Monthly Archives: February 2016

The Big Short All Over Again

“The Big Short” is a movie that is currently in the theaters and has been nominated for an Academy Award.  It very accurately describes what happened during 2006-2008 when the real estate bubble burst sending Lehman Brothers, Bear Stearns, AIG, Fannie Mae, Freddie Mac and many other banks and financial institutions into bankruptcy and/or bailout.  It chronicles how a handful of investors and firms figured out that the US federal mortgage system, which was rated triple A and supposedly guaranteed, was about to fail. They shorted the US mortgage market by the use of “credit default swaps,” which are inexpensive insurance contracts on these mortgage pools of securities.  As hard as it may be to believe, it’s happening again.  Everything is lining up just like it did in 2007 and 2008, but this time it’s going to be worse, and the central banks are not in a position to intervene like they did last time.

Sub-prime mortgages were the catalyst for the 2007- 2008 collapsed real estate market. With the politically correct, but financially foolish, objective of making home mortgages more available to risky borrowers, these mortgages were given to people who couldn’t fully document their income and didn’t qualify for a conventional mortgage. These borrowers had to pay a higher interest rate because they were a greater risk. This in turn attracted investors, who got a much higher yield, but also took a much higher risk to get that yield. History documents this did not work and everybody involved lost money. The home owners defaulted on their loans and lost their homes, the investors and investment firms who invested in these supposed triple A mortgages lost their money, and the banks and Fannie Mae & Freddie Mac, would have defaulted had they not been bailed out by the US government with tax payer dollars.

All of this helped fuel a tidal wave of defaults during the housing crisis, and these types of mortgages subsequently fell out of favor. These sub-prime loans (also known as Alt-A loans or low-doc loans), gained prominence in the years leading up to the financial crisis, with lenders originating $400 billion at their peak in 2006, according to trade publication Inside Mortgage Finance. The Wall Street Journal reported that Wall Street firms want to bring back the low-doc loans, because investors are searching for a high yield in a low interest rate environment, so prominent investment firms like PIMCO, Neuberger & Berman, Legg Mason and others are once again pooling these high risk loans together to create high yields for their clients. The question everyone should be asking is: Why are we doing this again and why do these investment companies think they can manage the risk any better than Bear Stearns or Lehman Brothers could?

The other half of the equation that contributed to the 2007 real estate crisis was the lax standards of Fannie Mae & Freddie Mac, and their “too big to fail” attitude. The Wall Street Journal reported, Fannie and Freddie and their regulators just completed changes that will allow them to make loans cheaper and easier for risky borrowers. Fannie Mae and Freddie Mac said Feb 2nd that they have come to terms with lenders on how to resolve mortgage disputes, capping an effort that regulators hope will make loans cheaper and easier to get for some risky borrowers.

As the US high yield/junk bond market has tanked, investment companies are looking for alternatives for their yield hungry clients. So in addition to the above changes, they have become even more inventive. A group of hedge funds, convinced they have found the next Big Short, are looking to bet against bonds backed by sub-prime auto loans. Currently, cars are being sold to almost anyone who can breathe and sign their name, so investment companies again are pooling these high risk/sub-prime auto loans together and selling them to their clients. “Too many borrowers are likely driving away with cars they can’t afford,” said Janet Tavakoli, president and founder of Tavakoli Structured Finance. Tavakoli sounded alarms about the mortgage bubble before the 2008 collapse. (Bloomberg)

More Subprime Borrowers Are Falling Behind on Their Auto Loans (2-23-16)
Some Hedge Funds Want to Make Subprime Auto Loans Next Big Short (2-8-16)
Fannie Mae and Freddie Mac Agree to Terms on Resolving Mortgage Disputes (2-2-16) WSJ
Remember ‘Liar Loans’ Wall Street Pushes a Twist on the Crisis-Era Mortgage (2-2-16) WSJ
Mutual Funds Are Risky (2-3-16) WSJ |

Global Markets Down, Central Banks Directionless & Ineffective

The Dow started the year at 17,425 and ended on Friday at 15,973, down 1,452 and down 1,850 from its high in 2015. The first six weeks of 2016 have not turned out the way that Chairman Yellen and the Federal Reserve predicted at the end of December. Yellen reported to Congress last week that the Fed is now discussing the possibility of negative interest rates, like they have in the European Central Bank (ECB) and the Bank of Japan (BOJ). This is a reversal of everything Yellen said seven weeks ago when the Fed raised interest rates.

