By Simon Grey, on January 18th, 2012
Now, with the property worth roughly $60,000 less than the balance of their mortgage, Martin, 68, has been giving serious thought to just walking away, a process lenders call “strategic default.”
“Guilt and morality are one side, and objective financial analysis are on the other side,” Martin said. “They’re coming to two opposite conclusions. I wonder how many other people are struggling with the same question.” [Emphasis added.]
Actually, there is nothing at all immoral about walking away from an underwater mortgage. Yes, people (particularly Christians) are generally morally bound to pay their debts. But here’s the thing: If you default, your debts will be paid.
In a general mortgage agreement, the borrower agrees to borrow a certain amount of money at a specified price (called interest) from a lender. Since houses tend to be expensive, lenders don’t generally give out unsecured loans; in fact, lenders generally demand some type of security—also known as collateral—to secure the loan. In general, a mortgage is secured by the property being purchased with the mortgage.
This means that if a borrower misses a specified number of payments (known as default), the lender has the right to confiscate the property pledged as security as compensation for the loan. Stated another way, if you default on your loan, your lender will confiscate your pledged property. In essence, by confiscating your property, your debt is considered paid in full by the lender. You therefore owe the lender nothing, for the lender has stated, per the terms of the contract, that ownership of property offered as security will suffice as repayment in lieu of currency.
That the lender may take a loss on the loan is the concern solely of the lender. The lender has a moral responsibility to do due diligence on each loan, in order to maximize profit. If a lender fails to anticipate a declining housing market, that is his own problem. If a lender fails to anticipate high inflation, that is also his own problem. The borrower is not responsible for ensuring the lender’s profits, the lender is. If the lender is a fool, it is not the borrower’s job to save the lender from his foolishness.
As such, it is not inherently immoral to walk away from an underwater loan. If the lender contractually accepts the property used as security as sufficient for repayment, then there is no problem with using that property to repay the loan. The only question the borrower has to ask himself is which payment method is cheaper—cash or property—and act accordingly.
Note: obviously, this is a general moral guideline, not specific legal advice. Treat it as such. If you are considering a strategic default, consult with an attorney first.
By Claus Vistesen, on January 5th, 2012
One point that I have been shouting from the proverbial roof tops in my research, to partners and colleagues is that 2012 may well be the year when all major central banks will be conducting both conventional and unconventional monetary easing at the same time. I think this is a very strong testament not only to the severity of the ongoing debt crisis in the developed world, but also to the propensity of central banks to choose inflation as the desired route to recovery. We need not initially discuss whether they are deploying the proper set of policies or even whether such policies represent moral hazard or a ponzi scheme on government debt.
The main thing is to realise that this is an unprecedented global monetary experiment.
My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won’t work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy.
In so far as goes the idea that an investors’ interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. I believe that
From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time.
Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below).
750 Billion USD, and counting …
Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.
In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe’s banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.
Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?
Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.
The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history.
While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.
I base this on two points.
- The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.
- ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.
The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons. When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.
I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.
As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012 as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.
The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular).
Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.
John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds.
Well the Euro fix is in. Whether it works – that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.
I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this.
The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010.
Quote Reuters
The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB’s overnight deposit account.
The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won’t act as a drag on their respective sovereign’s balance sheet as long as the ECB is involved.
I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank.
Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10.
However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out.
Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn’t assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day.
This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign’s banks and postponing the day of reckoning which is bank failures or nationalisation or both.
If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won’t be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds.
But Edward makes another interesting point;
Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.
(…)
Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.
It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little.
The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.
In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB’s balance sheet and, quite possibly, Fed’s USD swap lines.
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(1) – Even if such purchases have been fully sterilised.
By Christopher Briem, on December 28th, 2011
So to admit upfront, this is all parasitic on some neat reporting from Bloomberg out on the Analytic Journalism frontier. They have acquired and made available to the public (which means they want us to use it right?) data as they describe “Once secret ” from the Federal Reserve on its lending to major banks during during the peak of the financial crisis.
