Archive for February, 2014

Credit Crunch: End Of The Beginning?

It is now seven years since the first signs of strain and balance sheet writedowns signalled trouble in the US subprime mortgage market. A few months later – in June 2007 – the first credit rating downgrades of securities backed by pools of these mortgages occurred. The collateralization and ownership restrictions placed on institutional investors in the vast “asset backed” market were superglued to these ratings. On the back of the downgrades, Bear Stearns put up $3.2bn of lending to prop up one of its two subprime hedge funds. Amid collateral calls the entire subprime mortgage market collapsed. In July Bear announced that both its funds were worthless, and for the next few months an explosion in downgrades (and underlying mortgage defaults) began to focus the financial world’s attention.

So it may seem surprising to say that we are only really at the end of the beginning of this crisis. Seven years is a long time. And yet …

Last week saw the release of Q4 mortgage delinquency data for the US. The headline number showed that delinquencies – loans at various stages of falling behind with payments up to and including foreclosure – as a proportion of the whole mortgage market fell again, to 6.4%, as they have done steadily since peaking at 10.1% in March 2010. But dig deeper and we find that the subprime delinquency rate ticked up. In fact it has been stuck in a 20-22% range for the last two calendar years, not far shy of its 27% peak in ’10. The overall improvement in delinquencies has been entirely due to improvements in the prime mortgage market over that period. Subprime foreclosures are running at over 10% of loans, still materially higher than at the peak of the previous default cycle in 2000. For that reason, there are still plenty of ratings downgrades on mortgage-backed securities working their way through the system.

At the same time it is right that the US mortgage market has lost its power to terrify. Overall, as we know, the real estate market has been picking up again (with a recent setback driven by the execrable weather). And bank balance sheets have improved steadily and considerably in line with the mortgage market overall. Reserves for losses on loans across the Big Four US banks – JP Morgan, Bank of America, Citigroup and Wells Fargo – peaked at $158.8bn in Q1 2010. The current reporting season showed that had fallen by almost 60% to $67.8bn in the quarter just gone. That’s some way north of the $42.2bn reported at the end of 2007, but still pretty impressive.

Perhaps this partly explains why it looks too cautious from a US perspective to say we are only at the end of the beginning of the credit crunch. From a more global perspective, however, the description fits more clearly.

Here in the UK our banks have not recovered so well. At Barclays, loan loss reserves only trickled slightly lower last year and are roughly 41% below their reported peak. For Lloyds the figure is 38% and at RBS of course reserves hit a new high of £25.2bn for Q4 – 39% higher than the amount provisioned for at the end of 2010.

Turning to Europe, where banks are at least as far adrift, we have another aspect of the crunch to contend with. In some cases (most notoriously perhaps in that of Iceland), bank distress led directly to a sovereign debt crisis. In most countries it played a significant role – as did the crunch’s recessionary effects on the wider economy, of course. And we should remember that the Cypriot banking system went down less than a year ago, all part of the same protracted drama of downgrade, writedown, bailout and default.

Symptoms of the sovereign crisis remain. The yield on ten year Greek government debt fell below 7% only today for instance, the first time since the country’s ignominious junking by S&P in April 2010.

Which brings us on to the next stage. Greek government debt to GDP for 2013 is forecast by the IMF to reach 175.7% – more than 5% above the peak reached prior to the debt restructuring of 2012. It is still not certain whether another restructuring of one kind or another will be needed to make this manageable on a 5-10 year view. Much will depend on how the economy performs this year. And it is still less certain when Greece will be able to consider re-entering the bond market, as some less severely crippled bailout economies have already done.

Once we know that the Greek debt position is settled it could be the beginning of the end of the credit crunch, and not before. Then Greece – as others, including the rest of the eurozone, UK and the US – will be set on the path of managing its economic affairs with a huge burden of borrowing round its neck that will mark fiscal planning with servicing costs for many years to come. That is the lasting legacy of the insane credit markets of the mid-2000s. Only when that borrowing, weighing down across most of the developed world, has been firmly established on a reducing path for some time – only then will we be able to say that the credit crunch is over.

In terms of what all this means for markets let me make one observation.

Risk markets became absurdly optimistic in a short period of time during the end of the Great Recession in 2009, not at all seeming to understand the scale or possible longevity of the problem. Then came the sovereign debt crisis and a period of complete panic in 2011, and then, pretty steadily since the most successful example of Open Mouth Operations in history (by the ECB in mid-2012), risk has come back into favour.

The key point is this: by backing fundamentals, and so being sceptical of risk in late 2009 and more constructive thereafter (and especially in the autumn of 2011), investors would have done pretty well.

The gargantuan upheaval of the credit crunch and the hysteria which followed have left their mark in different ways at different times. There are still plenty of anomalies out there both between and within asset classes. As and when (and if) the ripples from that giant explosion seven years ago continue to fade, there is every reason to continue to expect that backing the fundamentals will remain a profitable thing to do.

