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Are US Banks Facing a Credit Trap?
Are US Banks Facing a Credit Trap?
Punta del Este | As we head into Q4 2019 earnings this week, US financials have never been so expensive and risk indicators have never been so skewed. Just as last July we called the problems brewing in the short-term money markets in a discussion on CNBC’s Halftime Report with Mike Mayo of Wells Fargo (NYSE:WFC), today we want to put down a marker regarding the concealed credit risk inside US banks.
Our favorite bank portfolio holding, U.S. Bancorp (NYSE:USB), closed Friday at 1.87x book value, down about 5% from the peak in December just over $60 and 2x book. Still a little too rich to add more to our portfolio of USB common, but we continue to accumulate a number of bank preferred issues. With the number of profitless unicorns dying at an accelerating rate, steady cash flow has a certain appeal right about now.
More important, credit default swap (CDS) spreads for high quality issuers are also at all time lows. JPMorganChase (NYSE:JPM) is inside 40bp or around a “A” rating for the largest bank in the US. In 2015, JPM’s CDS was trading close to 120bp over sovereign swaps. Question is, does the market know, really, how much risk sits on Jamie Dimon’s books in the world of corporate CDS and more obscure credit products, like “transformation repo.” We think not.
For those not familiar with the wonders of OTC derivatives and collateral swapping, see our 2019 comment “HELOCs and Transformational REPO.” We wrote in March of last year: “The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer.
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Volcker Rebukes Bernanke and Yellen
Volcker Rebukes Bernanke and Yellen
In his new book, “Keeping At It: The Quest for Sound Money and Good Government,” by Paul Volcker (1979-1987) with Christine Harper, the former Fed Chairman delivers a sound rebuke to Chairmen Ben Bernanke (2006-2014) and Janet Yellen (2014-2018), and other Fed governors and economists, for fretting overmuch about deflation. He argues that the true danger is that loose monetary policy leads to inflation and market contagion caused by the manipulation of risk preferences.
Volcker specifically chides Bernanke and Yellen for their fixation on a two percent inflation target, one of the main ornaments on the data dependent Fed Christmas Tree. “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?” he asks. Good question. Volcker writes in Bloomberg:
“Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.”
Of course, Volcker is cut from different cloth than his successors. Janet Yellen was only chairman of the Federal Reserve Board for four years and with good reason.
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Debt Deflation Italian Style
New York – This week The IRA will be at the MBA Secondary Market Conference & Expo, as always held at the Marriott Marquis in Times Square. The 8th floor reception and bar is where folks generally hang out. Attendees should not miss the panel on mortgage servicing rights at 3:00 PM Monday. We’ll give our impressions of this important conference in the next edition of The Institutional Risk Analyst.
Three takeaways from our meetings last week in Paris: First, we heard Banque de France Governor Villeroy de Galhau confirm that the European Central Bank intends to continue reinvesting its portfolio of securities indefinitely. This means continued low interest rates in Europe and, significantly, increasing monetary policy divergence between the EU and the US.
Second and following from the first point, the banking system in Europe remains extremely fragile, this despite happy talk from various bankers we met during the trip. The fact of sustained quantitative easing by the ECB, however, is a tacit admission that the state must continue to tax savings in order to transfer value to debtors such as banks. Overall, the ECB clearly does not believe that economic growth has reached sufficiently robust levels such that extraordinary policy steps should end.
Italian banks, for example, admit to bad loans equal to 14.5 percent of total loans. Double that number to capture the economic reality under so-called international accounting rules. Italian banks have packaged and securitized non-performing loans (NPLs) to sell them to investors, supported by Italian government guarantees on senior tranches. These NPL deals are said to be popular with foreign hedge funds, yet this explicit state bailout of the banks illustrates the core fiscal problem facing Italy.
And third, the fact of agreement between the opposition parties in Italy means that the days of the Eurozone as we know it today may be numbered.
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CDO Redux: Credit Spreads & Financial Fraud
Adam Smith, 1811
Southport | This week in The Institutional Risk Analyst, we return to one of our favorite topics – namely credit spreads – as we consider the most recent statement from the Federal Open Market Committee. Fed Chair Janet Yellen made a presentation last week to the National Association of Business Economists illustrating that while she is puzzled by low inflation, Yellen is entirely clueless as to the workings of the financial markets.
For some time now, we have been concerned that the FOMC’s overt manipulation of credit spreads has embedded future credit losses on the balance sheets of US banks. But now we are starting to see even greater signs of stress as the large Wall Street banks again return to derivatives in order to manufacture the appearance of profitability.
The leader of this effort is none other than Citigroup (NYSE:C), which has surpassed JPMorganChase (NYSE:JPM) to become the largest derivatives shop in the world. Citi has embraced the most notorious product of the roaring 2000s, the synthetic collateralized debt obligation or “CDO” security, a product that fraudulently leverages the real world and literally caused the bank to fail a decade ago.
“It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system,” reports Bloomberg.
“But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.”
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