As they describe it in detail the data:
The data reflect lending from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, the Term Auction Facility, the Term Securities Lending Facility, the discount window and single-tranche open market operations, or ST OMO.
Got that? I have pulled the files for PNC and National City which now are one of course. Some may recall there was a certain bit of angst up the Turnpike that for some reason National City was denied TARP funding that might have kept it around a bit longer. The PNC takeover followed immediately on the heels of the government’s denial of TARP dollars. Some thought it a bit less than fair since along the way PNC used some of the same money to implement the takeover.
Well.. if there is any doubt over the flawed logic of a straight one on one comparison of the financial situation of the two banks at the time, here is what the Bloomberg data has for Fed lending to the two institutions as a percentage of their market capitalizations day by day.
Yes at one point near the end, Fed lending to National City well exceeded its market capitalization. PNC’s lending looked to be in itinerant blocks of a billlion. I am speculating completely when I wonder if that was $ pushed by the Fed as it wanted to shore up confidence in the system.. not really money desperately needed by PNC at the time.
By Bron Suchecki, on December 14th, 2011
If Tom from Metal Augmentor keeps on putting out great stuff like this post on negative lease rates, then I’ll be out of a (blogging) job.
It is heavy going but a comprehensive discussion of the issue with a dramatic speculation that “The selective collateral nature of the tri-party format may force bullion banks to eventually declare their unallocated LBMA gold accounts as backed by 100% physical bullion.” Other key points if you don’t have the time to read the 8500 word article:
“leasing is probably done directly by the bullion banks on behalf of commercial banks for a fee. Instead of pledging the assets acquired with the sale proceeds of gold leased pursuant to a carry trade, the borrower of gold now pledges existing collateral that it could not otherwise sell without incurring a loss. The central bank accommodates the gold leasing by accepting a wide range of collateral that would be otherwise prohibited in conventional funding schemes”
“An outright sale of gold could always be hedged by acquiring a gold forward contract. Therefore, even if gold leasing has not experienced a recent resurgence, the increase in the gold forward rate indicates that owners selling gold to generate liquidity still want their gold back once the funding need has abated. The combination of a falling gold price and rising forward rate is quite a bullish feature of the gold market that is lost in the reporting on negative gold lease rates.”
“the persistence of negative lease rates could be accompanied by the emergence of something entirely new: The result could be negative gold “lease rates” as gold price expectations may create an entirely new phenomenon: cash borrowed to buy gold for future delivery (what I call “gold bonds”). In effect, this is the equivalent of gold owners forward selling their gold at higher and higher prices, and receiving cash up front to be used for current liquidity needs. The above scenario may appear a lot like the current futures market because it involves leverage but the difference is that “gold bond” transactions are 100% backed by metal.”
A few of comments:
Tom: “From the perspective of the borrower (typically a bullion bank or its customer, a hedge fund), gold was historically leased as a way to fund a gold carry trade under which excess returns could be earned by using the sales proceeds from leased gold to purchase highly-rated securities meeting the central bank’s collateral requirements.”
Bron: This is by far the major use of leased gold, but gold can also be leased by users/manufacturers of gold products to provide physical funding of their work in progress inventories, which does not involve any sale of the leased gold.
Tom: “As just mentioned, the gold (or silver) lease rate does not represent the actual rate at which lease transactions are being done in the market. The published lease rate is simply an indicated value derived from two related variables, the gold forward rate and LIBOR.”
Bron: In support I would say that the Perth Mint has always paid positive lease rates when borrowing gold, although it does so for inventory funding rather than carry trade etc reasons. Note Perth Mint borrows without posting ANY collateral because of the West Australian Government’s AAA rating.
