Bank Profitability Rises FDIC Report

The FDIC issued a report today on the strength of bank earnings in Q4 2010 versus Q4 2009.  Earnings are up $23.5 billion.  Sounds great right?  Banks are recovering as clearly the headlines states.  CNBC reports the following.

"The banking industry continues to recover from the 2007-2009 financial crisis but lending will need to pick up if progress is to continue, Federal Deposit Insurance Corp Chairman Sheila Bair said on Wednesday.

Industry profits were up considerably from a year ago standing at $21.7 billion in the fourth quarter of 2010, which compares to a net loss of $1.8 billion a year ago, according to the quarterly banking report released by the agency.

Most of the increase was due to banks putting aside less to guard against loan losses.

Banks put aside $31.6 billion in the fourth quarter for losses, about 50 percent less than a year ago."

In case you missed it, banks put aside 50% less for reserves against credit losses in Q4 2010 versus Q4 2009.  In Q4 2009 approximately $60 billion was charged to reserves for credit losses.  In Q4 2010 the number was $31.6 billion.  The graph below shows the percent reserved for credit losses for JPM, WFC, C, BAC.  Notice the improving trend, meaning they are reserve less as a percent of total credits.  

Improving credit quality?  What?  Banks are not extending credit because they already have enough homes coming back to them.  Interest rates are rising putting further pressure on home prices.  About 40% of CRE to be rolled in 2011 does not meet rating agency standards (do rating agencies really have any standards in the first place?).

• BAC just restated goodwill impairment and credit card losses retroactively from 2009 through 2010 by an additional 10 billion.

• The CFO of WFC abruptly left in the midst of an internal review of their credit quality.  Is there a reason he could not finish the review and sign off on the audit.  I mean he is only 60 and makes north of $5 million.  He actually took an unpaid sabbatical for a few months at which point retirement is more financially beneficial.

• Home prices have begun double dipping, meaning higher strategic defaults.

• The volume of homes to go from delinquent to REO is growing.

• Second tier credits still have yet to be marked down.

• Didn't the Fed just tell all banks to stress test against a GDP decline and unemployment at 11%?

Don't fall for it.  Read beyond the headlines from CNBC.  Banks are a mess and at some point, their bullish bet on improving credit quality will result in them taking a massive hit to earnings.  

Bank Profitability Rises FDIC Report

Bank Of America Credit Quality Deteriorating

This most recent earning season saw all of the large banks quote improved credit quality as the basis to reduce reserves for credit losses and subsequently beat on the bottom line.  Recently that has been called into question with the departure of Howard Atkins, CFO of WFC.  This weekend's actions by BAC further question the improving credit quality assumption.

Feb. 22 (Bloomberg) -- Bank of America Corp., the biggest U.S. lender by assets, almost doubled a goodwill impairment for its credit-card unit to $20.3 billion to reflect increased defaults and an almost 2-year-old change in rules.

The bank restated federal regulatory filings to record the writedown to its FIA Card Services unit in 2009’s first half, the firm said yesterday in a statement. The non-cash charge, which replaced a $10.4 billion impairment booked on the unit last year, doesn’t affect “the financial results, safety and soundness or the capital position” of the Charlotte, North Carolina-based parent company, said Robert Stickler, a spokesman.

In November, the bank said some measureswould cut annual revenue by $1 billion, undermining efforts by Chief Executive Officer Brian T. Moynihan, 51, to improve returns for investors. The firm yesterday said the act and “deteriorating credit quality” caused the revision.

With deteriorating home and commercial real estate prices, rising unemployment (read beyond the BLS headlines), a rising interest rate environment and a US economy stuck at stall speed, BAC very likely will be forced to begin adding to reserves for credit losses in the coming quarters as the truth about "improving credit quality" is exposed.  Don't confuse the recent dead cat bounce in this stock as a sign of corporate health.

Bank Of America Credit Quality Deteriorating

Future Bank Earnings

The chart below is very interesting and supports the recent commentary by Chris Whalen that banks are sitting on far bigger losses than they are reporting.

The volume of foreclosure sales has stayed relatively flat yet the serious delinquent category has grown much faster.  Foreclosure inventory has not kept up with the growth in delinquency either.

I've heard reports of people not paying a mortgage for months, in some cases over a year.  That would be a delinquent credit, yet the banks in those instances are ignoring this non-performing credit.  Unless notice is given, the credit is performing and not delinquent.   Why do that? Why would a bank let someone not make a mortgage payment for months? Why does the foreclosure process take up to 19 months for the top banks?

