A virtual interview with the WSJ and the FT - Part 1

WSJ: We read with interest your views on the origin of the financial crisis we went through: In a recent article you were indicating that you would prefer to be short instead of long in the banking sector: why?

M&B: The crisis that started in August 2007 is the abrupt adjustment to 20 years of over-indebtedness: over indebtedness by governments, individuals and corporations (to a lesser extent), thanks to central banks having provided plenty of liquidity, particularly in the US. Each time we had a crisis, the liquidity ticked up, and we had such crises more often over the past two decades and they became more acute and important in size. No decision was made to go to the root of these crises: over-liquidity leading to the misallocation of resources. Besides a loose monetary policy, these crises were also spurred by bad political decisions.

Is there anything new? No. The G20 in London focused on tax havens and in Pittsburgh on traders’ bonuses. Wrong, these are meaningless vis-à-vis the current crisis and its causes even if they do the front page of media and are talked up by politicians. These are pure scapegoats to deflect the attention of the public from the real roots of the problems and solutions that will be painful.

Regarding the banking industry, I do not believe that problems are healed. True, a collapse has been avoided and this is fine; we gained time, very important in troubled times. Many banks received public money, and many have repaid it. However so called toxic and non-performing assets are still in their balance sheets (or off balance sheets) and their value has not improved (home values not really increasing, credit card delinquencies on the rise, commercial real estate starting to hit, to name a few). Bank’s lending continues to go down, so the real economy is not getting the financing it needs, particularly small and medium businesses (loosing 50k jobs 10.000 small business is politically and journalistically irrelevant, loosing the 10k jobs via GM is important, this is the power of communication and making “events”).


Many banks have returned to profits, but a lot has to do being financed at close to 0% whilst investing the proceeds in Treasuries yielding +/-3 % - a no brainer to make money by the way. The core business of banks (or what it should be) is not improving at all.

Look at Q3 results at JP Morgan Chase in details – one of the best managed banks. Net profit $ 3.6 billion: 7X Q3 2008 and +32 % / Q2 2009. Great! But hold on, look at the details. Over 50% are coming from investment banking (and over 2/3 of Investment banking revenues coming from trading profits). Retail financial services are hardly making any money ($ 7 million profits) and the situation is deteriorating compared to previous quarters with provision increasing (nearly $4 billion representing nearly 50% of net revenue). Card services losses are mounting: $ 700 million (close to $5 billion provisions) vs. a Q2 $ 672 million loss and a Q3 2008 $ 292 million profit (if I however do not dismiss the ability of the management to "overcharge" provisions to reduce the effective tax rate and create a cushion for the future and smooth results, in this case I believe the assessment is real). The rest of business lines is more or less flat.

And what about Goldman Sachs – the best fully-fledge investment bank – where 70% of its net revenues are derived from trading at $ 8.8 billion during Q3? Net common equity stand at more or less the value of level 3 assets (the illiquid difficult to value assets). From what I read, Goldman Sachs is also back to the happy days of leveraging (15X from my rough calculation of common equity/total assets - it is beyond the purpose of this interview, but I would be quite interested to know the ratio with off balance sheet items...). We are back to a Return on Equity (ROE) above 20%: I thought we were in a new world... Never mind, the tax payer bails out, and management retains their position with no financial sanction (the only one that really matters, besides jail).

A final word on commercial banks and subprime mortgages. A recent study published by the US FED showed subprime borrowers represented 20% of all new mortgages in 2006 to zoom down to zero in Q1 2008 to reach... 20% currently in an environment where net lending is negative for the first time since 1970.

All this led me not to be optimistic about the banking sector, bearing in mind that deleveraging will translate into lower ROE and lower valuations (just look at the collapse in private banking valuations that went from 6-8% of AUM some years ago to 1-3% now).

Sources:

Goldman Sachs
http://www2.goldmansachs.com/our-firm/press/press-releases/current/pdfs/2009-q3-earnings.pdf

JP Morgan Chase
http://investor.shareholder.com/jpmorganchase/press/releases.cfm?type=

Federal Reserve Bank of St Louis
https://research.stlouisfed.org/fred2/series/TOTLL?cid=100

Federal Reserve Bank of San Francisco
Economic Letter: Recent Developments in Mortgage Finance
http://www.frbsf.org/publications/economics/letter/2009/el2009-33.pdf

Chart of the Day

For some long-term perspective, today's chart illustrates the Dow adjusted for inflation since 1925.

When adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s.

The inflation-adjusted Dow is now a little more than double where it was at its 1929 peak and trades a mere 51% above its 1966 peak – not that spectacular of a performance considering the time frames involved.

