Peak profits, stock prices?

Recently a respected colleague said our strategy was rational but markets, and the world for that matter, were highly irrational.  After participating in financial markets for the last 25 years I thought my experiences allowed me to see it all-wrong!  So after reflecting on our irrational state of affairs the logical side compiled some of the glaring data sets signifying a massive market top. 

First, a chart created by John Hussman (www.hussmanfunds.com) indicates how much excess we’ve witnessed in corporate profitability vs GDP lately.  Keep in mind his data includes financials which to this day remain a subsidized black box.  (Click on image to enlarge).New Picture (1)

Of course this hasn’t stopped wall street from expecting further net margin expansion:

 

Profit margin growth

Before Wall Street follows Congress out the door for the holidays maybe they should scrutinize this:

profits vs labor

To derive this unprecedented profit picture both consumers and government went on a spending binge.  US national debt, through 5 years of record deficits, added almost $7.7 trillion to our balance sheet-can you say malinvestment?personal savings govt deficits profits

 

Now, if we remove the creators of financial alchemy we notice the real economy topped many quarters ago. 

 

Nonfinl corp profits

So if you care to break away from CNBS and look at the graphs above rational behavior would suggest profit taking and or short exposure.  In fact, it was just 7 years ago that many of these same signals were sent to the market yet we were labeled as the boys crying wolf.  If your timing is perfect the crowd labels you a genius but too early, a chump. 

 

 

Global asset deflation: nowhere to run, nowhere to hide

Over the past several months global stocks, bonds and currency markets have hit a wall.  Just 6-8 months earlier the central banks of Europe, Japan and the US were signaling endless monetary accommodation which initially emboldened global speculators and their reach-for-yield mantra.  Now we look around for evidence or confirmation that the four year stimulus experiment is DOA.

First, emerging market stocks, bonds and currencies have all dropped somewhere between 7% and 12% the last few months as the carry trade (borrowing in low cost currencies in order to buy higher returning risk assets, thus capturing the spread) comes off the boil.  Second, political commentary out of China confirms our earlier thoughts that a credit bubble for the ages has begun to burst.  Since the central banking talking heads opened their mouths last month, Shibor rates (Chinese overnight unsecured lending rate amongst 16 largest banks)  have spiked to levels not seen since 2004:

Shibor-overview

Here is the latest on the Chinese banking system from Bloomberg:

Policy makers could be taking advantage of tight funding to “punish” some small banks, which previously used low interbank rates to finance purchases of higher-yielding bonds, Bank of America Merrill economists led by Lu Ting wrote in a report. Tight interbank liquidity could last until early July, according to the report.

‘Warning Shot’

“The PBOC [People’s Bank of China] clearly has an agenda here,” said Patrick Perret-Green, a former head of Citigroup Inc.’s Asian rates and foreign exchange who works at Mint Partners in London. “To fire a massive warning shot across the banks’ bows and to see who is swimming naked. Moreover, it fits in well with the new disciplinarian approach” adopted by the government, he said.

Chinese regulators are forcing trust funds and wealth managers to shift assets into publicly traded securities as they seek to curb lending that doesn’t involve local banks, so-called shadow banking, according to Fitch Ratings.

The tightening is “emblematic of some of the shadow banking issues coming to the fore as well as some of the tight liquidity associated with wealth management product issuance, and the crackdown on some shadow channels,” Charlene Chu, Fitch’s head of China financial institutions, said in a June 18 interview. She earlier estimated China’s total credit, including off-balance-sheet loans, swelled to 198 percent of gross domestic product in 2012 from 125 percent four years earlier, exceeding increases in the ratio before banking crises in Japan and South Korea. In Japan, the measure surged 45 percentage points from 1985 to 1990, and in South Korea, it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011. [Emphasis mine.  Japan and South Korea experienced bubble economies during these periods which both burst.]

Look at the massive growth in nonbank (shadow) lending in China post 2008 credit crisis while keeping in mind most of this was indirectly backed by the largest banks under the “wealth management” label:

Chinese shadow banking

Maybe this is why China made the news last week when a proposed 15.5 billion renminbi bond offering failed (for the first time in nearly 2 years), receiving only 9.5 billion renminbi.

Over in Russia and Korea we see even more instability permeating the credit landscape.