It's all part of extend and pretend.  When a credit is delinquent, the bank is still accruing interest on that note even though the probability of collecting that accrued interest is very low. Additionally the asset is marked at full value.  When a bank finally seizes a property it becomes an REO (Real Estate Owned) and that is when the hit to the balance sheet for the value of the asset and the income statement for the accrued interest happens.

What we have seen the past few reporting seasons is banks reducing their reserves for credit losses when in fact there is a mismatch between their realized losses and future losses.   They claim improving credit quality and perhaps that is true but they still are under reserved.  Should housing take another leg down, strategic defaults will occur and this problem will grow.  For now banks are balancing their dwindling profit with balance sheet write downs.  This, is why the US economy is being held hostage by the TBTF banks.  The last thing they want to do is extend credit to anyone without a perfect credit score and very low LTV .

Future Bank Earnings

MERS Is Slowly Going Away

I'm not an attorney and don't know the full implications but I do no the most recent MERS action is not a positive for an already struggling housing market.  MERS (Mortgage Electronic Registration System) was created by the mortgage banking industry as a way to "streamline" the securitization process and make home loans more affordable.  In reality, it was created to bypass recording fees across the country.

If memory serves, MERS is involved in about 50% of all mortgage transactions.  This means that half of land transactions in the US have not been recorded at the state level and therefore only MERS knows who owns what.  I'm not making this stuff up.  MERS has been ruled against a number of times during foreclosure proceedings and as a result has issued a 90-day comment period ahead of a stoppage of foreclosure under MERS.

"Mortgage Electronic Registration Systems, or MERS, told its members Wednesday not to foreclose on residential mortgages in its name."

The amount of fees bypassed over the years is in the billions (possibly hundreds of billions).  With states facing over 200 billion this year alone in budget gaps, it is only a matter of time before they proceed with their own suit to reclaim these lost revenues.

During judicial state foreclosures (about half the states in the US), MERS was shown as holder of the title and not the note which is a problem in itself.  Equally problematic that the courts will not allow is lack of endorsement of title and note.  MERS is now asking to not be involved in any future foreclosure proceeds.  This begs the question then, who holds the mortgage?  Are the true holders in theory unsecured creditors?  The problem facing the industry is very simple in eyes of the law, there is no sign of who sold what and therefore who owns the note and the mortgage.  As to how this is remedied, no one really knows.  But one thing for sure, this action by MERS today has made the solution even more confusing.

MERS Is Slowly Going Away

JPM Sued By Allstate

The banking sector is a mess.  Every day a judicial ruling goes against them, a lawsuit is entered, you name it.  Today was no different with Allstate now suing JPM (it has already filed suit against BAC) claiming reps and warranty violations on RMBS purchased.  JPM catches a bid in the face of a nearly 700 Million suit.  Pure comedy.

This suit is similar to that Allstate filed against BAC, as it uses statistical sampling to quantify put back amounts.  BAC had argued they would force anyone requesting a put back to go loan by loan but in a prior ruling a judge said no.  We are not talking a few loans that violates reps and warranties.  We are talking upwards of 70% if not more.

The market continues to ignore any negative banking news.  Either because the reality is too difficult to understand or people simply believe it will go away on its own.  It won't. Stay focused on the issues facing the banking sector.  If not for a longer term short trade, then at least a reason not to invest in any of these true zombie banks.  We are a credit event away from another financial crisis and the banks are weaker now than they were in 2008.  

JPM Sued By Allstate

The Importance Of Understanding The Bigger Picture

A few weeks back after the banks reported earnings, I compared the reserve rates for the top four banks.  Clearly, WFC stood out as having a lower reserve as a percent of total loans and leases.

With the recent and sudden departure of the WFC CFO rumors began circulating as to why Howard Atkins left a high paying job, very suddenly and at a relatively young age. Well today one of the best bank analysts is shedding light as he questions the validity of WFC's disclosure process.

"The departure of Atkins, we are led to believe, was not merely the result of personal issues, but reflects an ongoing internal dispute within [Wells Fargo's] executive suite regarding the bank's disclosure," 

There is a lot of noise in the market right now.  Bank stocks seem to catch and endless bid but the problems have not gone away.  Understanding and staying focused on the bigger picture, beyond the day to day noise is critical.  You are better prepared to understand how to respond to the WFC news today and determine if the sell off is an overreaction or in fact true pricing of real risk at WFC.