It is also interesting to note that the Dow is up 54% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today.

Chart of the Day

Despite a host of concerns (weak economy, high unemployment, mounting foreclosures, geopolitical issues, etc.), the Dow made another post-crash high today. While the recent string of new rally highs is significant, it should be noted that the Dow is currently testing resistance (see red line).

Liquidity is still abundant and flowing to investing asset classes more than to the real economy. The dichotomy between the real economy and equity markets is widening.

The magnificent 7 and equity markets - Review 4

For the past 3 months, equity markets have continued to forge ahead unabated. The magnificent 7 are telling us that there is no reason for the markets to pause beyond short term overstretched valuations (I recommend the reader to go to the GTI web site for their monthly newsletter, one of the best available).

S&P 500 Banks index: the index has now been consolidating for 2 months around the 130 level. The index continues trading over the 200 days moving average which in turn is near its inflection point and on the brink of becoming positive. Results fro banks should be positive for Q3 and any disappointment should be limited around the 200 days moving average. The new support at 128-130 is holding very well. Positive.

Global 1200 financial index: The world financial sector broke through the 800 cap mid-July to gain +/- 25% since. The new cap/consolidating zone is around 1000. The index looks more over-extended than the S&P 500 Bank index (but also with better fundamentals due to emerging markets not plagued by the sub-prime and the-likes debacle), standing well above its 200 days moving average; the latter is however firmly on a positive slope, technically favorable. Positive.


TED spread (LIBOR USD 3 mth - US 3 mth T-bills): The spread is back to normal - no stress showing at +/- 20 basis points (0.20%). Positive.


USD bank BBB 10 yr - US 10 yr yield: Whilst still high and above historical average, the spread has decreased by 1.5% since our last review in August, and now stands at 5.4%. Positive.


OEX volatility: OEX volatility is now hovering around 25% well below the stress times of Q4 2008 and Q1 2009. Ideally, I would like to see it at 20% or below. Positive.


S&P Case Shiller house price index (source: S&P): The latest data (July) published in September show the 6th consecutive month of yoy decrease in the rate of decline. More importantly, the index continued to increased:

Composite-10: July 2009: +1,7%, y/y: -12,8%
Composite-20: July 2009: +1,6%, y/y: -13,3%

Signs are becoming more positive. Slightly positive.


Oil price: For nearly 3 months, oil prices have been trading in a narrow $65-75/b band , the latter seeming to be the resistance. This range will last as long as the economy in the US is not decisively improving (watch retail sales numbers). When it breaks upwards, it will rally very sharply. Positive for the time being.


Conclusion: All these indicators are now positive for the first time since 2006. I am not (yet) in the camp of the commentators that see a bear market rally. I however expect a 20-25% correction in equity markets by 2010 Q1.

In my last review (11th August), I advised to relax and wait for the next move, expecting a consolidation that did not occur beyond a few percentages in July. Liquidity and strong anticipations are very forceful factors that have driven markets higher. I still believe that they went ahead of themselves and will very carefully watch retail numbers as well as the employment situation (whilst a lagging indicator, in the current crisis, I think it is important to follow it due to its strong psychological effect on consumers).

I however do not forget that banks' balance sheets are still fragile (look at all the capital increase announcements in Europe for example) and may be hit by commercial real estate write-downs. In that case I would change my view and become bearish. I will watch the bank index regularly for any clue about a possible repeat (whilst not as large) of last year collapse.

Chart of the Day

Friday, the US Labor Department reported that nonfarm payrolls decreased by 263,000 in September. Note how the number of jobs has steadily increased (top chart) over the long-term. During the last economic recovery, however, job growth was unable to get back up to trend (first time since 1960). More recently, nonfarm payrolls have pulled away from its 50-year trend by a record percentage (bottom chart). The number of US jobs is currently at level first seen in early 2000.

Chart of the Day

Where do we stand with the US residential real estate?

Whilst the Case-Shiller index has improved over the past few releases, yesterday's single-family home price dropped 2.3% in August.The stock market sold off on the news.

today's chart illustrates the US median price of a single-family home over the past 39 years. Not only did housing prices increase at a rapid rate from 1991 to 2005, the rate at which housing prices increased – increased. That brings us to today's chart which illustrates how housing prices are currently 30% off their 2005 peak. In fact, a home buyer who bought the median priced single-family home at the 1979 peak has seen that home appreciate by a mere 4%. Not an impressive performance considering that three decades have passed. Over the past two months, single-family home prices have resumed their decline and remain (until proven otherwise) in an accelerated downtrend.