Along with the US markets, European stocks tumbled for a seventh day and the lender gauge of banks slid to its lowest level since 2012 as the global equity rout showed no signs of abating. Greece’s Eurobank Ergasias SA led lenders lower, sliding 12%, as the cost of insuring financial debt rose amid concern over whether banks are strong enough to cope with a downturn. Deutsche Bank AG reversed gains, falling 4.3% to its lowest price since 1992, even as it reassured investors that it has enough cash to pay its debts. The Stoxx Europe 600 Index dropped 1.6% to 309.39 at the close of trading, its lowest level since October 2013, sending it into so-called “oversold” territory. Greece’s ASE Index slid to its lowest point since 1989.

Global market turmoil has also upended Japan’s finely tuned plan for recovery, sending the country’s top economic advisers scrambling for ways to cope. Following market selloffs in the U.S. and Europe, Tokyo’s Nikkei Stock Average fell nearly 5% on Friday to complete its worst week since October 2008. Global investors opting for the safest assets helped push the yen to a 15-month high against the USD.

As Chinese markets and the yuan have continued their volatility, China is continuing its attempt to switch gears away from heavy investment and toward consumption; the reverberations are being felt Down Under. Prices for Australia’s biggest export, iron ore, have slumped and the country’s trade position has steadily deteriorated, culminating in a record 32.7 billion AUD (22.9 billion USD) deficit in 2015, according to data dating back to 1971.

One of few countries exceeding expectations is India with a 7.6% expansion rate and economists estimate they will overtake China. Bloomberg reported the top 5 worst economies are Venezuela and Argentina (who are dealing with inflation and unemployment), and South Africa, Greece and Ukraine, who are desperately trying to stop unemployment from deepening. The top 5 best economies are Thailand, Singapore, Switzerland, Taiwan and Japan.

Market Meltdown Threatens Japan’s Economic-Revival Plan (2-12-16) WSJ
Smashed Valuations Show S&P 500 Used to Profit Recession (2-12-16)
Markets Going to Be Mauled by Bear Said David Stockman (2-9-16) Bloomberg Video
U.S. Stock Rally Fades as Commodity Shares Slip; Dollar Weakens (2-9-16)
European Stocks Retreat to Lowest Since 2013 as Banks Tumble (2-9-16)
Asian Stocks Extend World Rout Amid Rising Yen While Oil Rallies (2-8-16)
India Sees Growth Exceeding Estimate as Modi Prepares Budget (2-8-16)
Stocks Retreat Worldwide, Credit Weakens Amid Signs of Distress (2-7-16)
These Are the World’s Most Miserable Economies (2-4-16)
Inflation-Racked Venezuela Orders Bank Notes by the Planeload (2-3-16) WSJ
Aussie Woes as China Slows Seen in Record Trade Deficit Chart (1-30-16)


Central Banks & Negative Interest Rates
Janet Yellen testified before a Congress, that the Federal Reserve still expects to raise interest rates gradually, while at the same time making it clear that continued market turmoil could throw the Fed off course from the multiple rate hikes they have planned for 2016. “Financial conditions in the United States have recently become less supportive of growth,” Yellen said. US Markets, global markets and most investor expectations for additional rate increases from the Fed this year have collapsed. The probability that the Fed will lower interest rates into negative territory and possibly resume printing money and purchasing bonds like the EU, Japan and China is becoming more likely.