Tom: “a customer may execute a gold swap with a bullion bank pursuant to which the customer’s physical gold is initially stored in an unallocated account and used as the collateral for dollars loaned to the customer. The bullion bank then sells the gold from the unallocated account to replenish its funds and concurrently enters into a gold forward contract with a gold refinery. The forward contract is then used to back the gold liability to the customer.”
Bron: My emphasis on “physical” in that. This sequence of transactions is what fractional bullion banking is. In this case the customer’s metal is “lent” to the refiner.
Tom: “sane market participants will naturally demand that gold as a financial instrument retain its utility as the ultimate collateral for non-recourse funding. Under these circumstances, the appearance of 100% physical backed LBMA unallocated bullion accounts seems like a very good possibility”
Bron: I note that some years ago balances in LBMA unallocated accounts attracted no fee, whereas now there is a very small account fee as % of value. Indication perhaps that bullion banks have had to increase the percentage of physical backing unallocated (and thus need to recover that cost) due to an increase in physical redemption/turnover on those accounts. 
By Bron Suchecki, on December 13th, 2011
As usual, Zero Hedge and others hype a story way beyond the reality (see here for the Bloomberg story), such as: ZH: ”is whether or not MF Global was rehypothecating (there is that word again), or lending, or repoing, or whatever you want to call it, that one physical asset that it should not have been transferring ownership rights to under any circumstances.”
TF: “A lawsuit such as this one could easily bring about the total destruction of the Comex/LBMA-based, fractional bullion banking system”
1. Mr. Fane and MFGI entered into five COMEX gold contracts and three COMEX silver contracts relating to the Property. HSBC is the depository for the Property pursuant to a certain Gold Delivery Point Agreement and a certain Silver Delivery Point Agreement entered into between HSBC and the New York Mercantile Exchange, Inc.
2. By e-mail dated October 25, 2011, MFGI notified HSBC that “MF Global’s customer Mr. Fane would like to take possession of [the Property] and move [the Property] to his account at Brinks (sic). I have already canceled for load out. Customer will advise of date and time.”
3. Mr. Fane did not contact HSBC to request that the Property be transferred to his account at Brink’s prior to the Commencement Date.
4. By letter dated November 18, 2011, HSBC, through its undersigned counsel, notified the Trustee that it had possession of the Property. HSBC also notified the Trustee, in light of HSBC having received instructions from MFGI prior to the Commencement Date to transfer the property to Mr. Fane upon his request, that HSBC would act in accordance with MFGI’s prior instructions barring an injunction or contrary instructions from the Trustee.
5. By letter dated November 21, 2011, Mr. Fane requested that HSBC transfer the Property to his account at Brink’s.
6. By letter dated November 22, 2011, the Trustee, through his counsel, asserted to HSBC that the Property constitutes customer property under Part 190 Regulations of the Commodity Futures Trading Commission and that the treatment of the Property must be administered by the Trustee. The Trustee further instructed HSBC not to release the Property to Mr. Fane.
7. By letter dated November 22, 2011, HSBC notified Mr. Fane that the Trustee had instructed HSBC not to release the Property to him and that the Trustee asserted an interest in and claim to the Property.
Not being a lawyer, I read this as “before you went bankrupt, you said I could have my metal”, “yeah, well, you didn’t take it before I went bankrupt, so it is now part of the bankruptcy proceedings”.
So no rehypothecation or loaning, no “suing” by HSBC, no stealing or counterfeiting of the bars and certainly not the total destruction of bullion banking. Just another lesson in counterparty exposure and possession is nine tenths of the law.
By Bron Suchecki, on November 1st, 2011
Very good two page analysis of negative lease rates by Pollitt & Co’s John Paul Koning, including central bank activity in this market. Quote:
What sort of “non-banks” might be supplying leased gold to the market-making banks at these extremely negative rates? As we already pointed out, central banks seem willing to lend only at positive rates, which leaves only one other source: the investing public. …
The public effectively lends gold to banks when they deposit their physical gold in unallocated form at a bank. … The negative interest rate received by the borrowing bank is probably in the form of client fees or bid-ask spreads. …
By serving as the cheapest source of lent gold, the investing public has effectively priced central banks out of the gold lending market.
