Financial Review

Casino Mentality

Sinclair Noe — July 22, 2015

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DOW – 68 = 17,851
SPX – 5 = 2114
NAS – 36 = 5171
10 YR YLD – .02 = 2.32%
OIL – 1.62 = 49.24
GOLD – 7.00 = 1095.00
SILV – .05 = 14.90

As of today, Wall Street will have to comply with the “Volcker rule,” which bans taxpayer-insured banks from making bets with their own money. Although major financial institutions have fought for years to change the rule, they have for the most part fallen in line – shedding their proprietary-trading desks, pulling money from certain investment funds and ceasing other speculative activities. The new rule has also changed much of the industry. The five largest U.S. investment banks cut staff on bond sales and trading desks by 18% from 2011 to 2014, while 1,428 new hedge funds were launched during the same period.

Greek MPs are debating a second set of reforms they need to approve to secure a €86 billion-euro bailout, as thousands protest against further austerity measures. The protest outside parliament briefly turned violent. Earlier, Greece’s PM urged rebels within his own Syriza party to support the reforms demanded by creditors. Meanwhile, the European Central Bank has increased its cash lifeline to Greek banks with an emergency injection of an extra €900 million-euro, the ECB’s second in a week, coming just hours before the vote.

The National Association of Realtors reports sales of previously owned homes climbed to an eight-year high in June. Closings on existing homes, which usually occur a month or two after a contract is signed, climbed 3.2 percent to a 5.49 million annualized rate, the most since February 2007. Compared with a year earlier, purchases increased 9.6 percent in June. The median price of an existing home rose 6.5 percent from June 2014 to $236,400, the highest on record before adjusting for inflation. First-time buyers accounted for 32 percent of existing-home purchases in May.

In a separate report, the Federal Housing Finance Agency reports home prices rose 0.4 percent on a seasonally adjusted basis from April to May. The FHFA’s report showed home prices rose 5.7 percent in May from a year earlier. The measure is 1.8 percent below its March 2007 peak and about the same as the April 2006 level.

And it looks like people are catching the real estate bug, again. A new survey from Bankrate.com shows 27% of respondents believe real estate is the best investment, beating out cash for the top spot, as 2006 fades away in the rear view mirror.

Bad news ladies, you have taken a step backwards on the pay scale. New data from the Labor Department shows women earned 81.9 cents for every dollar a man earned in the second quarter of the year. That’s down from almost 84 cents for every dollar a man earned in the second quarter of 2014. Overall, median weekly earnings of all full-time workers climbed 2.7% from a year earlier to $801. Men got bigger paychecks, with wages and salaries climbing 3.4% from a year earlier to $886. For women, the increase was a more moderate 1.4% to $726. Men tend to work more hours than women. Women ages 20-24 come closest to earning the same as their male peers. That gap widens noticeably for women 35-44 and continues to grow.

The report also shows big disparities in pay related to race and educational attainment. For example, median weekly earnings for black men working at full-time jobs were $696 per week, or 76.1 percent of the median for white men. And full-time workers age 25 and over without a high school diploma had median weekly earnings of $499, compared with $1,210 for those holding at least a bachelor’s degree.

New York moved to raise the minimum wage for fast-food workers to $15 an hour by the end of 2018 in New York City and by mid-2021 in the rest of the state. The New York Wage Board voted unanimously for the increase, which would cover some 180,000 workers statewide.

A new report from the Annie E. Casey Foundation finds 22 percent of American children are living in poverty (as of 2013, the latest data available) compared with 18 percent in 2008. Poverty rates are nearly double among African-Americans and American Indians. Problems are most severe in South and Southwest. Particularly troubling is a large increase in the share of children living in poor communities marked by poor schools and a lack of a safe place to play.

Late Tuesday, the American Petroleum Institute said its data showed a 2.3-million-barrel increase in crude stocks in the past week. The more closely-watched data from the U.S. Energy Information Administration was released today, and that report showed stockpiles increased by 2.5 million barrels for the week ending July 17. Since the start of the year, oil prices are down about 5%. The decline in oil prices is part of a larger drop in commodity prices that has seen precious metals dropping 7 of the past 8 sessions; in turn dragging down prices on copper, zinc, and lead. And good news for coffee drinkers, the beans are down 23% since the start of the year.

