Monday, July 14, 2014 - Clearing Up Outstanding Issues

Financial Review with Sinclair Noe

DOW + 111 = 17,055
SPX + 9 = 1977
NAS + 24 = 4440
10 YR YLD + .03 = 2.55%
OIL + .22 = 101.05
GOLD – 32 = 1307.80
SILV - .54 = 21.00

The Dow Industrial Average hit an intraday high of 17,088, but couldn’t close above the old closing high of 17,074 from July 2.

I woke up this morning and checked the Euro markets; the headline read: Global Stocks mostly higher as Portuguese debt concerns ease. Banco Espirito Santo’s parent company sold part of its stake in the bank to pay off short-term debt, so everything is cool. Portuguese bond prices popped. Nothing to see here. Move along, move along.

Just to refresh your memory, Banco Espirito Santo is 25% owned by Espirito Financial Group, which is in turn 49% owned by Espirito Santos Irmaoes, which in turn is wholly owned by Rioforte investments, which in turn is wholly owned by Espirito Santo international. What’s the point of owning a bank if you can’t make loans to yourself; and that’s what happened, until last week, when Espirito Santo International, the parent company failed to make a payment on short-term debt. The collective companies under the Espirito Santo umbrella have borrowed several billion from the bank, and then the bank made about 8 billion euros in loans to Angola, and that has a non-performance rate approaching 90%. And I know you’re wondering why you should be concerned about loans to Angola, and it’s because everything in finance is leveraged. No loan lives in isolation.

Panic ensued. The fear was that creditors and/or depositors might be on the hook in the event of a shortfall; no one could be certain because of a lack of transparency. But the bank says they have a cushion; the parent company sold a few assets to come current on the loan. Hopefully, I’ve cleared up the transparency issue. Regulators say there’s nothing to worry about and they should know because they didn’t see this coming in the first place, and so there’s nothing to worry about; the situation in Portugal is contained, and global stocks moved higher.

Here in the US, we know a thing or two about banks behaving badly. Today, as expected, Citgroup agreed to pay $7 billion to settle civil claims the bank misled investors about toxic mortgage backed securities leading up to the 2008 crash. Citigroup admitted it was aware that "significant percentages" of sample loans did not comply with underwriting guidelines but the bank pooled them into securities anyway. In one 2007 deal, a Citigroup trader told colleagues in an email he had reviewed a due diligence report on the poorest quality loans, and that they "should start praying." Many of the loans listed unreasonable borrower incomes or home values below the original appraisals, the trader wrote, saying he "would not be surprised if half of these loans went down." Citigroup still securitized loans from the pool. Quite simply, they knew the mortgage backed securities were full of bad loans, they lied about it to make the sale.

Under the agreement, Citi will pay $4.5 billion in cash and provide $2.5 billion in aid to low-income tenants and struggling homeowners; details of terms of the help and how many will benefit are not yet known, but there’s no indication people they will go back to help make people whole. Some homeowners with Citi mortgages could see the amount of their loans reduced, or could have their interest rates reduced. There will also be down payment and closing cost assistance to future homebuyers. But none of that starts until 2018. I don’t know why.

Last year Citi settled with the FHFA for $250 million. The regulator of Fannie Mae and Freddie Mac had sued the bank over soured mortgage securities sold to the taxpayer-owned entities. The cash portion consists of a record $4 billion civil payment to the Justice Department, double JPMorgan’s penalty in November, and $500 million to resolve claims from five state attorneys general and the Federal Deposit Insurance Corp.

And there is a little gift for Citi; the state AG and FDIC payments would be deductible, along with any costs Citigroup actually incurs in relation to consumer relief, which could be less than the $2.5 billion amount of relief in the settlement.

As part of the settlement, Citigroup “will take a charge of approximately $3.8 billion pre-tax in the second quarter of 2014." Second-quarter earnings results were also posted this morning, and if you exclude the multi-billion dollar settlement, Citi beat expectations. The settlement wipes out the quarter’s earnings, but if you look the other way, it was a kick ass quarter for earnings. Citigroup exceeded Wall Street expectations in the second quarter with adjusted earnings of $1.24 a share. On that basis, analysts had been expecting Citigroup would earn $1.05 a share. Citi posted a 15% drop in trading revenue. Investment banking revenue rose 16% from a year ago. Mortgage originations were down.