The Importance Of Understanding The Bigger Picture

Housing - Two Big Developments

It is human nature to ignore problems versus understand them.  The housing market is no different.  There has been almost zero coverage of two very large developments over the past few days.  Many have failed to understand robo-signing or mortgage-gate in the first place.  The media has stopped almost all coverage of the subject so the majority of investors think this issue has gone away.  Well, it has not.  

In courtrooms across the country rulings are being made almost every day that continue to find fault at the mortgage servicing industry as it relates to foreclosure and mortgage back securities.  This problem is not going away, it is festering but until the market euphoria wears off, these issues will not be priced in.  Still, as investors our edge is in understanding the issues now so we can act when the time is appropriate.

Development 1:

A NY bankruptcy court ruled that the process used by MERS to transfer title is invalid.  Plain and simple, the law is the law and MERS violated it.  The implications are massive as the judge states but the law is clear and it was violated.  

“MERS’s theory that it can act as a ‘common agent’ for undisclosed principals is not supported by the law,” Grossman wrote in a Feb. 10 opinion. “MERS did not have authority, as ‘nominee’ or agent, to assign the mortgage absent a showing that it was given specific written directions by its principal.”


Development 2:

Legislation is passing through the state of Arizona, similar to the findings above that if a foreclosing party cannot show clear endorsement of title and thus ownership, then foreclosure cannot happen, period! Anyone who is being foreclosed upon can use this legislation to halt the foreclosure and seek attorney fees and damages.


I find it funny that today JPM is up over 2% at one point as were BAC, WFC.  Just last week the rating agencies issued a report claiming RMBS put back risk to JPM, WFC, BAC and C was 60 billion and yet again the bank stocks rose.   As a trade, OK as an investment?  No way!

Housing - Two Big Developments

The Latest On The Irish Elections - Fine Gael Close To Majority

With the Irish Parliamentary elections less than two weeks away (February 25, 2011) things are getting interesting.  The IMF, ECB, EU, German and French banks and pretty much anyone trying to protect senior debt holders must be squirming.  The most recent polls show the two opposition groups Labour and Fine Gael with a pretty decisive lead. They could join forces but Fine Gael currently at 38% could also win the 40% needed for a majority without Labour.

What is interesting about this and something bulls should fear are the following quotes from the Irish Times regarding the views of each party towards future bank bailouts.

From the Irish Times

"THE LEADERS of the two main Opposition parties have ruled out any immediate recapitalisation of the banks if they are elected to form the next government."

"Under that renegotiation, Labour would insist on “burden sharing” with bondholders as part of bank restructuring, he said."

This would be a wonderful development should senior bond holders be forced to accept risk for a change.  

The Latest On The Irish Elections - Fine Gael Close To Majority

Derivatives Overview Part 2 - Interest Rate Derivatives

Remember back in 2008 each Sunday night seemed to be a new class on the latest financial product that failed.  Guess what?  They are still out there and the risk in many cases is even greater.  So as we watch a market chop up anyone trying to price in reality, time is better served for longer term and or macro traders to study and be prepared for those falling shoes still being levitated by the Fed, FASB and Treasury.

Over the next few days I'll discuss various derivatives.  Derivatives are important financial products but like anything in moderation.  Derivatives have outgrown their intended use and as a result represent major systemic risk to the global economy that still have yet to be addressed.

Below is an example of an interest rate derivative product.  In its most basic definition, all this product does is convert a floating rate to a fixed rate and vice versa.

GM needs capital and wants to sell debt to GEICO.  They offer to sell $100 million in debt to GEICO for five years at an adjustable rate of 6 month Libor plus 200 bp (2%).  GEICO loves the deal but wants a fixed rate.  The interest rate derivative is the product that allows this deal to get done.

Transaction 1 - The selling of debt between GM and GEICO

GEICO gives GM $100 Million

GM pays GEICO
6 month Libor + 2%

Transaction 2 - GEICO converts their adjustable rate to a fixed rate

GEICO needs to find someone who will convert their adjustable rate for a fixed rate.

They call JPM who agrees to buy GEICO's 6 month Libor and will pay GEICO 4%.