28/02/2014 at 6:07 pm

Don’t Frighten The Horses

The most significant UK event this week was the release of the Bank of England’s latest Inflation Report and accompanying press conference. Mr Carney’s “forward guidance” on interest rates, introduced last year, came under particular scrutiny with unemployment now within sight of the 7% level originally identified as a precondition to tightening policy. This guidance – “open mouth operations” in City slang – has been broadened. In line with statements from the Fed, the Bank is making quite a strong effort as the recovery strengthens to contain expectations that its base rate will rise. From the introduction to the Report:

“The UK recovery has gained momentum and inflation has returned to the 2% target … employment gains have been exceptionally strong and unemployment … is likely to reach the MPC’s 7% threshold by the spring of this year. Even so, the Committee judges that there remains spare capacity, concentrated in the labour market.

Inflation is likely to remain close to the target over the forecast period. Given this … the MPC judges that there remains scope to absorb slack further before raising Bank Rate. Moreover, the continuation of significant headwinds — both at home and from abroad — mean that Bank Rate may need to remain at low levels for some time to come.”

The message is clear. On the one hand the Bank has partially unwound one of its emergency monetary measures by taking residential mortgages out of the scope of its Funding for Lending scheme. The economy has picked up. On the other hand the Bank mustn’t frighten the horses by allowing premature expectations for rate rises to dampen confidence. Tighter credit markets and a stronger pound could undo the work of an accommodative base rate whose work against a fragile background is not yet done.

At the same time the Bank must justify its stance with an eye on the outlook for inflation. This is something it has woefully misjudged in recent years. Yet the argument remains the same: with spare capacity in the labour market there is no upward pressure on wages (which the data shows has been true) and so an increase in rates to tamp down demand is unwarranted.

This blog noted a few months ago that inflation is not yet on the world’s list of concerns. Indeed, in Europe the annual rate of CPI inflation has come in below 1% consistently since September and there is now talk of deflation in the eurozone. But in the UK prices have been much more stubborn. Can we really expect them to remain around the CPI target level of 2% over the next two years as Mr Carney’s model expects – the first time this will have happened since 2005?

We ought to have some sympathy for the Bank. Some of the inflation since the Great Recession has been attributable to VAT hikes, fuel duty and other indirect taxes. The question is: have these effects – which have nothing much to do with capacity in the labour market – really gone away?

When it comes to utility bills, for example, are we sure that costs due to capital investment programmes and environmental measures can be kept away from consumers? And is the impact of flooding on the price of food destined to be entirely negligible? There is also housing to consider. House prices are rising at over 5% on the ONS measure: over three times the average rate for 2012. For most months in 2011 they fell.

Governor Carney’s message on Wednesday saw bond yields and expectations for shorter-dated interest rates increase, and the biggest one-day rise in trade weighted sterling since last April. The market’s horses are not frightened, but nor are they discounting the eventual policy impact of the UK’s recovery entirely.

As conditions improve and risks remain, central banks have a tightrope to walk between destabilising recovery and fanning inflation. We must all hope they have a very keen sense of balance.

14/02/2014 at 4:25 pm

Extreme Weather

We noted last time that some of the popular analysis of market jitters doesn’t really stand up to scrutiny. So far this month those jitters have eased. But one of their possible sources has persisted.

The punishing winter weather in the US has been devastatingly persistent. Record low temperatures have seen a long series of severe snowstorms and associated transport disruption and this pattern is expected to continue.

As well as flight cancellations there have been some sharp effects on energy markets. The shale revolution has transformed the domestic American supply picture for gas and oil, but the harsh winter has blown it back for now. Natural gas prices have spiked back to levels not seen since early 2010 and the nation soon expected to be the world’s largest oil producer has been reduced to importing heating fuel from Europe.

Inevitably, the wider economy has not gone unscathed. Most obviously, consumer activity has felt the chill, with retail sales data disappointing and fears that the inflationary effect of heating costs will see this persist into the spring. Employment numbers have been more mixed but there seems to have been a temporary effect on hiring too.

It used to be said that when the Fed sneezes, the world catches cold. Fears over tapering remain, but it is yesterday’s news. In this case it is the US which has been caught out by a nasty cold snap. Activity has suffered, the shale phenomenon behind much of America’s economic optimism has had its limits tested – and even Wall Street titans can’t like trudging under damp grey skies through sleet.

A white winter doesn’t make a proper black swan. But it has had an effect. The US recovery has been a self-conscious beacon over recent quarters; Wall Street dominates cross border capital flows in emerging markets; and Americans have even been calling time on the Great Rotation.

With the UK suffering terribly in some places from flooding and tidal surges we know that brutal weather should not be dismissed as a storm in a teacup. But we also know that in time, even the worst storms do blow over.

07/02/2014 at 3:56 pm


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