The growing consensus is that intervention/stimulus by central banks is becoming less and less effective, and is part of the problem. Many now believe that the massive intervention since the 2008 financial crisis) have created artificial environments and financial bubbles which in turn do not respond to current economic conditions as they normally would. To say it another way, central bank intervention has created artificial economic environments which don’t respond to natural economic principles and they don’t have any vaccine to deal with the contagion they’ve created.

The WSJ reported, the Bank of International Settlements (BIS), the central bank of central banks, has expressed more concern about excessive debt than market turbulence. “Central bankers should resist the temptation to support tumbling financial markets by pursuing easier monetary policies,” the head of the BIS said on Friday. Speaking at the London School of Economics, Jaime Caruana warned against efforts to sustain or revive rises in asset prices by lowering interest rates or adding to quantitative-easing programs saying: “The temptation may be to try to keep the financial booms going, or to give them a new lease of life, but this will be just a palliative unless the stock of debt is adjusted and vulnerabilities are reduced.”

We have reached that fork in the road within the monetary twilight zone, where Europe’s largest bank is openly defying central bank policy and demanding an end to easy money. Alas, since tighter monetary policy assures just as much if not more pain, one can’t help but wonder just how the central banks get themselves out of this particular trap they’ve set up for themselves. (WSJ)

Global central banks have opened the door to negative US interest rates, in Wall Street’s view. After the Bank of Japan cut some rates below zero last month, to spur growth and inflation, strategists are weighing the Federal Reserve’s options in case of a crisis. If the world’s biggest economy weakens enough that traditional policy measures don’t help, the Fed may consider pushing rates below zero, according to Bank of America Corp. and JPMorgan Chase & Co.

The Probability of Negative U.S. Rates Is on the Rise (2-7-16)
A Fed Rate Cut in 2016 The Odds Are Increasing (2-10-16) Bloomberg Video
Yellen Signals Rate Path Hinges on Whether Turmoil Persists (2-10-16)
Gundlach Says Fed May Have to Ease Again: Barron’s Roundtable (1-16-16)
BIS Warns Against Easier Policies to Support Markets (2-5-16) WSJ
2007 All Over Again Banks Starting To Implode (2-8-16) by
John Rubino


Bloomberg reported, it’s been a bad seven weeks for European banks – worse even than during the 2008 financial crisis, by some measures. Deutsche Bank, hit this week by concern over its creditworthiness, is down 39%. While all industry groups have suffered, lenders have been hit the hardest, those in the Stoxx Europe 600 Index have plunged 29% this year, including their biggest sell-off since August 2011 on Thursday. UK banks weren’t spared, with Standard Chartered Plc down 31% in 2016, its lowest price since 1998.

International central banks steering of interest rates into negative territory is taking a heavy toll on big US banks and their stocks. Along with the Fed’s testimony that they are considering negative interest rates, US markets were selling off again Thursday. Banking and financial stocks are falling, as their profit margins shrink along with interest rates. Fox News reported negative interest rates mean “the biggest US banks, all of which have massive international exposure, will have to pay to hold their cash reserves in central banks in places such as Japan, the Eurozone, Denmark and Sweden,” where interest rates have been lowered into negative territory. The financial sector is the biggest losing sector so far this year, down more than 15% ahead of Friday’s open. The financial sector is now officially in a bear market, down a little more than 20% from the recent highs in July and down more than 15% year to date. The simple discussion by the Fed of negative US interest rates has contributed to the drop in bank stocks.