Romania’s Finance Ministry rejected all bids at a seven-year bond sale yesterday because of market volatility, while South Korea raised less than 10 percent of the amount planned in an auction of inflation-linked bonds. Russia scrapped a sale of 15-year ruble-denominated bonds June 19, the second time it canceled an auction this month, and Colombia pared an offering of 20-year peso debt by 40 percent. A cash shortage led to failures last week of China Ministry of Finance debt sales.

More than $6.9 billion left funds investing in developing-nation debt in the four weeks to June 19, the most since 2011, according to Morgan Stanley, citing EPFR Global data. The exodus is reversing the $3.9 trillion of cash that flowed into emerging markets the past four years as China’s annual economic growth averaged 9.2 percent and spurred demand for Brazilian iron ore, Russian oil and gas and Chilean copper.

Romania rejected all 688 million lei ($200 million) of bids at a bond sale yesterday because of “unacceptable price offers,” according to an e-mailed statement from the central bank. It was the first failure since August.

South Korea sold just 9 percent of the 600 billion won ($524 million) it targeted from 10-year inflation-linked bonds this week. Colombia’s government pared an auction on June 19 of 20-year inflation-linked peso bonds by 40 percent, to 150 billion pesos ($77 million).

Russia canceled planned sales of 10 billion rubles ($311 million) of notes this week, citing a lack of demand within an acceptable yield range of 7.70 percent to 7.75 percent. Yields on ruble bonds due in 2028 jumped 30 basis points, or 0.30 percentage point, yesterday to 8.1 percent, the highest level since the debt was sold in January.

After endless monetary interventions the prior 3-4 years governments around the world temporarily created the illusion that interest rates would stay below nominal GDP growth targets.  The sleight of hand only lasted this long because so many of the “professional money managers” never questioned the actions of central bankers (a.k.a. asset inflationistas) .  As currencies, bonds and stock markets decline in unison around the world, one might pose the question “Have central bankers lost control of their monetary experiment?”  Or better yet, why would so many “investors” believe that a group of central banks with combined reserves of $11.5 trillion could levitate with over $240 trillion in global assets?   Which then begs the question,  where does one hide?

Cracks in the sovereign debt bubble?

2013 started with a roar as risk assets rallied off of late 2012 QE-to-infinity rhetoric from both the Federal Reserve and the Bank of Japan.  As speculative juices continued to flow we witnessed a new all time high in NYSE margin debt (April) coupled with a new high in covenant lite levered loans (double the peak in 2007).

Predictably, along the path to QE addiction is a road paved with economic casualties.  One example of the real economy hitting road blocks is the Caribbean sovereign debt debacle.  According Bloomberg:

Jamaica and Belize, which restructured about $9.5 billion in local and global bonds this year for the second time since 2006, face a “high probability” that they will default again, Moody’s said in a May 20 report.

Among Caribbean island economies, only the Bahamas is expected to grow more than 1.5 percent this year compared with 4 percent for Latin America, Moody’s said in an earlier report. Without faster growth, repeat defaults may become common as Caribbean governments find it easier to cut bond payments than spending, said Arturo Porzecanski, a professor of international finance at American University in Washington.

Maybe the professional speculator accessing cheap financing from his prime broker to buy “distressed sovereign debt” should consider the following:

“These countries are exhibiting an increased unwillingness to pay,” according to Arturo Porzecanski, a professor of international finance at American University in Washington. “We may be seeing the birth of a region of serial defaulters.”

Takeaway: Like Cyprus and Greece the tipping point for many of these small, tourist dependent nations appears to be roughly 110% of debt-to-GDP.  This begs the question, “How much longer can countries such as Spain, France, Japan and Portugal put off the day of reckoning?”

Housing recovery?

Over the past year, more and more of the housing pundits, circa 2006, have resurfaced on Bloomberg and CNBC.  Many claim the bottom in housing is in as the US recovery continues due to low interest rates and a healing consumer.  Like any story, the devil is in the details so let’s parse the facts and make our own diagnosis.

Beginning in 2009 the new administration, assisted by the new wards of the state Fannie Mae and Freddie Mac (thank you Hank Paulson), began a series of mortgage moratoriums -aka “mortgage modifications.”  Essentially, the government would entertain a variety of mortgage defaults/delinquency cases with the intention of keeping bodies in their homes.  Can’t let the home ownership (or should I say “lease”) program go to waste now.  Since then we note the following facts provided by housing analyst Mark Hanson:

Mods are greater in number by 50% than legacy Sub prime loans in 2006. And they are worse in structure.