JPM pays GEICO 4%

GEICO gives JPM 6 month Libor

The Result

• GM sold $100 million in debt to GEICO and pays an adjustable rate

• GEICO invested $100 million in GM at a fixed rate of 6%

• JPM purchased 6 month Libor for 4% for a period of five years

Derivatives Overview Part 2 - Interest Rate Derivatives

Wikileaks And Bank Of America

Apparently BAC and the Department of Justice are rather concerned with the material Wikileaks has on the bank.  By way of background, Reuters ran a story the other day claiming a "source" told them Wikileaks has questioned the power of the to be leaked documents.  Apparently Julian Assange is unsure if he can use the 5GB of data and if it will in fact reveal any new insight to the actions of BAC.

Shortly thereafter Wikileaks leaked a document showing the strategy BAC has developed through outside consultants to proactively defend against future leaks.  A few things are very troubling about these actions.

• The Department of Justice worked with BAC in deciding what agencies to use in development of their strategy.

• The strategy includes discrediting Wikileaks through false accusations.

• The strategy includes attacking bloggers who have supported Wikileaks.

• The strategy includes penetrating Wikileaks servers where possible.

This is no longer about Wikileaks and if they have failed a moral test in leaking various information.  This is about freedom of speech.  This is about the government working with BAC to bring down  Wikileaks using various tactics, some of which are illegal.

President Obama spoke today about the developments in Egypt.  He is such an eloquent speaker and possessed so much promise.  I couldn't help but think about his speech and how it easily could have been a speech to those in power in the US for we have much to learn.  We have lost our moral compass ourselves.

I also cannot help but think why would BAC go through such efforts unless they know of what lies in their closest.  Clearly BAC would rather block freedom of speech regardless of the legality of their methods to keep this closet closed.  I'm not a fan of BAC.  I am short the stock and will remain to be short the stock.

For a little background on BAC's desperate strategy, the RT video below is very concise.

Wikileaks And Bank Of America

BAC and Wikileaks

With an hour to go into the trading day, BAC caught a nice bid causing a 2% move up in the final hour.  Apparently a  Reuters report released around the same time questions the integrity and damage associated from the to be released Wikileaks documents.

Shortly thereafter, a Wikileaks release highlighted a planned strategy by BAC to go on the offensive ahead of this release by Wikileaks.

The Reuters story reads right into the BAC strategy.  I am not a fan of BAC at all and am short the stock via various call spreads.  I find the Reuters story highly suspect though only time will tell where the "truth actually lies."

BAC and Wikileaks

Stay Focused

If you are a longer term trader and not a day trader then it is very important to stay focused on the issues facing the global economy.   The issues are very real and have yet to be confronted in a serious manner, one that will achieve true resolution.  In the day to day noise of ES futures or pundits that are all in and refuse to question their long trade it is very easy to get distracted and drawn into the power of group think.  As investors we need to understand the environment in which we risk capital to determine how the risk and reward coexist.  Sometimes this means missing powerful moves up as I personally have.  Other times it means realizing that early to a trade is the same as being wrong, again as I personally have learned.

I continue to sit on hands until the following items are priced into this market for I feel these issues are very real and skew the risk reward equation far to the risk side.

EU Debt

Portugal 10 year yields are at 7.3% as of February 8 (7% is the threshold for the need for ECB / IMF support).  Ireland has asked for an additional 40% in funding to support banks that are faced with an acceleration in deposit runs and reduction in credit quality.  Italy is facing a leadership change as Berlusconi is now very likely to face charges for his sexual escapades.  Recent reports have raised the question that Greece should default as their ability to repay their debt is growing impossible.

Global Unrest

Yesterday, Egypt saw its largest protest to date.  Just when it appeared Egyptians were tiring, they were rejuvenated by the release and subsequent statement by a Google executive.  Protests have spread to Saudi Arabia, Yemen, Syria, Jordan, Algeria and more.  This movement is just getting started in my opinion.

QE

Bernanke is coming under greater pressure to cease QE2 in June and not commence QE3 thereafter.  From rising bond yields, inflation concerns to growing internal dissent the case for QE3 is becoming more difficult.

China

This is a big question mark that should not be ignored.  China has grown more hawkish in their monetary policy yet US markets have ignored this completely.  China is trying to slow its real estate growth as its economy grows from one that is export driven to consumer driven.

Currency

China, India, Russia and many others are increasing their precious metal reserves as they realize the day of the USD reserve status is diminishing and are now trading with non USD currencies.  Charts of the USD look simply horrid and other than a two day bounce cannot reverse trend.  Meanwhile with all the problems facing the EUR it has shown greater strength.  So in the race to the bottom, the USD appears to be winning.