The Perth Mint does a bit of leasing and certainly no one is paying us to borrow metal. However, unallocated accounts at bullion banks do attract an account keeping fee, as Koning notes, and this is effectively paying the bank to use your metal.
Another factor as to why investors may be prepared to pay people to borrow their metal is that it can be cheaper than the costs of storing it (ie Allocated). I do also think the derived negative rates are a theoretical interbank no counterparty risk rate. Once you add in a premium for the counterparty risk the actual rate is positive.
Finally, there is a mathematical relationship/arbitrage between the futures markets and GOFO (and thus lease rates) and this could also have an impact (not something I’ve been following too closely). 
By Bron Suchecki, on October 14th, 2011
Very funny to read this from Reuters where Iran claims that its enemies were deliberately causing the price of gold and foreign exchange to rise in a bid to undermine the Islamic Republic’s economy. “The enemies and ill-wishers want to make a fuss and present wrong information to provoke and deviate the market,” Ahmadinejad told a crowd in a town in the western province of Hamadan, where he was on one of his frequent provincial visits. “In order to disturb the market they buy a lot of gold coins with their huge amount of money …
Seriously, this should be read in context of Vietnam’s issues with its citizens buying gold as an inflation hedge/savings, which I’ve blogged about in the past. We are seeing how politicians respond to high inflation. In Vietnam’s case, try to ban/restrict gold or in Iran’s case, blame outsiders. In neither case take responsibility. Don’t expect it to be any different in Western countries.
I also note DGC Magazine’s pick up of expansion of reporting (in USA) of export/import of physical money to prepaid access/stored value card products. Of course all about preventing the “transfer of money obtained through illicit activity”. I wonder how long before the movement of money between states within a country has to be reported. They may as well get it over and done with and tell us fuck your privacy and just ban all forms of physical money/value and tell us we have to have one government issued credit/debit card we have to use for any transaction. Finally, I recommend reading Unqualified Reservations blog post on maturity transformation, on which he has written about before. His argument is that borrowing short and lending long is at the heart of our banking problems and cause of the business cycle. Quote:
The genius of Professor Krugman is that he goes so near the truth that he makes it obvious even to his commenters – who typically are both idiots and fools, but several of whom spontaneously exhibit the same insight themselves: Why can’t we regulate or even ban the maturity mismatch? Savers would have to make the maturity choice themselves and it would be transparent. Currently, the savers don’t understand the huge run risks that the banks have by funding with demand deposits and lending long. It’s hiding the risk.
By B.P.T., on September 16th, 2011
With increases in college tuition showing no signs of slowing down, despite the recession, students are being required to borrow more and more money to fund their education. Since a report from the US Census values a bachelor’s degree at about $900,000 in additional salary earned when compared to a high school diploma, and a master’s degree at $400,000 beyond a bachelor’s degree, most students are making a wise decision to borrow money now for college, since the costs of the debt are greatly outweighed by the financial benefits of a college degree.
However, given the limits on public student loan amounts put into place by the federal government, it is becoming more difficult to pay for college with public loans and personal savings. The maximum amount that can be borrowed from the government is $31,000 for dependent undergraduate students, $57,000 for independent undergraduate students, and $138,500 for graduate students (and any undergraduate loans count against this total). Given that tuition at many private schools has exceeded $50,000 per year and many professional graduate programs can cost over $100,000, federal student loans are inadequate. This means that the student is responsible to fill in the gap, and the best option for students that don’t have thousands of dollars in cash available is private student loans.