This is a civil settlement, not a criminal settlement. Attorney General Eric Holder at a press conference said: “Citi settlement doesn’t absolve bank, employees from criminal charges.” Of course nobody expects the Department of Justice to pursue criminal charges. Citi is also under investigation for possible fraud and money laundering in its Mexican unit. And if you look at all the wrongdoing, you might come to the conclusion that this is just a corrupt organization.

If you’re wondering where the next subprime meltdown will occur, well you can pick from a wide selection of possibilities. Markets seem to be considering only a very narrow spectrum of potential outcomes. They have become convinced that monetary conditions will remain easy for a very long time, and may be taking more assurance than central banks wish to give. Debt ratios in the developed economies have risen by 20 percentage points to 275% of GDP, since the Lehman crisis. Credit spreads have fallen to wafer-thin levels. Companies are borrowing heavily to buy back their own shares, and 40% of syndicated loans are to sub-investment grade borrowers, a higher ratio than in 2007, with fewer protections from loss.

The Bank of International Settlements, the central bank for the central bankers of the world, warned it is annual report two weeks ago that equity markets had become "euphoric". Volatility has dropped to an historic low. European equities have risen 15% in a year despite near zero growth and a 3% fall in expected earnings. The cyclically-adjusted price earnings ratio of the S&P 500 index in the US reached 25 in May, six points above its half-century average. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.

Some of you might pick the student loan market, with over $1 trillion in outstanding loans and growing. The deeply indebted college graduate has become a stock character in the national conversation: the art history major with $50,000 in debt, the underemployed barista with $75,000, the struggling poet with $100,000. That’s not really typical of student loan debt. Only 7 percent of young-adult households with education debt have $50,000 or more of it. By contrast, 58 percent of such households have less than $10,000 in debt, and an additional 18 percent have between $10,000 and $20,000.

That’s not to say student loan debt is not a concern, it is, and it is growing. In 2010, 36 percent of households with people between the ages of 20 and 40 had education debt, up from 14 percent in 1989. The median amount of debt, among those with debt, more than doubled, to $8,500 from $3,517, after adjusting for inflation. Student loan debt is a problem, but it isn’t a new problem, it’s just a trillion dollar problem now, but it hasn’t imploded in the past 2 decades and there doesn’t seem to be an immediate catalyst.

How about a bubble in energy? Ambrose Evans- Pritchard writes: Data from Bank of America show that oil and gas investment in the US has soared to $200 billion a year. It has reached 20% of total US private fixed investment, the same share as home building. This has never happened before in US history, even during the Second World War when oil production was a strategic imperative.

The International Energy Agency (IEA) says global investment in fossil fuel supply doubled in real terms to $900 billion from 2000 to 2008 as the boom gathered pace. It has since stabilized at a very high plateau, near $950 billion last year. Output from conventional fields peaked in 2005. Not a single large project has come on stream at a break-even cost below $80 a barrel for almost three years….

There are, of course, other candidates for the bubble prize of the current economic cycle, now into its 22nd quarter and facing the headwinds of US monetary tightening. China’s housing boom has echoes of the Tokyo blow-off in 1989, and is four times more stretched than US subprime in 2006, based on price-to-income…Emerging markets have racked up $2 trillion in foreign currency debt since 2008. They are a much larger animal than they were during the East Asia crisis of the late 1990s, so any crisis would do more damage.

Yet the sheer scale of “stranded assets” and potential write-offs in the fossil industry raises eyebrows. IHS Global Insight said the average return on oil and gas exploration in North America has fallen to 8.6%, lower than in 2001 when oil was trading at $27 a barrel. What happens if oil falls back towards $80 as Libya ends force majeure at its oil hubs and Iran rejoins the world economy?

And that’s before we get to another threat to fossil fuel investments that Evans-Pritchard mentions: that governments might get serious about climate change and impose meaningful restrictions, like hefty carbon taxes. Right now, that seems like a tail risk, but the crisis just past was a tail event as well. And much higher energy prices resulting from restriction on fossil fuel production would slow down economic activity markedly, which again could blow back to leveraged investors in unexpected ways.