Asset Prices

Residential and commercial real estate have not bottomed as many pundits will lead us to believe.  The levels of residential mortgage underwater are growing that will lead to further strategic defaults, thus higher levels of shadow inventory further pressuring home prices. A recent report from Fitch said that over 30% of commercial real estate that needs to be rolled in 2011 do not meet their standards.  We have far more real estate than this economy and job market can support.

Unemployment

The job market is horrid.  Regardless of the weather pattern behind a specific report the bottom line is the US has yet to create the minimum of 160,000 jobs needed each month to simply keep up with population growth.  We have a structural problem in this country and it will not be solved by QE.  20% of income is in the form of a government transfer payment yet only 49% pay taxes.  Meanwhile 1 in 7 Americans are on food stamps and this trend shows no sign of reversing.

I can go on with this list and more detail for each subject but the message is tiring.  This market can stay elevated for another hour, another week, another few years.  No one knows.  Many have learned not to stand in front of this market but as investors its important to understand the issues that surround us aside from the noise.  We must be ready to act when the market begins to price in the above items.  It is human nature to ignore problems we are faced with.  That is exactly what is occurring right now among our leaders.  That will not cause them to go away but only grow.

Stay Focused

Treasury Yield Curve

The Fed has officially lost control of the yield curve.  First it was the ten year and beyond but now the shorter end of the curve is being assaulted.  Just imagine if the Fed said they would be pumping $125 billion into equities each month for six months.  Would you ever expect equities to sell off?  That is exactly what the bond market has been doing.

The implications of higher yields cannot be understated nor should they be ignored. Bernanke is going to need to do something soon and try and stop the exodus.  Today's three year auction was not a positive sign with a very low indirect bid leaving primary dealers to buy over 60% of the auction.  The Fed cannot come out and say QE failed. They either have to cause a sell off in equities (and hope people rush to the "safety" of treasuries) or have to say the economy is improving so much, QE2 can be stopped.  The past few days we have heard from three Fed members (two of which are voting members) that they won't support QE3 but will the bond market wait until June when QE2 ends? Time is becoming of the essence.

Below are two charts of treasury yields from June 1, 2010 through February 8, 2011.

The first chart is of various maturities over time.  Yields actually dropped from the August Jackson Hole rumor of QE until the Nov. 2 official announcement.  Then rates, primarily the long end really began to move up. Most recently the one and two year maturities have begun to move rather significantly.

The second chart is the yield curve over time.  It is now approaching a record in terms of steepness.  In a normal credit cycle this would be advantageous for the banking sector but no credit is being formed.  Instead the rise for example in ten year treasury yields is having a very negative impact on housing prices, while the five year will put added pressure on commercial real estate that needs to be rolled in 2011.

Treasury Yield Curve

Treasuries

The two year just took out key support and moving down rather aggressively.  The ten year put in new lows from yesterday and the thirty year also is ready to test yesterday's lows.  The three year auction had very low indirect buyers (foreign central banks).  Primary dealers purchased over 60% of the offer.  Will be interesting to see how they close today.  The move in bonds the past six or so trading days have been pretty negative.

Treasuries

Two Year Treasury

Below are two charts (1) three year weekly and (2) three month daily for the two year treasury.  Key support that has been held for three years has failed.  Looking closer at the daily chart shows support that will soon be tested.  If it fails well the "Bernank" has some decisions to make sooner than later regarding the future of QE.   He's already lost the 10 and 30 year bonds.

Two Year Treasury

The EU Plays Hard Ball. Good Luck!

Ireland is in need of a bailout but so are the German and French banks most exposed to a default. Trichet comes out today and tries to play hardball by declaring the deal has been worked out Ireland, now you must execute. Oh they may execute alright. They may execute the deal but in the definition that would cause serious problems. From the Irish Times, Trichet comments are below:

EUROPEAN CENTRAL Bank (ECB) chief Jean-Claude Trichet has reiterated his opposition to any debt restructuring by Ireland, saying the terms of the EU-IMF bailout plan for the State have been approved by “the entire world”.

In Brussels yesterday, Mr Trichet said the Irish rescue plan and that of Greece did “not comprehend” the notion of bondholders being compelled to take a “haircut” on their investments.

Ireland entered an €85 billion EU-IMF programme last November and Greece was bailed out to the tune of €110 billion last May.