Shopping for private student loans can be a difficult process because there are many more options available, but those options also provide the opportunity to obtain a good deal on student loan debt. We suggest using one of the many private student loan comparison sites that are available online to find the lender that suits you best, and our research found that Discover private student loans offered attractive rates, the option to defer payments while in school part time, a graduation bonus, and numerous other perks. Even if you do qualify for public student loans, current rates and terms for private loans make them an attractive option, so keep them in mind when looking at your options for next semester.
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By Claus Vistesen, on September 7th, 2011
 One of the stories that caught my attention this week was the Bloomberg piece about how banks in London and New York are starting to jump ship on the old finance hubs due to fear of effects from planned regulatory tightening.
Quote Bloomberg
Banks in Europe are exploring ways to cut costs by routing more of their trades and other business through overseas subsidiaries, a plan that may shift tax revenue away from London and loosen European regulators’ influence over the lenders.Nomura Holdings Inc., HSBC Holdings Plc (HSBA) and UBS AG (UBSN) are among lenders preparing plans to book as much business as possible through legal entities in jurisdictions where tax rates are lower and rules on capital and liquidity are less onerous, the banks and lawyers and accountants working with them say.
(…)
Banks could record as much as 30 percent of the value of their trades through Hong Kong, Singapore and other jurisdictions instead of hubs such as London and New York without running into trouble with regulators, Matten said. Such a move would hurt traditional hubs such as London because assets are treated for tax and regulatory purposes in the country where they are booked. It would also allow banks to sidestep the U.K. bank levy, introduced last year to raise 2.5 billion pounds ($4.1 billion) from lenders operating in Britain, as well as any financial transaction tax imposed by the European Union.
Perhaps this is a sign of the times in the sense that both banks and market participants seem to be looking increasingly outside the boundaries of the developed world for growth, profit and eventually prosperity. Having just moved to the Big Smoke I would not necessarily lament a downsizing of the finance sector even if it is the pond that I also do my fishing for the daily meal ticket. Perhaps, if fast moving financiers chose to go to Singapore instead of London, the residents of the latter would not have to endure paying 300.000 GBP for a studio flat in Canary Wharf [1].
Of course, it may all be a red herring but it could also be part of a number of tentative signs that the locus of global activity on a variety of fronts is moving to new epicentres. Let us hope they do not travel entirely in our foot steps.
More generally, we just put out our monthly report and the outlook is very much wishy-washy. Surely, our leading indicators are pointing down, but after the market puke in August it seems to me that the end of the world had almost been priced in as the S&P500 hit the 1100 marker. In this sense, do not be surprised to see it ticking towards 1250 even if the recent job data were abysmal, but beware. The old range has been broken and we are finding a new lower one. Market prices have a tendency to become “normal” after a period and with global economic activity visibly slowing the fundamentals are not really on the bulls’ side even if they point to the merits of chasing a counter trend rally after a 10% drawdown.
More generally as I noted before, the divergence between respectable analysts is widening which always makes me take a few steps back. On the one hand I see both buy side and sell side analysts rather stubbornly sticking to their year-end S&P500 targets of 1300-1400 while other independent analysts put the fair value of the index at 900-1000. Both will obviously have an axe (or maybe even a book) to grind, but part of my job is to synthesize the consensus into a fairly straight road map for our clients, and it is getting difficult.
I tend to side with the pessimists if only because I find it difficult to see how US corporates can continue to operate as efficiently as they have been doing so far. Gerald Minack had some excellent points on this in his latest report;
A big medium-term uncertainty for DM equity investors is the sustainability of earnings. A decade ago, the big uncertainty was whether valuations could be sustained. They weren’t . The de-rating may have further to go, but clearly valuation is less of a headwind now than at the TMT-inspired peak. Earnings, on the other hand, are very high. Profits are now near an all-time high as a share of global GDP, and the real return on equity has followed . What’s not able, however, is not the cycle rebound, but the elevated level of earnings (and real returns) over the past decade. The forward-looking issue is whether those elevated returns can be sustained. At a global level, the answer may be ‘yes’ – for the simple reason it’s now possible to make profits in places where previously it was not. What’s not clear is the sustainability of high earnings in the developed world.