Earnings reporting season, and the past couple of days have been rough. Dim outlooks and guidance were seen at Apple, IBM, Microsoft, and Yahoo, while commodity producers deepened declines. Shares of Freeport-McMoRan slipped 4.5%, Vale dipped 3%, and BHP Billiton fell nearly 5%.

The biggest hit was from Apple, even though the company topped analysts’ estimates for revenue and earnings, sales of iPhones came in slightly below estimates. Yesterday, Apple stock lost $62 billion in market capitalization. It was the biggest one day loss for Apple, but the record for the biggest one-day market cap loss goes to Microsoft; back on April 3, 2000, Microsoft lost $82 billion in one day, after news that a federal judge ruled it violated antitrust laws. Don’t worry about Apple; their market cap is still around $714 billion and they’re sitting on $202 billion in cash.

While markets remain near record highs, June-quarter S&P 500 earnings are expected to dip 1.5 percent. Of the 102 companies to report through Wednesday morning, 70 percent beat earnings expectations, matching the rate over the past four quarters and above the 63-percent average beat rate since 1994. However, only 55 percent have topped revenue forecasts, below the 61-percent average beat rate since 2002. U.S. companies are expected to post their worst sales decline in nearly six years in the second quarter, in part due to the strong dollar that reduces the value of U.S. companies’ overseas income.

Boosted by a recent stock surge, Facebook’s market capitalization has overtaken that of General Electric. The social network’s 26% climb this year has brought its market value to $275 billion, compared to GE’s $273 billion. Some are expressing concerns: GE racked up $149 billion in sales last year and employed more than 300,000 people. Facebook reported $12.5 billion in sales and employed roughly 9,200.

U.S. authorities have charged five people in the first cases bearing some link to last year’s massive cyber-attack on JPMorgan, which exposed the contact information of 83 million accounts. The men were accused of crimes ranging from securities fraud to money laundering – not with anything directly related to the attack on the bank – but officials confirmed there was a link. Rather, the court filings detailed charges involving a multiyear campaign to drive up the price of worthless penny stocks by pitching them to unsuspecting investors through millions of spam emails. One of the people briefed on the matter said he believed that the defendants had intended to use some of the email addresses obtained in the JPMorgan hacking to find other people who could be persuaded to invest in otherwise worthless stocks. It seems like a particularly reckless way to get a mailing list but that’s the story. Four of the men were arrested in Florida and Israel, while a fifth remains at large.

The bankruptcy drama at Caesars Entertainment came to a head today. Caesars put its largest unit in chapter 11 protection in January, rather than the whole company, preserving many investments of shareholders. In January, subsidiary Caesars Entertainment Operating Co. and nearly 175 affiliates filed for bankruptcy protection in Chicago after the second-lien holders filed an involuntary bankruptcy petition against the entity in Delaware. A Delaware judge later moved the entire case back to Chicago, Caesars’ preferred venue.

The case, as well as the months preceding the chapter 11 filing, has been contentious. In four lawsuits against the parent company, creditors have said Caesars’ entities improperly shifted good assets away from them to benefit its owners, including private-equity firms Apollo Global Management LLC and TPG. At least seven transactions between 2009 and 2014 have been questioned.

Caesars has called the transfers proper. The bankruptcy reorganization plan on file, which calls for the $1.5 billion investment by the parent as part of a deal to restructure the subsidiary, calls for Caesars to be reshaped as a real-estate investment trust. Senior lenders support the deal, while more junior creditors, including a group of second-lien holders that is suing, have opposed it. The bankruptcy judge in Chicago ruled that creditor lawsuits against Caesars Entertainment can continue and the bankruptcy of the casino’s top subsidiary shouldn’t delay the cases against the parent. Caesars’ stock dropped 41 percent to $4.76 a share.