“We have plans. The plans have to be executed, have to be implemented in the best fashion possible as has been the case the world over and it is very, very important in my opinion not to confuse things,” he said.



This is going to get really interesting. Ireland may in fact have more power and the EU knows that. Why else would the EU have offered to extended Irish and Greek maturity dates to now 30 years? Careful how you approach Ireland Jean-Claude.

The EU Plays Hard Ball. Good Luck!

Let The Haircuts Begin!

The Danish government today seized Amagerbanken, the country's eighth largest bank per Bloomberg. Under new regulation, senior bond holders and depositors above the insured limit will take a 41% haircut. It is about time! Just like Tunisia led the first of many revolutions against oppression, perhaps Amagerbanken will lead to many senior bondholders assuming risk for a change.

Elections in Ireland are coming and Fine Gael will be able to site this example for similar actions in Ireland. But if the politicians can't force the issue, the markets will certainly try. Here's the latest from the Irish Independent and don't forget that December saw a 100% increase in bank deposit runs.

REPOSSESSION orders granted by the courts have risen almost six-fold since the peak of the property boom. Figures released by the Courts Service show that the number of orders granted by the High Court and Circuit Courts for the repossession of lands and premises were at their highest last year, a figure that is set to rise as lenders increase their interest rates.

Let The Haircuts Begin!

Treasury Yields - What Is Driving Them?

In a prior post, I commented on the move in treasury yields since QE was first mentioned by the Fed in August of 2010.  The very short end of the curve has not budged but as you begin moving beyond one year and especially five years to ten years yields have moved substantially higher.

In the equity markets there is talk of the Bernanke put.  If any market should welcome this free option play it should be the bond market.  After all, the Fed has communicated regularly their goal of low rates for an extended period and the launch of QE to specifically keep rates low.  The Fed has said to the bond market we will put a floor under your security.  For some reason though the bond market has decided to take their ball and play elsewhere.  QE1 did manage to keep yields low when RMBS was being purchased.

There are a number of possible explanations for this move higher in yields.

• The Fed has encouraged yield chasing and with commodities rising 30% in a matter of months or equities up 25% in five months, why invest in a ten year bond yielding 3%?  It would take you ten years just to match a three month return on a long rice trade.

• The economy is improving so quickly that bond investors are demanding higher rates as the Fed will be forced to raise rates sooner than currently forecasted.  The problem with this argument is once QE2 was hinted at, rates began moving.  Perhaps the bond market was so confident in the success of QE2 and its ability to stimulate economic growth that bond yields responded immediately.  The results of QE1 combined with trillions in Federal stimulus did little to improve economic growth so why would QE2 be any different? 

• Inflation is a concern and nominal yields are moving accordingly.  If you look at the TIPS market though (TIPS are inflation adjusted or real yields) inflation does not look to be much of a concern.   The Fed's target for inflation is 1-2% annually so inflation is a concern beyond ten years but not much at just 36 basis points above the upper target.

                 5 Year Inflation - 1.50% in August 2010, now forecasted at 1.98%
                 10 Year Inflation - 1.86% in August 2010, now forecasted at 2.36%
                 30 Year Inflation - 2.18% in August 2010, now forecasted at 2.55%

• The bond market is beginning to truly question the sustainability of US fiscal policy in the face of growing debt as a percent of GDP.  The question I would raise is why now?  Why not a few years ago?   The reality of investing in US treasuries is you are relying on additional debt to pay back your existing debt. The greater fool theory is the key to this market unfortunately.

The reality behind this move in yields is probably a combination of all of the above.  I was surprised in looking at the TIPS data to see how low inflation expectations truly are.  I think the inflation or deflation argument comes down to one simple truth.  Does QE choke off the remaining final demand in the economy before velocity explodes the money supply?  My vote is the former.  The bond market is sending a signal and one that needs to be watched as it will have direct implications on future monetary and fiscal policy. Let's hope it finally forces some discipline at the Fed and DC.  

Treasury Yields - What Is Driving Them?

Staying Focused

While the equity kids play near the hot stove, don't lose site of the big picture from a macro standpoint.  September 2008 was the start of a painful period for many.  Fortunes were lost in the blink of an eye.  Sunday nights unfortunately involved some CNBC special on learning about CDS, FX lines, Fed Liquidity Programs, etc.  Many vowed they would never use leverage again, they would not get caught in such a frothy market.  They would sell at the first sign of trouble.