In particular, I would would point to the contradiction between continuing ultra low unit labour costs and the need to now see growth moving from cost cutting to topline growth. Something does not add up.
Real unit labour costs are now at 60-year lows. This matches the decline in wage share of GDP to a 50-year low. Arithmetically, this is the most important support for high profits. As I’ve discussed in prior reports, it’s not clear how long households can support consumer spending at near 70% of GDP with labour income at multi-decade lows. That’s been possible recently due to massive transfers from the public sector, but that support appears unsustainable.
In my opinion, this is big elephant in the room in relation to the US stock market. It will be difficult for earnings (and margins) to stay at current levels going forward. It follows naturally from the fact that if all companies cut costs and this improves margins this will only work for a limited period time as there are decreasing returns if everyone follows this strategy at the same time. Now we need to see topline sales growth for margins to be sustained, but this is obviously difficult with the current macroeconomic backdrop, so something has to give.
Globally, coincident data is already slowing visibly across the globe with headline PMI readings and trade data coming in steadily lower. In that sense we are up against the wall again only so shortly after the shock of 2008/09 and this time, the ability of policy makers to respond is limited.
However, I would be weary about calling this another 2008. One of the effects of experiencing a balance sheet recession with subsequent deleveraging is that trend growth falls and thus that the economy becomes liable to more frequent recessions. This applies to the US in particular but essentially also to the whole of OECD. This means that we will see more frequent but also essentially shallower recessions. The only qualifier here is really that some parts of Europe are now stuck in a depression locked in a vice of dysfunctional institutions and a lack of willingness and political capability to deal with the problems.
As such, within Europe also lies the potential source a Lehman like shock should the crisis prompt a rapid and violent default of one or more sovereigns and/or financial institutions. Certainly, euro area banks are feeling the pinch as USD funding is getting cut off and if anything it seems to me that the EURUSD is looking a bit too strong for its own good given the backdrop of the mess in the euro zone. As cash levels at euro zone banks are drawn down the currency will adjust to fundamentals not to mention of course the fact that the ECB is slowly but steadily being pushed into full blown QE and monetisation of peripheral debt.
The latest G&F provides a good summary;
(…) The risk of a dollar rally against the euro in coming months is growing. This is because, sooner or later, the ECB will have to reverse its recent insane monetary tightening. Trichet made a start in this direction this week in his usual ponderous manner. Thus, he told the Committee on Economic and Monetary Affairs of the European Parliament in Brussels on Monday that “risks to the medium-term outlook for price developments are under study in the context of the ECB staff projections that will be released early September.” The issue here is whether markets will allow Trichet to save face and not performs an abrupt U-turn before his scheduled departure from the scene on 31 October.
More generally, the recent comments from the IMF that euro zone banks need additional capital is once more a case of stating the almost obviously obvious. The transmission mechanism here is very simple. The market is now effectively pricing in a default of Greece and possibly other peripheral economies and this means that the attention must now turn to the losses that creditors will bear or, alternatively, the size of the bailout if we stick to the old mantra of no losses. As a good friend of mine pointed out recently,
All trough last month’s banking shares’ collapse, I have been thinking that perhaps, equity investors are worried that the recapitalization will be different this time, with either the taxpayer (wrong solution) or the bondholder (rightly, through a bond-for-equity swap), massively diluting the shareholder. Politicians obviously do not have the stomach, nor the muscle for new bailouts.
Or to put it differently, there are no easy solutions left. One solution is the Brady Bond plan which is currently being floated in the case of Greece. The problem as I see is that it is fudged precisely when it comes to the current valuation of the bonds. Basically, there has to be pain today for the creditors, otherwise we are just kicking the proverbial can down the road as recapitalisation is avoided today but made worse for tomorrow. A solution for recapitalising banks today would naturally be for their creditors to accept a swap for equity and thus being moved into the frontline to absorb any losses that the banks would bear on sovereign debt, but that is not popular. Essentially, being degraded to equity holder in a bank with known sovereign assets in the European periphery is equal to taking a haircut on your initial investment, but all this then leaves the inevitable question of who and when someone will step up to take the lead in the debt restructuring.