Credit stress in the European banking system has suddenly turned virulent and begun spreading to Italian, Spanish and Portuguese government debt, reviving fears of the sovereign “doom-loop” that ravaged the region four years ago. “People are scared. This is very close to a potentially self-fulfilling credit crisis … We have a major dislocation in the credit markets. Liquidity is totally drained and it is very difficult to exit trades. You can’t find a buyer,” said Antonio Guglielmi, head of European banking research at Italy’s Mediobanca. Marc Ostwald, a credit expert at ADM said, “the Bank of Japan’s failure to gain any traction by cutting interest rates below zero last month was the trigger for the latest crisis, undermining faith in the magic of global central banks. That was unquestionably the straw that broke the camel’s back. It has created havoc,” (The UK Telegraph).

Guglielmi said, “There is a gnawing fear among global investors that these draconian “bail-ins” may be crystallised as European banks grapple with €1 trillion of non-performing loans.” The bail-in rules were first imposed in Cyprus after the island’s debt crisis, stripping European bank debt of its hallowed status as a pillar of financial stability and of its implicit guarantee by EU states. The Telegraph reported, the new banking regulations came into force for the whole currency bloc in January. Both senior and junior debt must now face wipeout before taxpayers have to contribute money. While this makes sense on one level, the eurozone banking structure is now dangerously deformed. Individual eurozone states cannot easily recapitalize their own banking systems because that breaches EU state-aid rules, but there is no functioning European body to replace them. It cannot usefully cut interest rates any deeper into negative territory since the current level of -0.3% is already burning up the “net interest margin’ of lenders and eroding bank profits. “How much further can the ECB go before it becomes outright harmful?” Guglielmi asked.

Europe Bank Selloff Deepens as Traders Locked in No Man’s Land (2-11-16)
Fear, Uncertainty, Negative Rates Pounding Financial Stocks (2-11-16) Fox News
BOJ’s NIRP failure Triggers Doom-Loop In European Bank & Credit Markets (2.10.16) The Telegraph
When Crunch Comes, Bankers Lie Says David Stockman (2-9-16) Bloomberg Video


Recession Looking Like 2008
“The risk of recession and deflation is rising,” said Francois Savary, the chief investment officer of Prime Partners SA, a Geneva-based investment manager. In a Bloomberg article Lee Ferridge, the Boston-based head of macro strategy for North America at State Street Global Markets said “It’s not enough that valuations have receded quite significantly and earnings haven’t been too bad — sentiment is very low and there isn’t much visibility right now. That’s frightening.” The payrolls weren’t strong so it doesn’t make everything fine, but it brings the Fed back into play, because of the wages … Retail sales takes on a prominence because, if that’s a weak number, the consumer’s slowing, manufacturing’s slowing, services are slowing.”

The Telegraph reported that, along with oil, commodity prices have crashed by two thirds since their peaks in 2014. “We are in a very unusual situation where market sentiment is of a different nature to anything we’ve seen before,” says Thomas Thygesen, head of economics at SEB in London. Unlike previous pre-recessionary eras, the current sell-off has seen commodity prices, equities and credit conditions all move in dangerous lockstep. Although a 75pc oil price collapse should represent an unmitigated positive for the world’s fuel thirsty consumers, the sheer scale of the price rout is imperiling the finances of producer nations from Nigeria to Azerbaijan, and is now threatening to unleash a wave of bankruptcies across corporate America.

Indebtedness is not just the scourge of the US. Globally, the oil and gas industry has issued $1.4 trillion of bonds and taken out a further $1.6 trillion in syndicated loans, driving the sector’s combined debt to $3 trillion, according to the Bank of International Settlements. They warn of an “illusion of sustainability” that could quickly turn toxic as the credit cycle unravels. “Conditions that usually pave the way for mounting defaults – such as growing bad debt, tightening monetary conditions, tightening of corporate credit standards and volatility spikes – are currently met in the US”, says Bronka Rzepkowski at Oxford Economics. He went on to say, “Such levels of financial distress, more often than not, portend a global recession.”

The US economy is flashing warning signs, particularly in the industrial and manufacturing sectors. Demand for oil, and particularly so-called distillates — which are refined oil products such as jet fuels and heating oils — is crashing. Distillates were the weakest sector, down 18%. The scale of the decline in distillates demand in January has only ever been seen before during full-blown US recessions.

