Midweek Thoughts

I'll again point out some of the better material I have come across this week for the benefit of my readers.

"Andy Dufresne" at the Zero Hedge blog is telling people "Don't Be Bearish The Bonds, Seriously." He makes some good points that I have highlighted before. I believe that the savings rate will be above 15% before we see an actual recovery. The historical average is around 7%, but we visited levels at the low end never seen before earlier this decade (below 1%), and I believe the historical mean will be overshot on the upside as well. Where will all that money go? Toward government securities is the typical spot. Remember how it was seen as outrageous that the US debt was climbing from 7 to 8 trillion just a few years ago? People said that any more of that was going to cause inflation to skyrocket. And it never happened. Now we're at 13 trillion and people keep saying the same. Yields kept going lower as the demand for debt was seemingly insatiable. Some of that was absorbed by foreigners, which, it is true, will at some point stop buying. But that is a smaller percentage of the overall picture than is typically talked about.

People seem to be assuming that the asset allocation tendencies of savers and investors will remain the same as they have for the past 20 years. They assume that people are "underweight equities" but only by looking at 10 or 20 years of data. They forget that people used to allocate significant portions of their savings to government backed term deposits and treasuries. In other words, the past few decades are the anomaly, and the demand for government paper over the past few years is actually a reversion to the mean.

Of course, this is not the way it should be. Government shouldn't be allowed to go into debt at all. But this is the way it is. And as we see in Japan, an increasingly frugal and risk-averse citizen will provide ample demand for guaranteed ROI. The article below outlines this well.

Everybody loves to hate the bonds. “Confetti”, “certificates of confiscation”, “wall paper” are some recent terms used to describe them. I agree, it sounds like a loser's bet to give your money away to that “malfunctioning corporation called America” (Gordon Gekko, correct me if I am misquoting) for a measly 3.75% a year for 10 years. For 30 years the assumptions begin to sound even more ridiculous. But are they really? (Hint: check the 10-year return on an S&P 500 index fund, negative right?)

So why not short them?

We have a deflationary problem, which cannot be simply solved by printing. Let me elaborate. The original “printers” are not Bernanke & Co, but the Japanese, which pioneered quantitative easing in the late 1990s. From the CLSA 1Q review, which was available in the public domain earlier this year on their website for everyone to see:

Obama is sending increasingly explicit signals about the fiscal package he feels necessary to stimulate the US economy. He has also made it clear that he will not be dissuaded by a growing budget deficit. This was already US$436bn or 3.1% of GDP in the fiscal year that ended in September and as Figure 13 shows, net issuance of Treasuries exploded in September and October.



A successful Chinese fiscal stimulus implies a fall in the current account surplus. China’s forex reserve growth is therefore likely to slow further and with it official purchases of Treasuries. Despite this we would be long duration in the US bond market; for most of 2009 we expect 10-year yields to be well below 2%. [They have changed that forecast now given the green shoots, not taking the piss--AD]

Though foreign buying of Treasuries will shrink, US savers will more than make up the gap. The US private savings-investment imbalance is swinging towards savings as households cut discretionary spending and corporate investment falls. The visible expression of this will be the collapse in loan to deposit ratios as bank deposits take a disproportionate share of newly generated savings and ultra-tight lending attitudes and debt repayment shrink loan portfolios. This is not just specific to the US; expect loan to deposit ratios to shrink across all Anglo-Saxon economies.

There are two additional factors that also suggest lower yields. First debt issued to finance the purchase of distressed assets really amounts to a debt swap. The institutions that sell problem assets to the Treasury (or Fed) will be the buyers of the government debt that is necessary to fund the purchase. Second, as we note in Question 9, Bernanke has explicitly included outright purchases of Treasuries as one of the unconventional policies that he will pursue to expand the Fed’s balance sheet. Such outright purchases in Japan contributed to an historic low of 45bp for 10-year Japanese government bonds in June 2003 (Japan’s general government deficit was around 8% of GDP at the time):




The scale of Japanese outright debt purchases was not the only factor that generated sub-1% yields in Japan. The dip in yields came at the end of a long period of private sector deleveraging, sub-1% growth (in 2001 and 2002; 2003 saw GDP growth accelerate) and consumer price deflation. All are present in our US forecast for 2009 and 2010 also.

Now the Fed is winding down purchases of Treasuries, because it has averted the crisis (TBD I think). Even Roubini is praising Ben, only Nassim Taleb calls them as he sees them (h/t Nassim). Whatever you do, don't short the bonds by digging your heels in. An idiot that I worked for last year did it 5 times in a row and five times lost money. A bond short is OK for a (well-timed!) trade; the late Benet Sedacca nailed them back in December. But if you are looking for the short of the century, that one will have to wait for quite a few years, IMHO (JGBs on a longer scale presented below).

Also from Zero Hedge comes a study of Capital Expenditures (CapEx) by the S&P 500 companies. As I pointed out in my article "Digging Beyond Better Than Expected Earnings," we would need to see significant new investments in future productive goods and services in order to legitimately talk about recovery. This is how the structure of production works - even one based on credit. Costs fall, and the savings are used for reinvestment in new technologies that were previously uneconomic. As this is not happening, my intuition says that we are still in the early stage of liquidation/deleveraging phase and companies are waiting for costs to fall even further and therefore for risk to be reduced even lower before they spend their precious cash resources.