– There have been 9.953 MILLION loans “tampered with” through trials, mods and workouts based on OTS data through Q4 2012.  

– Bank “proprietary” Alt-A, high-risk mods outnumber HAMP (Home affordable modification program) mods by over 200%.   Banks have had a field day re-leveraging millions of bad loans into structures that would make Angelo Mozillo blush.  

– Mods are why banks brought back $10s of billions in loan loss reserves as revenue. And why they will have to add back reserves.  

– Mods are where all that housing “supply” went.

– Mods are why foreclosures are at pre-crisis lows.

– Mods turn people into underwater, over-levered renters of their own house.

– Mods prevent the deleveraging process needed for housing to achieve a “durable” recovery with “escape velocity”. 

– Mods compete fiercely with all those new-era buy and rent “investors” (Blackrock, Och-Ziff, Tom Barrack) whose top demand theme when raising opportunity capital a couple of years ago was all of the “millions of homeowners displaced through foreclosure who will need a place to rent until they can buy again”. 

If you look at mods structurally — sky-high DTI, LTV, CLTV and low credit score — they make legacy Subprime loans look sane.  People say “banks aren’t lending”. I say ‘go look at their loan mods volume’.  Loan mods are nothing more than low rate, exotic refi’s for people who can’t do a traditional refi. But they are so exotic they make Pay Option ARMs look structurally sound.  

To put this in context there were only about 4 million legacy Sub-prime loans in existence in 2007 when the wheels came off the sector spurred by the ‘Sub-prime Implosion”.

– Four million Sub-prime loans ignited the mortgage meltdown. So, six million or more ‘worse-than-Sub-prime’ loans hanging over housings’, banks’, and MBS investors’ heads probably isn’t a great thing. 

-HAMP mod redefaults are surging…but banks and servicers have been making much more risky “proprietary” mods than HAMP in much larger volume.   Thus, expect redefaults across ALL loan mods to increase significantly over the next year.  Obviously, this means more distressed supply and for many banks this could mean higher loan loss reserves, etc.  See picture below:

http://bearingasset.com/blog/wp-content/uploads/2013/05/Mortgage-modifications11.jpg

My Comment: So one should ask the question “How long can the government continue to hide inventory from the public”?  Or as importantly, since the public bailed out the banks shouldn’t they be entitled to purchase homes at reasonable price levels, not the artificially inflated kind?

Can Cyprus create a contagion within the EU?

Over the last week Cyprus has made front page news as the country teeters on the brink of insolvency.  Knowing the powers at be have stricken the word from their playbook, or replaced it with “liquidity issue”, one must now consider the fate of the EU.   How can this be when Cyprus is a tiny .2% of eurozone GDP?   Consider this, according to the latest bank figures from the BIS, European banks had $38 billion of exposure to Cyprus!   In addition, last week the ECB threatened to withdraw emergency lending access (ELA) to the Central Bank of Cyprus unless they move forward with the proposed bank bail-in restructuring.

Cyprus has proposed the idea of a bail in as a way to recapitalize their insolvent banking system whereby depositors above and below 100,000 euros will be given haircuts of 9.9% and 6.75% respectively.

Of course, this completely violates traditional bank restructuring laws where depositors are the last party in line to incur any losses.  Which then begs the question, “why is the ECB trying to protect bondholders”?

Lets take a step back and review the moving parts in this game.  First, Cyprus is a low tax haven for Russian oligarchs while total deposits from Russia are somewhere near $26 billion or 130% of Cypriot GDP.  Total bank deposits are approximately $140 billion.

Over the last week the Central Bank of Cyprus has been posting sovereign debt at the ECB window, with undisclosed haircuts, in order to keep a lifeline open for the banks (which have been closed over this period of time).  During the Greek crisis haircuts ranged from initial 25% to 50% as the situation worsened due to strings attached by the ECB.