Time to short the banking sector?

After being hit hard (and for a reason), the banking sector posted fantastic gains:

	High	Low	Close	H to L	C to L	C to H
S&P 500 Banks	414.75	46.72	131.45	-89%	181%	-68%
	Feb-07	Mar-09	18-Sep-09
FTSE 350 banks	11696.3	1877.1	5308.74	-84%	183%	-55%
	Feb-07	Mar-09	18-Sep-09
DJ Euro Banks	491.78	84.61	231.75	-83%	174%	-53%
	May-07	Mar-09	18-Sep-09
DJ Stoxx Asia Pacific banks	96.93	32.97	56.96	-66%	73%	-41%
	May-06	Mar-09	18-Sep-09
Topix Bank Index	508.18	125.65	150.72	-75%	20%	-70%
	Apr-06	Mar-09	18-Sep-09
Hang Seng Financial	4932.55	1718.91	3573.2	-65%	108%	-28%
	Nov-07	Mar-09	18-Sep-09

Are these sustainable (at least in the developed world)?

• Banks profitability is driven by the endless open check book provided by central banks around the world at 0% or near 0% financing cost whilst investing in US treasuries or equivalent and getting around +/- 3% for 5-10 years maturities. Despite the rhetoric, central banks are more interested in banks increasing their shareholders funds than increasing lending to consumers and companies. The decrease in lending accelerated in July to an annual rate 10.4% (7.4% the previous month) according to data from the FED.

• Whilst having improved, balance sheets are still weak despite deleveraging, capital increases seen for the past 12 months and write-downs. According to today's FT:

  There is mounting concern among industry professionals about how to restructure or refinance the $2,100bn of European commercial property loans, in particular the $200bn in CMBS. [Commercial Mortgage Backed-Securities]

  A report from the UK industry group that met with the Bank highlighted that the UK commercial property sector could be in negative equity until 2017 and undercapitalised by up to £120bn ($195bn) based on current conservative banking refinancing terms.

  Close to £43bn of loans to the commercial property sector are due for repayment this year alone, according to De Montfort University research.

  Half of the outstanding European CMBS market needs to be repaid in 2011 and 2012, and CMBS in default have already proved difficult to restructure.

• In the US, the situation is not much rosier. Since the beginning of the crisis, the FDIC (Federal Deposit Insurance Company - the body that insure deposits) has spent approximately $50 billions and is now underfunded (see graph below). Write-off on US commercial real estate loans could amount up to $400 billion. Add increased delinquency for credit cards and you get the picture.

• Banks are again mulling calls to their shareholders to raise new equity, Royal Bank of Scotland being the last one to queue. With banks showing profits again during H1 2009, investors would have thought that they should not need to come to the markets again so soon. This lead me to be suspicious about the solidity of banks' balance sheets, and I am not convinced by the argument where new equity is needed to get freer from Governments: they need to raise capital because their loan losses are high and rising. The latest release from Institutional Risk Analytics shows that bank stress in Q2 2009 was at the highest level ever.

Conclusion

Between being short or being long, I would choose the former since too many uncertainties are lingering at this juncture of the crisis in the banking industry which benefited from the central bank largess. And I do not expect anything great from the G20 meeting in the US if I refer to the previous meeting in London where tax havens were wrongly targeted and now traders' bonuses seems to be the next scapegoat. I however still scratch my head with leading indicators having improved for 5 months in a row...

Sources:

Financial Times
European property groups face debt time-bomb
http://www.ft.com/cms/s/0/a29bce72-a60e-11de-8c92-00144feabdc0.html

Federal reserve Statistical Release
Consumer Credit
http://www.federalreserve.gov/releases/g19/Current/

John Mauldin
Thoughts from the Frontline Weekly Newsletter
The Hole in FDIC
http://www.frontlinethoughts.com/gateway.asp

Institutional Risk Analytics
Q2 2009 Bank Stress Index Ratings
http://us1.institutionalriskanalytics.com/pub/IRANews.asp

Northern Trust
Loan Delinquency and Charge-Off Rates at Troughs of Business Cycles
http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0909/document/dd091809.pdf

W shape recovery?