From "Tyler Durden": V-Shaped Revenue Recovery Combined With L-Shaped CapEx Growth

The chart below demonstrates two things: i) the revenue decline in the current quarter indicates no inflection point in revenue pick up, and ii) expectations are for a V-shaped recovery in revenue.



So the logical question is where will all this revenue come from? With massive excess capacity overflowing in the economy, pundits point to inventories, which will be "restocked" in order to increase sales for all these lean and mean companies that continue laying off workers even as the recession progresses. In other words, capex spending should already be picking up, as that is the primary driver of revenue increases down the line: indeed, a simple fact nobody likes to talk about. We shall get back to that in a second.

The other notable fact is that companies which have for the most part shut down the dividend spigot, and are virtually not paying any corporate taxes anymore (hey, if Goldman can get away with it, everyone will be pocketing those NOLs compliments of a horrendous 2008 for a long, long time). So cash should be higher? Presumably. And that cash should be going to paying for capex. At least that is the thinking if one wants to be bullish on revenue increases.

Zero Hedge decided to analyze quaterly revenue and capex trends among S&P 500 companies over the past year, and we also threw in a study of total and net debt, just to get a sense of what the capitalization of these "poised for a recovery" companies looks like.

Here are the results:




Not only has CapEx not been increasing, it continues plunging: both YoY and sequentially. In fact, S&P CapEx likely at maintenance levels on a revenue/capex basis: not one company is interested in investing in revenue growth projects. Which makes sense: if you have a horde of cash and no clue what your access to debt will be like, any IRR on new CapEx projects can be thrown out of the window before it is even started. Forget the revenue V-recovery: companies will be lucky to preserve revenues where they are, let alone grow them in the future. Alas, what the MSM forgets is that you need investment in expansion opportunities to grow the topline - SG&A trimming can only take you so far, and with decimated and unmotivated work forces, good luck growing organically in this oversupplied economy.

click the link above to read the rest of the article

Elsewhere, Michael Panzner believes we are About To Get Blindsided Again. The multi-trillion dollar mistake that was (and still is) Fannie Mae and Freddie Mac apparently did not teach any lessons. The FHA (Federal Home Administration) and Ginnie Mae (their partner), have been attempting to pick up the slack in "less than good" mortgage underwriting practices. While the private lenders have figured out that it is not so wise to give mortgages to people with very little skin in the game and suspect ability to pay, government based lenders are a little slow (as always) to adjust their practices. The result? Hundreds of billions of dollars in new loans that are, for all intents and purposes, subprime. You can put this in your folder of "problems to come" - if there's still room.

The article that Panzner points out is from the Wall Street Journal:

Ginnie Mae and FHA are becoming $1 trillion subprime guarantors.

Much to their dismay, Americans learned last year that they “owned” Fannie Mae and Freddie Mac. Well, meet their cousin, Ginnie Mae or the Government National Mortgage Association, which will soon join them as a trillion-dollar packager of subprime mortgages. Taxpayers own Ginnie too.

Only last week, Ginnie announced that it issued a monthly record of $43 billion in mortgage-backed securities in June. Ginnie Mae President Joseph Murin sounded almost giddy as he cheered this “phenomenal growth.” Ginnie Mae’s mortgage exposure is expected to top $1 trillion by the end of next year—or far more than double the dollar amount of 2007. (See the nearby table.) Earlier this summer, Reuters quoted Anthony Medici of the Housing Department’s Inspector General’s office as saying, “Who would have predicted that Ginnie Mae and Fannie Mae would have swapped positions” in loan volume?

Ginnie’s mission is to bundle, guarantee and then sell mortgages insured by the Federal Housing Administration, which is Uncle Sam’s home mortgage shop. Ginnie’s growth is a by-product of the FHA’s spectacular growth. The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee.

Herein lies the problem. The FHA’s standard insurance program today is notoriously lax. It backs low downpayment loans, to buyers who often have below-average to poor credit ratings, and with almost no oversight to protect against fraud. Sound familiar? This is called subprime lending—the same financial roulette that busted Fannie, Freddie and large mortgage houses like Countrywide Financial.

On June 18, HUD’s Inspector General issued a scathing report on the FHA’s lax insurance practices. It found that the FHA’s default rate has grown to 7%, which is about double the level considered safe and sound for lenders, and that 13% of these loans are delinquent by more than 30 days. The FHA’s reserve fund was found to have fallen in half, to 3% from 6.4% in 2007—meaning it now has a 33 to 1 leverage ratio, which is into Bear Stearns territory. The IG says the FHA may need a “Congressional appropriation intervention to make up the shortfall.”

The IG also fears that the recent “surge in FHA loans is likely to overtax the oversight resources of the FHA, making careful and comprehensive lender monitoring difficult.” And it warned that the growth in FHA mortgage volume could make the program “vulnerable to exploitation by fraud schemes . . . that undercut the integrity of the program.” The 19-page IG report includes a horror show of recent fraud cases.