Final comments:  Why all of a sudden are the Cypriots being threatened by a complete removal of ELA by the ECB unless a bail-in is imposed on depositors?  Could one reason be the $9.7 billion in German bank exposure to Cypriot banks?  Or is there really no collateral, unlike Greece, so the ECB has no choice but to go after Russian oligarchs with a 10% money laundering fee?  Either way, the tiny country of Cyprus has already set off Spanish and Italian bank runs as the EU periphery prepares for possible bail-in aka ECB theft operations.  Now all we need to see is Mario Draghi making a statement, a la Ben Bernanke at the outset of the subprime bubble bursting, “Cyprus is only .2% of ECB and remains contained”.

Hard landing underway in China

Ever since the global coordinated bailouts in 2008/2009 numerous market participants have debated the China hard landing thesis.  We wrote about this some time ago here and here so after various data points I think a reasonable decision can now be made.

First, our curiosity began during the credit build up in early 2002 until the great recession in 2009.  Fixed investment to GDP surpassed anything witnessed to date in the emerging market frontier.  Of course most of this “growth” was financed with the help of the state and local governments.  Today, after unprecedented debt growth since the ’09 structured finance debacle, local governments are experiencing  difficulty when rolling over close to $600 billion in bank debt.

People’s Bank of China Governor Zhou Xiaochuan said in a March 13 press briefing that about one-fifth of loans to the financing arms of local governments are risky. Net debt issuance by these entities surged 179 percent in 2012 to 1.132 trillion yuan ($182 billion), accounting for 50 percent of corporate bond sales, according to Bank of America Corp. data.

Is it any wonder that people both inside and outside the country are asking real questions?  Latest questioning from Fitch:

The balance sheets of China’s banks have been growing by over 30% of GDP a year since the Lehman crisis and are still growing at a 20%, wildly exceeding the safe speed limit.

Fitch Ratings said fresh credit added to the Chinese economy over the last four years has reached $14 trillion, if you include shadow banking, trusts, letters of credit and off-shore vehicles. This extra blast of loan stimulus is roughly equal to the entire US commercial banking system.

The law of diminishing returns is setting in. The output generated by each extra yuan of lending has fallen from 0.8 to 0.35, according to Fitch.

Mr Magnus said credit has reached 21% of GDP – far higher than other developing countries – and only half of new loans are “plain vanilla” under the full control of regulators.

Chinese Money Supply

Chinese corporate debt to GDP

Recently I had the privilege to join the Macroanalytics.com program where well versed host Gordon Long and author Charles Hugh Smith discuss both Japan and China.   For those of you interested in the similarities and differences feel free to listen at the following link:

http://www.safehaven.com/print/29048/china-japan-and-central-banking

Real estate recovery or more pretend and extend

Numerous data points on the housing sector tell a very different story from the main stream media cheerleading sessions of late. What can someone deduct from the following facts:

-May hit a record high for residential foreclosures

-Notice of defaults (May) declined although this is misleading due to HAMP II. 

-Federal/state moratoriums led to the more than 8 million mortgages in either delinquency or some type of default. Of these, roughly 80% should default over the next several years based on historical data.

-70% of loan modifications now defaulting up from 50% in ’09

-Shadow inventory (not to be confused with shadow banking) will explode due to redefaults

-Half of the home buyers in May were first time buyers while 60% put down 6% or less when closing. 14% put down 20% or more.

-30% of sales were distressed

-Mortgage applications hit a 12 month low even as mortgage rates approach lows not seen since the 1950s

-May existing homes sales down 2.2% from April.  New home sales declined 32.7% to a seasonally adjusted annual rate of 300,000, down from an downwardly revised 446,000 in April.

After the greatest credit bubble in history the current administration continues to pretend and extend ultimately leading to a greater crisis at some point in the near term.  Interventionism has precluded one of the largest asset pools from true market price discovery. Buyer beware!

The race to monetary hell

The Euro dropped to multi year lows as Hungary joined Greece in the global economic sovereign debt crisis. Like the Greeks, Hungary and other Eastern/Central European countries cope with economic contraction while debt servicing on both a private and public level remain insurmountable. Societe Generale (SocGen) rumors started overnight when several sources unveiled derivative impairment charges possibly linked to Hungary economic news which shouldn’t surprise anyone since SocGen has over $28 billion in Eastern/Central European debt exposure. To put things in perspective SocGens Eastern European exposure alone is roughly 60% of equity!

