Capital Context Update: Financials

From Capital Context

In a follow up to last week's discussion of
financials in context
, we revisit several of the points we made in the context of last week's sell-off. We were invited to discuss some of our findings on CNBC's Strategy Session this morning and the link above has the embedded video.

We include the notes we wrote for the discussion (please bear in mind they are notes - apologies), but the key takeaways are that financial credit is catching up to equity's weakness (driven by macro-economic, domestic residential/commercial real-estate balance sheet impacts, and expectations for higher cost of capital going forward - TLGP rolls) and what we will be concerned about is when spread decompression starts to lead equities as it did in 2007.

Global Financial Systemic Risk is rising and near one-year highs.

The reduction in the TBTF premium is coming and explains some of the bottom-of-the-capital-structure underperformance of equities (as first loss piece), but the fact that we are hearing chatter of significant US bank exposure to European sovereign credit protection and the start of basis compression (CDS rising back into line with bonds) tells us some counterparty risk overlays may be coming in.

At 5:30, the host Gary Kaminsky, makes a critical point with regard to why understanding financials in context is so important as he outlines his experience during the crisis in understanding what was going on by following equity and credit markets and their relationships.

Rather than reiterate all of the conclusions from our lengthy
financials in context
post, we suggest readers revisit it for the headlines and use the notes and charts below to extend that context:



NOTES:

European and US risk is rising rapidly as contagion concerns rise.

The 30 most systemically critical banks in the world - as defined by the FSB - are trading at an average 143bps - the highest in six months (12 months if we leave the spike in Jan)- and almost double their post crisis lows.

US and European financials have converged notably (US writing CDS on European Sovereigns?).

GS +35% in last 6 weeks at its widest in 9 months.

Most majors (ex JPM) consolidated in 150-170bps range.

BAML highest risk in the US but several European banks are riskier.

JPM stable and along with HSBC is lowest risk of global systemically important banks.

The Major US financials are widening significantly.

Stocks have underperformed credit (CDS not so much bonds) in the last few months



- example and reasons>: BAML (see lowest chart below and discussion of two-stage discovery cycle in financials) should either be 50bps wider or stock should be $3 higher - we think credit is being held down by technicals (flows not technical analysis) as curve/basis traders (people buying FIN bonds,reducing refi risk, which lowers short-term risk and steepens curve - a self-fulfilling trade as long as risk is being added all the time as financialsissue), a preference for US over EU financials, the veil of TBTF, and the more levered equity in the capital structure as fundamentals begin to weigh.

A few drivers/discussion points
:

~Rotation from European financial credit into US financial credit has sustained the disconnect.

~Momentum and safety has helped financials bonds - fund flows and the perception that financials are invincible (and the fact that they offer attractive spread/yield when judged on a ratings basis) has maintained a flow in credit markets while stock flows have flagged.

~The veil of TBTF has maintained spreads at a 'better' than otherwise 'expected' level.

~The same TBTF cover is what is hurting equities as they sit at the bottom of the capital structure and are most levered to performance.

~Equity is also the part of the capital structure that is likely to be hurt IF we ever see any re-emergence of insolvency risk - i.e. it seems investors believe senior debt holders are better protected from stress via the TBTF and contagion concerns BUT stockholders can take a hit.

The credit markets face huge supply issues later in the year as TLGP paper needs to be refinanced.

~Moodys comments begins to unwind some of that risk more explicitly for investors - i.e. basically they are saying big US Fins are less protected by TBTF than they used to be.

~
The need to roll TLGP debt is extremely important - a huge chunk is due in Q4 - this will raise interest expense dramatically for the banks - another drag on stocks where fwd valuations were extremely aggressive
. This is a critical point we think. The chart above shows the sheer size of the TLGP paper due over the next few years with a huge spike in Q4 2011. This debt is extremely low cost at a weighted average yield (not spread) of around 50bps. If one considers that Goldman Sachs has around $17bn outstanding at a yield of 26bps, BAML $28bn at 48bps, and Morgan Stanley $21bn at 23bps then it is not hard to imagine the drag on earnings when they have to refinance this debt at market rates in the 4% range currently (and rising).