Monday, April 28, 2014 - But Our Bankers Aren’t Oligarchs

Financial Review with Sinclair Noe

DOW + 87 = 16448
SPX + 6 = 1869
NAS – 1 = 4074
10 YR YLD + .01 = 2.67%
OIL - .03 = 100.57
GOLD – 7.50 = 1297.30
SILV - .16 = 19.67

This should be an interesting week. On Wednesday, the Federal Reserve’s Federal Open Market Committee, the FOMC, will meet to determine monetary policy; a statement will be issued Wednesday. On Friday, we’ll have the monthly jobs report.

The market is jittery. The Dow fell 140 points on Friday, rose 139 on Monday morning, and gave it all back Monday afternoon, then recovered at little at the close. Investors are worried about the Ukraine crisis, the Fed’s tapering, peak earnings, high PEs, low GDP, inflation, deflation, and of course, their own shadows.

So far, the stock market has merely been sluggish to start the year; no big crash, no big gains. Last week, the big 3 indices were down a little, while the indices are in negative territory year to date, that could change with one good week of trading. After doubling or tripling since 2009, stocks aren't cheap any more. Companies, meanwhile, are finding it harder to keep raising earnings in a period of soft economic growth. This makes investors more cautious, but because speculative excess still hasn't reached the extremes of past bubbles, and because the Federal Reserve is determined to sustain the recovery, there is less fear of a big decline. The Fed has started slowly rolling back its quantitative easing, gradually ending the unprecedented bond-buying program that dumped more than $1 trillion into financial markets. Investors are trying to figure out how well corporate earnings will grow with less Fed aid.

A big complication is that many companies are reaching the limit of their ability to boost profits by cutting costs. More companies now need to focus on building revenues, which means higher costs for investment, hiring and wages. The days may be ending when Wall Street will reward companies for holding down wages and doing little investing; the focus is shifting to sustainable earnings.

Margin debt, a measure of the use of borrowed money to invest, is at a record high in dollar terms. But as a percentage of market value, it is 2.6%, still between the 2008 low of 2.3% and the 2007 high of 2.8%. Still, the markets haven’t yet shown enough excess to warrant a crash, and so people are still buying the dips; probably because they haven’t yet figured out where else they can go.

Money managers are turning on stocks that have delivered the best returns during the bull market: small caps. Large speculators such as hedge funds are betting $2.8 billion this month that the Russell 2000 Index will fall. That’s the most since 2012 and the highest versus average levels since 2004.

Today, the National Association of Realtors reported its Pending Home sales index increased 3.4% to 97.4. The index is based on contracts signed last month to purchase previously owned homes. These contracts usually become sales after a month or two, and March's rise suggested home resales could rebound in the months ahead. Existing home sales had fallen to their lowest levels in more than 18 months, with March sales down 7.9%; but today’s report suggests the possible end to the soft patch in sales.

Along with the economic news this week, we’re keeping an eye on geopolitical events, as Ukraine is crumbling under a constant barrage. Russian backed militants extended their hold on eastern Ukraine by seizing more public buildings in Donetsk region, breaking up rallies by supporters of the government in Kiev. The mayor of the second largest city in Ukraine was shot today. Russian gunmen are holding about 40 hostages, including 6 military observers from the Organization for Security and Cooperation in Europe, their interpreter and 4 Ukrainian army officers who were accompanying them.

Today, President Obama announce more sanctions against Russian oligarchs; imposing travel bans and asset freezes for 7 individuals and 17 companies. So far, most of the sanctions have been targeted toward energy companies or energy company executives and banks and bankers. Stop and think about that for a moment. Russian bankers are considered oligarchs fomenting geopolitical unrest and supporting the corrupt regime of Putin. And in the US we’re supposed to believe that our bankers are the beneficent titans of industry and pillars of commerce.

Last week we reported that the Department of Justice was in the early stages of negotiating a settlement with Bank of America. The government is reportedly seeking $13 billion in penalties, on top of $9.5 billion that BofA agreed last month to pay to the Federal Housing Finance Agency. The problem is that BofA sold mortgage backed bonds stuffed with shoddy mortgages that did not meet basic standards.