If housing values continue to slide and 10% of FHA loans end up in default, taxpayers will be on the hook for another $50 to $60 billion of mortgage losses. Only last week, Taylor Bean, the FHA’s third largest mortgage originator in June with $17 billion in loans this year, announced it is terminating operations after the FHA barred the mortgage lender from participating in its insurance program. The feds alleged that Taylor Bean had “misrepresented” its relationship with an auditor and had “irregular transactions that raised concerns of fraud.”

Is anyone on Capitol Hill or the White House paying attention? Evidently not, because on both sides of Pennsylvania Avenue policy makers are busy giving the FHA even more business while easing its already loosy-goosy underwriting standards. A few weeks ago a House committee approved legislation to keep the FHA’s loan limit in high-income states like California at $729,750. We wonder how many first-time home buyers purchase a $725,000 home. The Members must have missed the IG’s warning that higher loan limits may mean “much greater losses by FHA” and will make fraudsters “much more attracted to the product.”

In the wake of the mortgage meltdown, most private lenders have reverted to the traditional down payment rule of 10% or 20%. Housing experts agree that a high down payment is the best protection against default and foreclosure because it means the owner has something to lose by walking away. Meanwhile, at the FHA, the down payment requirement remains a mere 3.5%. Other policies—such as allowing the buyer to finance closing costs and use the homebuyer tax credit to cover costs—can drive the down payment to below 2%.

Then there is the booming refinancing program that Congress has approved to move into the FHA hundreds of thousands of borrowers who can’t pay their mortgage, including many with subprime and other exotic loans. HUD just announced that starting this week the FHA will refinance troubled mortgages by reducing up to 30% of the principal under the Home Affordable Modification Program. This program is intended to reduce foreclosures, but someone has to pick up the multibillion-dollar cost of the 30% loan forgiveness. That will be taxpayers.

In some cases, these owners are so overdue in their payments, and housing prices have fallen so dramatically, that the borrowers have a negative 25% equity in the home and they are still eligible for an FHA refi. We also know from other government and private loan modification programs that a borrower who has defaulted on the mortgage once is at very high risk (25%-50%) of defaulting again.

All of which means that the FHA and Ginnie Mae could well be the next Fannie and Freddie. While Fan and Fred carried “implicit” federal guarantees, the FHA and Ginnie carry the explicit full faith and credit of the U.S. government.

We’ve long argued that Congress has a fiduciary duty to secure the safety and soundness of FHA through common sense reforms. Eliminate the 100% guarantee on FHA loans, so lenders have a greater financial incentive to insure the soundness of the loan; adopt the private sector convention of a 10% down payment, which would reduce foreclosures; and stop putting subprime loans that should have never been made in the first place on the federal balance sheet.

The housing lobby, which gets rich off FHA insurance, has long blocked these due-diligence reforms, saying there’s no threat to taxpayers. That’s what they also said about Fan and Fred—$400 billion ago.

And lastly, Jonothan Weil continues his good work for Bloomberg in his op-ed piece today: The Next Bubble To Burst Is Banks' Big Loan Values. For the life of me, I cannot figure out how people are surprised by this. It is a well known fact that banks have been massively overvaluing the assets on their books. Bank shares and optimism on the financial sector have been rising in spite of this information. Almost any analyst with credibility left knows full well that a good portion of the big banks are technically insolvent. But most economists provide economic recovery models that will eventually turn these books positive and therefore make it a non-issue. Their models suggest home prices will stop falling, unemployment will not exceed 11%, and that GDP will return to "trend growth" by the end of the year or sometime in 2010. As such, some of the assets currently showed as impaired will turn positive, and there will be very few new additions to the "loss" category. Take away these baseless assumptions about the future and it is plain as day that these banks are insolvent by a large margin.

Weil reports:

Aug. 13 (Bloomberg) -- It’s amazing what a little sunshine can accomplish.

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.

The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by year’s end.

Recognizing Loan Losses

The biggest change would be to the treatment of loans. The FASB’s current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values.

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

Widening Gaps

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion.

Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion.

When a loan’s market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasn’t missed a payment.

The trend in banks’ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loans’ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008.

Covering Liabilities

History provides some lessons here. A common problem at savings-and-loans that failed during the 1980s was that they relied on short-term funding at market rates to finance their operations, which consisted mainly of issuing long-term, fixed- rate mortgages. When rates rose sharply, the thrifts fell in a trap where their assets weren’t generating sufficient returns to cover their liabilities.

The accounting rules also left open the opportunity for gains-trading, whereby companies post profits by selling their winners and keeping losers on the books at their old, inflated values. Had the thrifts been marking loans to market values on their balance sheets, their troubles would have been clearer to outsiders much sooner. (The FASB didn’t require annual fair- value footnote disclosures until 1993.)

Arbitrary Accounting

If nothing else, today’s fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in.

Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind.

Fair-value estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly. The problem with relying on management’s intentions is that they may be even less reliable.

At least now we’re getting some real numbers, even if you have to dig through the footnotes to get them.

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