FINANCIAL REVIEW

Theories on Apples and Applesauce

Sinclair Noe — January 16, 2015

Podcast: Play in new window | Download (Duration: 13:16 — 6.1MB)

DOW + 190 = 17,511
SPX + 26 = 2019
NAS + 63 = 4634
10 YR YLD + .04 = 1.81%
OIL + 2.32 = 48.57
GOLD + 17.70 = 1281.30
SILV + .83 = 17.88

Stocks bounced back after five sessions of losses. All 10 of the S&P 500 sectors were higher, though energy led the charge, rising 2.8%. U.S. crude oil futures settled up 5% after the International Energy Agency said there were signs that lower prices had begun to curb production in some areas. On the week, oil rose 0.7%, snapping a seven-week losing streak. The IEA report said that the market’s floor was still anybody’s guess, but “the sell-off is having an impact,” and “A price recovery – barring any major disruption – may not be imminent, but signs are mounting that the tide will turn.

We love lower gas prices. A gauge of consumer sentiment jumped up to an 11 year high this month. The preliminary January reading on the University of Michigan’s consumer-sentiment index increased to 98.2, the highest level since January 2004, from a final December reading of 93.6. Also, more households were reporting increases in household incomes.

Consumer inflation in December saw the biggest monthly drop in six years. Consumer prices, the CPI, fell 0.4% in December. You know the big driver for lower prices; energy prices plunged 4.7% in December, the biggest drop since the end of 2008, as gasoline prices fell 9.4%. Overall consumer prices grew 0.8% in 2014, the second smallest calendar-year increase in the last five decades. Core inflation was 1.6% during 2014. Also, the government reported that inflation-adjusted average hourly earnings rose 0.1% in December. For the year, real average hourly earnings rose 1%.

Good news, everything is on sale. Well, not everything; beef, tomatoes, and eggs went up in price; and rents jumped last year. Most things are cheaper but it may not be cause for celebration. We’ve just seen the weakest stretch for prices since 2009, which was not a good year for the economy. The euro zone is in outright “deflation,” which is the opposite of inflation, prices fall instead of rise. Japan, went through a couple of lost decades when prices just went flat or even dropped. Japan has already started on a quantitative easing program. The Eurozone is expected to announce next week that they will start buying sovereign bonds to stimulate their economy.

Of course the problem is that when prices are falling we tend to put off buying stuff because we expect we can get a better deal tomorrow or next week. When everybody is waiting for a better price, nobody is actually buying; when people stop buying things, it is bad for the economy; really bad. The Federal Reserve tends to think this won’t be a problem; they are planning on raising rates at some point in the not so distant future. Unless something upsets the apple cart.

By the third quarter of this year, the Federal Reserve’s 0.25 percent interest rate is expected to at least double, according to economists surveyed by Bloomberg News. The Fed already has an idea of what the market impact will be: The so-called taper tantrum in May 2013, when then Fed Chairman Ben Bernanke first suggested the U.S. bond-purchase program would be scaled back, saw the yield on the 10-year Treasury jump half a percentage point in four weeks to end the month at 2.13%.

There’s a risk, though, that this time, having flagged the prospect of a change so far in advance, policy makers will be complacent about the probable market reaction. That’s what happened in 2008 when Lehman Brothers went bust. Treasury officials convinced themselves that the financial crisis had been rumbling on long enough for participants to have shielded themselves against the collapse of a big firm; turned out, not so much.

Right now there is a sort of similar situation with regard to Greece, where the problems have been going on so long, that people forget that Greece is on the edge of collapse. Today, two Greek banks applied for emergency funding from the national central bank. This could be a signal that depositors are pulling their money out at an alarming rate. Or it might just be another scheme to scare Greek voters ahead of next week’s election. After the election, the Greeks might repudiate their sovereign debt; the Euro Union might kick them out. Maybe it won’t be a problem.

The big problem seems to be when something happens without warning; like the Swiss abandoning a cap on their currency. Boom, markets move fast, somebody loses a boatload of money. Soon after the Swiss National Bank unexpectedly ended its three-year policy of keeping the franc weaker than 1.20 per euro, bearish bets on Europe’s common currency soared. While setting a record low versus the franc yesterday, the euro also plunged 3.5 percent against a basket of 10 developed-nation peers, the most since its 1999 debut, and reached an 11-year low against the dollar today. When the news was first announced, the franc exploded, up 41% versus the euro before things calmed down.