Initially equity leads, credit catches up and then credit leads - similar pattern to 2006/7

The last few days we have seen credit spreads jumping wider as financial stocks are rising modestly - we strongly believe this is capital structure arbitrage at play rather than any sentiment-driven strength in stocks. Worryingly, this pattern is very similar to the patterns in debt vs equity trading we saw in 2006/7 among the financials
. Debt and equity tracked each other nicely, then stocks started to leak lower in price and credit was largely unaffected, slowly credit started to catch up with stock weakness, and once it did, markets recognized the weakness and sold stocks off hard as credit led the way. So while we usually state that 'credit anticipates and equity confirms', in the case of financials, we see a two-stage process as the market switches from an equity-led consideration that bank debt is magically protected by Federal (what we call TBTF veil now) mandate (even though stocks will suffer from earnings/macro vol) to considering the what-if chance that the bank faces significant liquidity/solvency stress and then credit leads (as jump risk is bid and drags the rest of the curve flatter and wider). A glance at charts of BofA in Q4 2006 to Q1 2007 and the last few months will raise some neck hairs I am sure.

Bottom-line
- we see the implicit support of TBTF as very evident in the credit derivative markets (though less so in bonds) relative to stocks and other technicals have helped to sustain that. Evidently reducing TBTF status (and implicit support as Moodys has now highlighted more), along with weakening fundamentals and what will be a supply glut will take spreads wider - more in line with stocks. We expect to see stocks and credit underperform as the cost of capital is forced higher. Our preferred financial-related trade is short IG insurers relative to IG corporates - they are nothing more than levered HY investments and will struggle under the loss of liquidity.

What we are watching
- the CDS-Cash basis (for insight into flows), short-end of the CDS curve and 'gappiness' of trading (for insight into counterparty risk hedging), primary issuance concessions (for signs of risk aversion), and debt-equity context (for signs that credit begins to lead equities which like in 2007 will be a worrisome event).

Comments

[OC Money Man]

SMOOT-HAWLEY TARIFF IS COMING BACK       5-31-11

Chinese Proverb: When dancing with a scorpion, safety is in holding the tail firmly.
The U.S. Federal Reserve declared a Trade War last fall by flooding the world with newly printed paper money in a scheme to hammer China with inflation and force the nation to commit economic suicide by raising the exchange rate of their currency. Having failed to force China to change, the War just went global when the European Union imposed itsfirst-ever anti-subsidy tariffs for: “strategic and targeted subsidization of a specific industry by the Chinese government”. The action slaps a charge 4% to 8% duty against all coated paper exports from China, then wallops another 8% to 35.1% duty against individual Chinese companies accused of dumping paper below cost. This draconian action follows Belarus becoming the first European nation to financially collapse and be forced to devalue their currency by 56%. As China’s cheaper exports continues to destroy European jobs, the PIIGS of Europe - Portugal, Ireland, Italy, Greece, and Spain - are at risk suffering a fate similar to Belarus.

The problem with imposing punitive tariffs against countries is the process snowballs into a series of retaliations that will do considerable damage to both parties. When the U.S. Congress passed the Smoot-Hawley Tariff Act in 1930 the legislation was initially hailed as a great success as factory payrolls, construction contracts, and industrial production all increased sharply. But over couple of years as imports decreased 66% and exports decreased 61%. Banks

that had financed the trade began failing. Bank failures caused depositors of solvent banks to panic and withdraw their funds, causing more and more bank failures. By 1933, U.S. gross domestic product had fallen by more than 50% and our nation was in the grips of the Great Depression.