A big part of the settlement would go to the FHFA as compensation for selling the defective bonds to Fannie Mae and Freddie Mac. Another part of the settlement takes the form of consumer relief; requiring the bank to adjust mortgages to make them more affordable for borrowers; the problem is the bank probably doesn't own the mortgages, so the bank wouldn't really have that expense.

Also, digging deeper into the previously announced $9.5 billion settlement with FHFA, about $3.2 billion involved BofA buying back mortgage bonds, but they bought those securities for 20 cents on the dollar, and they still have value, probably a lot more than what BofA paid. When is a penalty a profit? When a big bank settles with the bank regulators.

The Supreme Court will hear a case that has some intriguing implications for mortgages; it involves the Truth in Lending Act. The case is Jesinoski v. Countrywide, the subsidiary of Bank of America. The Jesinoskis refinanced a mortgage in 2007; when their loan was closed, Countrywide did not provide all of the disclosures required by the Truth in Lending Act (TILA). Their suit states that they were not provided with two copies of a “Notice of Right to Cancel” and two copies of a “Truth in Lending Disclosure Statement.”

Under the Truth in Lending Act, a borrower has the right to rescind the loan by midnight of the third business day following the closing of the loan, or until the lender has provided the borrower with all the legally required loan documents. The Act also creates a three-year time limit to exercise the right to rescind the loan, even if the required disclosures have not been delivered to the borrower. Three years to the day, the Jesinoskis sent a letter to Bank of America rescinding the loan. BofA said the letter meant nothing. The Jesinoskis sued to enforce their rescission request, saying that their letter should have been sufficient.

The case has made its way through appellate courts, which denied their appeal, but other District Courts have been split on whether a letter is an allowable form of notification in instances such as the Jesinoskis’ case. The Supreme Court merely said they would hear the case; any actual decision is a long way off.

A more pressing matter for Bank of America is capital levels required by the Federal Reserve. You may remember the Fed recently conducted stress tests for big banks and it turns out that, following further review, Bank of America flunked the test; seems they miscounted  the treatment of structured notes assumed in its acquisition of Merrill Lynch in 2009. The bank notified the Fed of its mistake and the Fed is now “requiring the Bank of America Corporation to resubmit its capital plan and to suspend planned increases in capital distributions.” Or in plain English, no stock buybacks, and no dividend increases.

Particularly concerning for regulators and shareholders, the bank had been making the accounting error for more than four years, potentially inflating its true level of capital during that period. This basically goes to the practice of booking gains or losses based on changes in the value of a firm’s own debt, which led to BofA’s regulatory capital problem. Essentially, accounting rules mean that, in some cases, the worse off a firm is from a credit standpoint, the more it may gain in terms of earnings. That is because the value of its own debt would be falling during a stressed time. This would lead to a smaller liability. And a decline in a liability results in a gain to income.

This didn't used to be much of an issue since the value of bank debt didn't change all that much. Then came the financial crisis. And as bank debt remained volatile in its wake, firms were left with big counter-intuitive gains or losses in their income based on fluctuations in the value of some of their liabilities. Banks started to exclude the impact of such changes from their results. Investors couldn't make heads nor tails of the mess, and so they ignored it, at least until it affects buybacks and dividends. The important part to remember is that BofA flunked its stress test, and nearly 6 years after the financial meltdown they still have toxic junk on their books and they haven’t figured out how to count it.

Meanwhile, regulators in Britain announced they've begun criminal proceedings against 3 former Barclays employees suspected of manipulating the Libor. The new criminal proceedings are the latest development in a broad investigation into the manipulation of major interest rates by some of the largest global banks, including Barclays, UBS, Royal Bank of Scotland, and others. Twelve people in total are now facing criminal charges in Britain. All 12 are mid-level traders. Barclays, RBS, UBS, the Dutch lender Rabobank and ICAP have combined to pay more than $3 billion in fines to British and American authorities in the investigation of manipulation of various Libor-linked interest rates, but so far regulators have not been able to figure out whether higher level execs at these institutions knew anything about manipulation in a multi-trillion dollar market; which seems remarkably unlikely.