Other French banks remained quiet today as Trichet continues to monetize approximately $2-3 billion per day in Greek sovereign essentially bailing out his countryman’s finance houses while the Germans ask “where is our bailout”. According to latest ’09 filings some of the largest German banks are levered anywhere between 70-80X so a Greek bailout only partially removes some of the toxic waste from their respective balance sheets.

Institution A -TANGIBLE ASSETS(BILLIONS) B -TANGIBLE EQUITY A/B – LEVERAGE RATIO
DEUTSCHE BANK AG

€1,658

€27.4

60:1

COMMERZBANK AG

€842

€6.8

124:1

DEUTSCHE POSTBANK AG

€237

€3.0

77:1

LANDESBANK BERLIN AG

€143

€1.9

75:1

The Eurozone in general is challenged by rollover risk. Spain, for instance, has to roll over 40% of its external debt, which is about $700 billion to roll over, and because it is running a current-account deficit, it actually has to borrow more than that, which is almost another $80 billion. Just the government has to roll over about 20%, or about $125 billion. Spain will have to borrow more than it has ever borrowed before in the next year at the same time as people’s inclination to lend to Spain is reduced. The government debt of all the peripheral countries in the euro zone that has to be rolled over in the next three years is the equivalent of $1.9 trillion, and that doesn’t include the private-sector debt.

My Comments: The ECB has elected to enter the monetary race to hell so one should ask is Bernanke far behind? Answer: Dollar/Euro swap lines are wide open according to Bernanke thus an increase in the Fed balance sheet from current $2.4 trillion to $3 trillion seems likely.

Goldman bailing out Chicago bank?

As Blankfien & Co defend numerous lawsuits including the Federal kind it appears that one of President Obama’s Chicago banks is having a few problems.

Goldman Chief Executive Lloyd Blankfein has discussed the Wall Street bank making an investment in ShoreBank Corp. with Federal Deposit Insurance Corp. Chairman Sheila Bair, according to people familiar with the situation. He has also telephoned other bank executives as ShoreBank tries to raise $125 million it needs to forestall a possible takeover by the FDIC.

Looks like the Goldman boys pony up $20 million in order to repay the Washington crowd who saved the firm in late ’08 by making them a bank holding company.

Nice work Lloyd!

Opening Pandora’s box

On Friday Goldman Sachs was charged by the SEC with fraud regarding a real estate structured finance transaction during the height of the credit bubble in 2007. Like any fraud the various players jockey for position and in this case it appears the other players involve John Paulson, ACA and potentially other industry participants. First thought that comes to mind is how this coincides with the upcoming financial reform bill headed by Chris Dodd which goes to a vote in less than two weeks. Second, we really have limited information about the suit although readers of this blog are more than familiar with the underlying fraud that built the greatest credit bubble in history.

Questions we would like to see answered:

1) Was Goldman creating custom products for John Paulson while trading against other clients?

2) Were clients intentionally misled about what was being sold to them in order to reward other clients?

3) Were these and other transactions done at arms length?

4) How did Goldman and other banks emulate Lehman regarding repo transactions via off balance sheet entities at quarter end?

5) Did Paulson get access to other questionable custom Goldman products, specifically Greek CDS? If so, were these products fraudulent?

6) How were these various products assembled and were there known fraudulent activities within raw material? For example, did Goldman know about fraud at the mortgage origination level? Where did these mortgages originate? I mention this because WAMU executives were on Capitol Hill last week admitting to mortgage originations containing fraudulent documentation.

7) Knowing the plethora of global derivative allegations does the blueprint used by JP Morgan on Jefferson County, AL ultimately open Pandora’s box?

8) Since this is a civil suit do we have to rely on the criminal fraud trial beginning next month in Italy to finally receive the juicy details on this sham?

9) The four largest banks in America are also some of the largest mortgage servicing entities so are they privy to mortgage payment information which could or could not be shared with some of the entities creating structured credit?

10) Does Goldman employees’ $1 million contribution to Obama’s campaign coupled with over $344 million in lobbying efforts last year insulate the firm from criminal charges in the USA?

11) Is this material? “Head of allegedly Goldman buyer ACA is married to Goldman deputy general counsel”?

12) How many other derivative dealers have been front running their clients?

My comments: Slowly the details emerge on the greatest fraud perpetrated on the American people. As we discussed on numerous occasions the public wants blood so let’s see if the rule of law still exists in the United States.

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