Of course, the idea of substituting debt for equity is the same principle applied in the case of Greece posting domestic assets (islands, utility companies etc) as collateral for credit. We can then think about this collateral as Greek sovereign equity and as with creditors of banks, it is all good in theory but in practice, not so well.
Elsewhere, the game of Old Maid in global currency markets continue with the SNB still in the spotlight despite already having taken desperate measures to stop the appreciation of the CHF;
Quote Bloomberg
While the Swiss National Bank has so far avoided currency purchases in its latest bid to keep a lid on the franc, it may soon have no alternative but to follow through on its threat to intervene, economists and strategists said.
But what really caught my attention was comments by Brazilian Finance Minister Guido Mantega that lowering interest rates represents an effective antidote against an appreciating currency.
Quote Bloomberg
For “the next two or three years, the conditions will be there for rates to keep falling,” Mantega told reporters in Sao Paulo today. “Falling rates are a good antidote for the gains in the real.”
Allow me to quote myself from the post linked above;
Old Maid is a card game where the simple task is to avoid holding a given card (often the queen of spades) at the end of the game. Even in the company of good friends however, holding Old Maid at the end is not fun. Often, you have to buy the drinks, drop a piece of clothes, or endure other travails. And as it turns out, the global FX market is not unlike this good old game of cards where the Old Maid is proxied by having a strong currency on whose shoulders the correction of global macroeconomic imbalances must invariably fall. In this way, and although one sometimes get the feeling that everyone believes that everybody may actually export their way out of their current misery, buying one country’s currency means selling another and thus, someone (be it an individual economy or a group/basket of economies) must end up holding Old Maid.
The easy investment advice here is naturally to buy the Old Maid which means that just as the global financial punditry searching for clues as to what lies ahead for the global economy and the looming slowdown the SNB et al may have to skint yet awhile for light at the end of the tunnel.
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[1] – No my dear reader, I am renting and I would never touch these things but they are there and they are being sold.
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By B.P.T., on August 26th, 2011
With economic uncertainty continuing to hamper economic growth, inflation has been non-existent, and mortgage rates have remained low. Current rates for conforming loans have dropped below the lows seen late last year to set new record lows for fixed rate mortgages, 5 year ARMs, and 1 year ARMs.
However, many new home buyers looking for a new mortgage and existing home buyers that would like to refinance their current mortgage have struggled to take advantage of these record low rates because of stricter lending standards put in place by most banks or a lack of equity in the home.
Fortunately for people looking for a mortgage that have been unable to obtain one, there have been rumors of another attempt by the federal government to assist existing homeowners swirling around Washington, and most of the plans under discussion are more focused on benefits for existing homeowners that are expected to end the decline in home prices, rather than improving bank balance sheets or handing out credits to new home buyers. These programs are expected to help existing home owners immediately and new home owners in the long term by increasing home values, making a home a safer investment and a quality asset again.
One assistance program that has already been put into place is a refinancing program for existing home owners with little to no equity in their home. The program is for mortgages owned by Fannie Mae that were originated before June 1, 2009 without any mortgage insurance, and it will allow qualified applicants to refinance their mortgage debt (including a second mortgage) up to 105% of your current home value at current market interest rates. These stipulations do limit the pool of eligible home owners, but for people that qualify, it is a great opportunity. You can begin by determining if your home loan is owned by Fannie Mae here.
If you believe that you qualify for the Fannie Mae program described above or are looking for any other type of mortgage assistance, you should contact a lender like Aurora Loans to start the process of obtaining a new mortgage or refinancing an existing one.
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