Last year, the number of dividend reductions far surpassed 2008, according to Bespoke Investment Group, citing data from Standard & Poor’s. The ratcheting down of payouts to shareholders is a function of weak commodity prices, sluggish growth dampening corporate profits, and a tightening of credit conditions. The number of payout cuts enacted was almost 100 more than at the outset of the Great Recession — a time when the implosion of Lehman Brothers Holdings Inc. caused equity markets to plummet in the later stages of the third quarter (as reported by Bloomberg).

Matthew Whitbread, Boston-based investment manager at Baring Asset Management LLC, which oversees $35 billion said “There were some rather heroic growth forecasts built into a lot of U.S. earnings numbers, and clearly they’re no longer expected to materialize. Investors have started to question where that growth would come from, and they’ve realized we’re one step closer to a recession.”

Smashed Valuations Show S&P 500 Used to Profit Recession (2-12-16)
Stocks Retreat Worldwide, Credit Weakens Amid Signs of Distress (2-7-16)
Another Recession Indicator Flashing Red Distillate Demand in January Plunges 18% (2.10.16) by Business Insider
Are Europe Stocks at Recession Prices (2-9-16) Bloomberg Video
Debt, Defaults & Devaluations Why This Market Crash Is Like Nothing Before (2-8-16)
Asian Stocks Extend World Rout Amid Rising Yen While Oil Rallies (2-8-16)
Gundlach Says Dollar Will Drop in 2016 (1-5-16)
Another Sign of Rough Sledding Ahead Dividend Cuts Surpass 2008 (2-5-16)
Boone Pickens: Watch Out for Recession (2-4-16)


As of mid-February, the USD is dropping in value along with the US Stock market, as are global equity markets and bond markets. Commodities are continuing to fall and our capacity to store oil is almost maxed out. Central banks are proving ineffective and creating more problems than solutions and bank securities are dropping as people question their stability and solvency. The global equity bear market deepened in Asian trading, with Japanese stocks headed for their worst week since 2008 as anxiety over central banks’ ability to revive the world economy fueled a rally in the yen. “We’ve entered a different phase in the market,” said Juichi Wako, a senior strategist at Nomura Holdings Inc. in Tokyo, “We’re not simply in a risk-off mode; the market has fallen to the point of pricing in a recession in the US.” (Bloomberg)

“The US and European Union regulators reached an agreement on oversight of the $553 trillion global derivatives market, seeking to prevent capital increases from hitting EU banks this year,” Bloomberg reported. The Bloomberg article is very technical, but the first sentence ought to stir concern in the hearts of everyone who remembers the role derivatives played in the 2008 financial crisis and Lehman Brothers collapse. A derivative is an investment instrument that derives its value from something else, like stock, bond, property or bank deposit derivatives, and they can be leverage up to ten times their value. $553 Trillion is around twice as much as what the article below values the entire world’s wealth at $223 trillion. So based on these articles, the world owes twice as much as its worth, or to say it another way the world has $223T of assets and $553T of liabilities. Is it any wonder, that most of the banks and central banks of the world are having issues?

EU, U.S. Reach Deal on Clearing Rules for Derivatives Market (2-10-16)
It’s a “0.6%” World Who Owns What of the $223 Trillion in Global Wealth (6-2-13)
Asian Stocks Extend World Rout Amid Rising Yen While Oil Rallies (2-8-16)
BP CEO Very Bearish on Oil as Storage Tanks Are Filling Up (2-10-16)
IEA Raises Estimate of Surplus Oil Supply on Higher OPEC Output (2-9-16)
BP CEO Very Bearish on Oil as Storage Tanks Are Filling Up (2-10-16)
IEA Raises Estimate of Surplus Oil Supply on Higher OPEC Output (2-9-16)