still qualify for loans. This should not discourage investors from participating in the markets. However, investors should manage expectations. With some exceptions, companies which provide goods and services that people need will be better investments than those which provide goods and services that people want.

There is an interesting development happening in the fixed income markets. Now that credit spreads have tightened, retail investors are pouring money into preferred securities. What they may not realize is that preferred credit spreads to benchmark treasuries are approaching or have reached their historical range versus treasuries. Many of preferreds, especially those of high quality telecom and utility companies and banks which have paid or are about to repay TARP funds will follow long-term interest rates in almost lock-step fashion. This means that more price depreciation may be on the horizon. If you own a preferred trading over $26, sell it. Its call feature will prevent it from rising much farther. Also, remember that a company only calls in a preferred or bond when it is economically advantageous for them to do so. This means that it is done when it is economically disadvantageous for investors. LIBOR-based floating rate preferreds may present opportunities, but remember that they perform best when the yield curve flattens. This is due to their short-term coupon reset benchmarks (LIBOR) and their long-term trading benchmarks (long-dated U.S. treasuries.

Back In Black

Most of my posts during the past several months have had a decidedly negative tone. All the while, the equity markets have rallied and corporate bond credit spreads have narrowed. It has been difficult being a curmudgeon during this time of euphoria, but as with all periods of euphoria, investors and pundits can become overly exuberant, sometimes irrationally so.

Let's look at corporate profits. In many instances they have been better than expected. However, the profits have been by and large the result of cost cutting, not increased business activities.

What about smaller job losses as measured by the Non-farm Payrolls report and falling jobless claims. Job losses are declining because we are approaching the "right-sized" number of workers for current and expected levels of economic activity. After all, businesses cannot fire everyone. Employers are running out of workers to lay off. The same is true about jobless claims. Initial claims are falling (but disturbingly high) and continuing claims remain over 6 million. This is not a sign of recovery. Reductions in firings is not a sign of an employment recovery when the unemployment rate is approaching 10% (and should blow through it in the near future). The economic bubble was so large that jobs were created which fundamentally should not have existed. There lies the rub.

Bulls are waiting for banks to lend and credit to be freed up. I cannot believe that so many smart people do not understand lending in the United States. Approximately 70% of all lending in the U.S. is done via securitization.

Securitization has been impaired compared with what was the norm for the 10 years ending 2006. However, what these young raging bulls have to realize is that the lax lending standards and easy leverage of the early part of this decade was the exception, not the rule. It was unsustainable. Securitization still takes place. However, that usually requires GSE backing of the mortgage security, full disclosure of the quality of the underlying assets or higher yields for taking on the risk.

The result is that those borrowers with good credit, a comprehensive credit history and documented income which indicated the ability to repay the loan can get credit. What is so bad about that? The problem is that, since the popping of the tech bubble (and to some extent during the tech bubble), the U.S. economy and businesses have adapted to the levels of economic activity which can only be generated by a system of fog a mirror and get a loan. Those days are gone, at least for the next five or ten years as current investors have long memories and it takes five or ten years to get enough new players who do not know the past, but think the know everything being recently out of school.

We should all expect GDP to stabilize and even grow during the coming six to nine months as businesses replace inventories which had been permitted to deplete as cautious executives held back production while waiting for the economy to bottom. By next year, I think GDP growth will settle in at between 1.00% and 2.00%.

Tighter lending standards and slower growth spell trouble for Detroit automakers once the Cash for Clunkers program ends. I seriously doubt that GM and Chrysler can survive without more government help and / or shifting some production (especially smaller vehicles) overseas or at least to non-UAW plants in the American South.

Bank profits will decline once the profitable carry trade afforded by the steep yield curve disappears when the Fed begins raising short-term borrowing costs, thereby flattening the yield curve.

The companies which will do best from an investing standpoint will be telecom, utilities, consumer staples, discount retailers and cutting edge (only) consumer electronics). Housing will suck wind and large distressed banks could still be broken up, especially if the FDIC (Sheila Bair) becomes the dominant bank regulator.


I also publish articles on Seeking Alpha under the nom de plum Bernard Thomas.