Economic numbers have been rosier for a couple of months. Underneath, some fundamentals problems have yet to be solved:

• Rising unemployment (slowing, yes, but still)
• Households continue to deleverage /rebuild their balance sheet and savings
• Whilst conditions in the interbank market is back to normal according to OIS and TED spreads, banks' lending to consumers and companies is muted
• Governments are going to compete with the private sector to finance their needs
• Excess liquidity is finding again it way into financial assets, commodities in particular that are well above what the medium term economy warrants
• Taxes are on the rise in some countries to finance the fiscal gap: US and UK in particular. At a time of high unemployment and low wage growth, there is a risk of withdrawing additional money from households potential spending

I do not believe (as yet) that we will witnessed a double dip recession. However all the noise made by the media and politicians about a better economic outlook, makes me nervous, and the risk of policy mistake is on the rise, fear having disappeared.

Are US consumers going to get the economy rolling at the speed the markets are pricing in?

In a post yesterday, I indicated that unemployment, and therefore consumers, will be key to the recovery: recent numbers are not particularly encouraging with a continued deleveraging in consumer credit that ties up with an increase in the savings rate. These numbers seem to contradict positive noise on consumer sentiment (rebound in the Conference Board Consumer Confidence index in August compared to the bad July number); personally, I prefer hard facts.

Record Plunge in U.S. Consumer Credit Signals Weakened Spending

Sept. 9 (Bloomberg) -- A record $21.6 billion drop in borrowing by Americans added to evidence that consumer spending will be slow to recover as banks and credit-card companies tighten lending standards and households pay down debt.

Consumer credit fell by 10 percent at an annual rate in July to $2.5 trillion, according to a Federal Reserve report released yesterday in Washington. The drop was more than five times larger than economists forecast. Credit fell for a sixth month, the longest series of declines since 1991.

Do not misunderstand me: I do not say that Amaguedon is for tomorrow, but that equity markets went ahead of themselves and will need to adapt to the reality of the economy.

Sources:

Bloomberg
U.S. Consumer Credit Falls by a Record $21.6 Billion (Update2)
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aAYZpSNGocVM
Record Plunge in U.S. Consumer Credit Signals Weakened Spending
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avvF5aNtrCfc

The Conference Board
Economic indicators
http://www.conference-board.org/economics/indicators.cfm

Goldman Sachs
Where to invest now? Sustainability of rally depends on final demand
http://www.fullermoney.com/content/2009-09-08/WheretoinvestSep09.pdf

Can green shoots be sustainable?

For a couple of months, media ahs been full of greenshoots: the economy is back on track, we are going to see a V shape recovery, GDP upgrades are multiplying, corporate earnings are much better etc.

However without the consumer going back to shops to buy, these greenshots with end up like leaves on trees during the Autumn: brown.

Whilst a lagging indicator, unemployment will be key in this current recession due to its psychological effect on consumers combined with the depth of this recession. Let's review 3 graphs.

Graph 1 shows that the unemployment in the US will be the deepest since WWII. True the pace of employment destruction eased to 216,000 in August vs. 276,000 in July (revised up) and 463,000 in June (revised up). This is however not surprising being nearly 2 years in recession: the pace of 400,000/500,000+ new unemployed a month was not sustainable for very much longer with the stimulus package and money injected. Unemployment rate increased to 9.7%; however including part-time workers who would like to work fulltime and other unemployed that are discouraged to seeking a job, the rate is above 16%!



This recession is however by far the deepest since the early 70s, and will affect the way the baby boomers will consume and reflect on their pensions having lived on debt steroids for 20 years: fear is new; fear of losing their job, fear of losing their home, fear of losing their savings, fear about the social and health coverage, fear about their pension, concern about their children higher education and job, etc.

This results in reconstituting their savings (up to 6.9%) after having been sub zero 3 years ago. However, this steep increase is mainly in the form of debt repayment (and not in liquid savings accounts) and is helped by deflationary pressures. it does not bold well for consumption in the coming months.

The third chart illustrates that the current job market has suffered losses that are more than six times as much as average (20 months after the beginning of a recession). In fact, if this were an average recession/job loss cycle, the number of jobs would have begun to increase five months ago...

Whilst at odd with many commentators, I am still convinced that we are due for not so nice surprises on the economic front by year-end, Q1 2010 at the latest, hence my view of an equity market correction.


Sources:

Bureau of Labor Statistics
http://www.bls.gov/news.release/empsit.nr0.htm

U.S. Department of Commerce
http://www.bea.gov/national/nipaweb/Nipa-Frb.asp?Freq=Qtr

Prof. Michael Hudson
Debt Deflation Arrives:What the Jump in the U.S. Savings Rate Means
http://www.michael-hudson.com/articles/financial/090630ODebtDeflation_SavingsRate.html#_ftn2

The New York Times
http://economix.blogs.nytimes.com/2009/05/08/comparing-this-recession-to-previous-ones-job-losses/