Monday, July 14, 2014 - Clearing Up Outstanding Issues

Clearing Up Outstanding Issues

by 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.