In the early 1990s, when China was on the verge of a civil war following the Tiananmen Square protests and the Soviet Union was imploding; Europe and the U.S. united the West in strategically offering to subsidize China’s economic conversion to capitalism through unprecedented free-trade access to Western markets and toleration of China devaluing their currency by 76%. With hyper-competitive labor costs and free trade access, trillions of dollars

of foreign investments flooded into China to build new factories for exporting to the West.  The West’s initial relationship with China was symbiotic. China got 100 million desperately needed jobs to quell social unrest and the West got cheaper imported goods. Analysts referred to the period from 1994 to 2007 as the Goldilocks Economy, because real estate and stock prices soared in the West as Western Central Banks slashed interest rates without fear of unleashing inflation. The wealth-effects from rising asset values fostered an epic consumption and borrowing as hundreds of millions of Western workers felt economically more prosperous, while only 20 million manufacturing jobs were lost to China. The asset boom also caused tax revenues to sky-rocket and Western politicians eagerly joined in borrowing and spending spree.

The Western love affair with China ended with the 2008 credit crisis that burst the real estate bubble and caused the loss of another 20 million Western jobs. China refused Western demands to raise their exchange rate and parasitically destroy more jobs in the West; as 16 million new Chinese workers enter the labor force each year.  Belarus had served for decades as the Europe’s convenient low-cost manufacturing location for European Union and Russian companies. But brutal competition from Chinese exports has driven unemployment from 1% to over 30% in the last three months. When the country financially collapsed and was forced to devalue its currency by 56%, the nation’s bank

depositors and bondholders also lost 56% of their savings in a single day. Europeans are recoiling from television scenes of panic spreading in the streets across country as store shelves have quickly been emptied by desperate locals trying to spend their collapsing rubles on food and consumer products before another feared wave of devaluation strikes. Neighboring Russia has offered Belarus $3 billion in emergency loans; but only on the condition the government

sells $7.5 billion of assets to Russia at garage-sale-prices. Now on the verge of starvation, Belarus is a frightening preview for what could happen to the PIIGS of Europe if they financially collapse and are forced to devalue their currency.

The West heavily subsidized the growth of globalized trade with China to serve their political and economic goals of destroying the “march of communism”. The strategy was wildly successful, but China has been transformed into a monster that is now devouring jobs in the West. With China unwilling to compromise its competitiveness and the PIIGS of Europe on the brink of Belarusian style disasters; the West is headed down the path of erecting tariff walls

against China. Once nations start tariff cycles, the process politically snow-balls to cause unintended consequences. Just like the passage of Smoot-Hawley Tariffs in the 1930s; the world economy will soon be headed for big trouble.

[oogs66]

almost as confusing to listen to them as to read them

[rocker]

At least somebody at CNBC is honest about the U.S. bank's fraudulent books and trying to explain the differential between the spreads and reality.

Kind of funny. Some of the Singapore Banks said they wanted to do the things, (derivatives and conduits), that the U.S. Banks get to do. Their regulators said sure. BUT, only if and they must be declared on the books. The banks then said, "No thanks".

[jm]

I always appreciate your thoughts and insights.

I wonder if looking at senior/sub differentials might be a better guage of the TBTF thesis?

[CapitalContext]

Thanks JM. We've been looking recently (http://twitpic.com/5b8r8w and http://twitpic.com/5b8rff) but don't see too much to scream about yet. Seems to us like Senior-Sub is a 'cheap' short here but deltas/DV01s make it a little more complex (and liquidity in Subs).

There is a little more variation in the single-names - e.g. BAC has seen the largest jump in the Senior-Sub spread since tights on 4/20 +8bps or 38%, but interestingly MS the least +1bps 3.5%. JPM offers the biggest relative spread (the Senior/Sub spread is 22% of Senior) compensation while MS offers the largest absolute spread at 30bps. Citi's ratio is pretty much at its lowest on record (at 14%). All in all, the main standout is BAC to us as the name that has shown the biggest move in this period relative to the others in the Senior-Sub space.

On a side note - Always frustrating why IG has no major financials and there is no liquid FINL index in US (unlike Europe!!) - time for exchanges to offer to fill that liquidity gap?

[jm]

Yeah, there are a lot of moving parts in these spreads in financials.  Think JPM Senior is bid because counterparty exposures are hard to assess.  Makes their sub debt scary and their secured debt becomes an easy solution to opacity.

I have to think that RMBS rumbles are a part of what is making the financials jittery.