Generally, currency trades don’t have big moves. And so brokerages and exchanges allow leverage to entice traders. The U.S. Commodity Futures Trading Commission allows investors to put down as little as 2 percent of the value of their foreign-exchange bets. Brokers may get stuck with the balance of losses suffered by clients who used leverage, borrowed on credit cards, or did both to bet against the franc. FXCM handled $1.4 trillion in currency trades last quarter; today they say clients owe $225 million on their accounts. This afternoon, Leucadia National announced it would provide $300 million in financing to FXCM, which would allow FXCM to maintain its regulatory capital requirements. FXCM isn’t the only casualty from the franc’s sudden move. Global Brokers Ltd., based in New Zealand, said losses from the surge are forcing it to shut down.

Meanwhile the Chicago Mercantile Exchange announced that it will double, then triple, margin on Swiss franc futures contracts. That means they will extend a bit more credit and hope their customers just wait it out and everything will return to something like normal. That will reduce the margin calls but it won’t eliminate them, and I suspect we’ll see some more tales of woe in coming days. And that includes some of the big banks; both Deutsche Bank and Citigroup each reported lost $150 million on Swiss franc trades. The losses are mounting, but so far nothing the markets can’t absorb.

Now let’s look at another market that has seen some fast moves – oil. We’ve been tracking the decline since last summer, but still, that is considered a fast move. The day traders have certainly had their chance to get in or out of a trade, but there are many other investors who can’t jump in and out of positions quite so fast. For example, there is quite a bit of debt associated with oil exploration and drilling and refining. And that energy debt is then bundled together in pools, known as CLOs or collateralized loan obligations, and then those CLOs are traded. But the market for CLOs is not as liquid as you might think, and it becomes less liquid when it looks like some off the loans that were bundled might not perform.

Under provisions of the Dodd-Frank Act, banks are required to sell their stakes in certain complex securities, such as CDOs and CLOs. But there has been a push to repeal parts of the Act. The Volcker reprieve would have given banks until 2019 to sell their stakes in CLOs. Much of the recent energy boom has been financed with junk debt and a good portion of that junk debt ended up in collateralized loan obligations. CLOs are also big users of credit default swaps, which are an important target of the Dodd Frank push-out. In addition, over the past 6 months banks were unable to unload a substantial portion of the junk debt originated and so it remained on bank balance sheets. That debt is now substantially underwater and, potentially, facing default. To hedge or hide the losses, banks are using credit default swaps. Hedge funds are actively shorting these junk debt financed energy companies using credit default swaps.

The Dodd-Frank Act was supposed to get the banks out of that derivatives business in 2015, but if the banks had to mark to market on those CLOs today, it would likely lead to big losses. And so they are asking the politicians to delay implementation of the Volker Rule, so they have more time to sell off their bad CLOs, or maybe for the market to rebound. The reason to expect such heavy concentration of energy debt in CLOs is that energy debt has made a big increase in its total share of the junk bond market, up from 4% ten years ago to 16% now. 16% might not seem like a big deal until you realize that the real increase in energy credit issuance happened in the last few years, so the proportion of energy borrowing to total risky borrowing was vastly higher of late so as to move the averages so much in a short time.

We don’t know exactly how much bad energy debt is bundled into CLOs. Some estimates peg it around $200 billion, but that doesn’t mean everything will go into default. But here is where CLOs are dangerous; they take good energy debt and bad energy debt and other types of debt and they smash it all together. It’s kind of like taking a bunch of apples, and making apple sauce. And once you smash the good apples with the bad apples, you can’t unmake the apple sauce.

The opacity of the banks’ situation is creating a mindset on Wall Street to sell first and ask questions later. On days when oil is plunging in price, big bank stocks are getting hit across the board. Institutional investors with large bank positions who can’t readily dump shares are trying to hedge their exposure by buying puts on Exchange Traded Funds (ETFs) which track the financial services sector. Wholesale dumping of shares could come later if more negative news emerges.