This was in the backdrop of the Fed saying that subprime was contained, Kudlow talking about Goldilocks, fund managers saying now was the time to buy.  Now fast forward about 30 months and we find that margin debt is back to pre LEH levels.  Obama in his state of the union says all is well because the stock market is up.  There will be no second leg in housing.  The bond market selling off is not a signal of problems.  I can go on.  Honestly though, I'm tired of watching the kids play, knowing sooner or later their hand is going to get burned again.

I find myself listening to less and less trader chats during the day.  There is just so much noise out there.  A majority truly believe this market will just keep going up and any correction will be minor.

The reality is a vast majority of people in this market are long, have been long, have made a lot of money or recouped a lot of losses, yet they have no appreciation of their surroundings.  For the past twenty three months now, anyone long has been right. Anyone calling into question the validity of asset prices has been wrong, or shall I say early.  The longer this rally goes on, the harder it is to stay focused on the bigger picture. I keep an open mind in my research and am not hung up on a deteriorating macro theme in 2011.  If I find data that contradicts my views, I will change my investing thesis.  Until then, I find the following macro trends to be vary scary indeed:


Sovereign debt:  It's not going away even though the media doesn't talk about it.  The reality is there is an ongoing bank run in Ireland and elections in Ireland that could easily derail the current bailout.  That would then turn the problem to German and French banks along with many other creditors.  Yields in Portugal are at the 7% threshold, Spain is at 5% and no going down.  CDS rates are rising.

Global Unrest:  Egypt may or may not achieve their goal of unseating Mubarak but to think it ends in Egypt I think is a grave misunderstanding.  People have been oppressed for years and now they are being starved through higher food prices.  Yemen is beginning to protest, Saudi Arabia even had a small protest.  I am convinced yet another unintended consequence of QE was a foreign policy nightmare for the US.

Residential and Commercial RE:  Anyone thinking assets prices have bottomed is kidding themselves.  The second leg down has started and more than likely will overcorrect just like equity markets overcorrect, because human emotions are involved.

Jobs:  The data is plain horrid.  People are suffering.  People are trying to provide for a family on part-time income.  People have blown through their savings.  20% of income is in the form of transfer payments from the government.  There is no health here.  Sunny weather in January won't bring back the 160,000 jobs alone each month needed just to match population growth.

Corporate Margins:  They are simply being squeezed by higher input costs.  Any costs that can be passed along will simply cause the consumer to be squeezed.  The economy is slowly being choked to death again in the face of zero real demand by consumers beyond the necessities of life.


I remain largely in cash with a few small hedge credit call spreads on financials.  It is my decision to miss out on any upside and I am fine with that.  

Staying Focused

Fed - Extended Period

The Fed has clearly stated its policy regarding the Federal Funds rate with each monetary statement

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."


Let's take a look at other rates which are less controllable by the Fed as witnessed by changes since August 2 when hints of QE began surfacing.

1 Month: gained 1 bp (basis point)
6 Month: gained 2 bp
2 Year: gained 21 bp
5 Year: gained 63 bp
10 Year: gained 67 bp
30 Year: gained 67 bp

So the shorter end of the curve the Fed has managed to keep rates low but as you move further out on the curve rates have clearly moved up in the face of a monetary policy intended to keep rates low.  If you remember when Bernanke gave his 60 Minutes special he clearly says at 6:45 in the video - "What we are doing is lowering interest rates..."

Clearly QE in the eyes of the Fed is not working and they know that.  They have shifted the bar of success to equity performance but don't lose site of the Fed's failure to achieve a low interest rate environment for an extended period.  They have in fact lost control of the yield curve beyond one year.

• Recently Fitch issued a report that 30% of commercial real estate that needs to be rolled in 2011 do not meet their standards.  

• Residential mortgage is negatively impacted by rising 10 year yield.

Regardless of what Bernanke may say publicly about the success of QE they understand its failures and they understand the extreme negative impact rising interest rates will have on future growth, bank balance sheet risk and credit formation.

Listen to Bernanke in the video below discuss employment.  He's very concerned and this was only two months ago.  Either QE is going to occur for the 4-5 years he says it will take for unemployment to come down to acceptable levels or the Fed will be looking for a way to save face while exiting future QE.  If this move in rates continues, the bond market may very well set future monetary policy and NOT the Fed.

Fed - Extended Period