Bond Vigilantes - benlord

A Bond Vigilante visits the Bank of International Settlements - Video update

Wed, 02 Jun 2010 10:17:00 GMT

Anyone who has had a flight delayed or cancelled as a result of the volcano in Iceland will know how frustrating it can be. For someone in that position, there isn’t much that can be done about it. Ben Lord, Fund Manager of the M&G High Interest Fund, recently found himself stuck in Basle, Switzerland on the morning after the announcement of the eurozone bailout package. Rather than haggle with the airlines about paying over-the-odds for a plane ticket back to London, he used the opportunity to visit the Bank of International Settlements (often thought of as the central bankers’ central bank) and managed to get a bit of footage on his flip camera.

In the following video, Ben discusses the recent banking regulatory changes that have been implemented by the BIS. This is a “must see” for anyone interested in the past, present, and possible future framework in which international banks operate in. Ben also has a look at Europe’s sovereign debt worries and the massive bailout package. Finally, he highlights the views of the M&G bond team and provides some insight into the most recent developments in bond markets.

We hope you enjoy the video and as usual feel free to send us any comments you might have.

Dear George...

Tue, 18 May 2010 16:08:00 GMT

Mervyn King introduced himself to George Osborne last night by writing him a letter, not to wish him luck in his new and frankly unenviable role, nor to advise him on just how much austerity is needed on 22nd June to keep the markets supportive of gilts, but instead to explain why he has again overseen a rate of inflation of more than 1% above the target rate of 2%. The letter states that the Governor should:

1. Explain why inflation has moved significantly away from the target.
2. State the period within which the Governor anticipates inflation to return to target.
3. State the policy action that is being taken to deal with it.

1. The CPI index rose to 3.7% year over year in April, up from a 3.4% rise in consumer prices the previous month, and not insignificantly 0.2% above the market's expectations for where today's number would be. The Governor blames oil prices, the VAT increase and the fall in sterling for the inflation miss (no mention of higher duty on cigarettes and alchohol!). He believes these three factors are temporarily boosting the inflation rate and expects that inflation will fall back over time to its desired level of 2% due to the output gap. We are sympathetic with the Bank's argument that there is a significant amount of spare capacity in the economy at present and that this will likely see inflation fall in the future.

2. Mervyn King believes that it is likely that inflation will fall back to target "absent further price level surprises.....within a year". What a nice performance target for the year, if you are an inflation forecaster (which, thankfully, Mervyn is not): he will hit his forecast unless he is wrong.

3. The Bank of England took unprecendented action in response to the huge contraction in demand at the onset of the financial crisis with the aim of keeping inflation near target in the medium term, by which I am referring to quantitative easing and near zero interest rates. The Governor today states that in this meeting the Committee felt it appropriate to maintain the current level of stimulus in the economy, citing an appropriate balance between downside risks (spare capacity) and upside risks (commodity prices, amongst others) to inflation.

So Mervyn's seventh letter (now to his third different chancellor) once again explains that whilst inflation is substantially higher than where he and the MPC expected it to be at this time, and whilst inflation continues to come in higher than the market's expectations, he and the Committee are happy for the extraordinary level of stimulus to remain in the economy for now, for fear of the fall-out that would result were stimulus to be removed too soon. This is a view we here have huge sympathy with. One only has to look at the panic in the Eurozone in recent weaks to realise that the current recovery is extremely fragile. On top of this, our new government has already announced an emergency budget for 22nd June, which will surely see fiscal tightening dampening some of the inflationary effects of monetary stimulus currently in the system.

So whilst there is sure to be some heavy criticism coming from the media and other commentators about the apparant ineptitude of the MPC to correctly forecast near term inflation, spare a thought for Mervyn. First of all, whilst the MPC has got near term inflation wrong (underestimating) for the best part of the last year, its remit is to manage medium term inflation, for which it has a strong record since its independence. My interpretation of the Governor's citing the fragile balance between 'upside' and 'downside' risks to inflation is that it is actually a balancing of near term and medium term inflation, with the former on the one hand being boosted by extraordinary policy measures and the resulting global recovery, and the latter being justified by concerns about the recovery's persistence and strength. Perhaps he realised that the MPC was too focused on short term inflation rather than medium term inflation when it left rates too low after the dot.com crash and then had them too high from 2007 as we approached the financial crash? This is a criticism that is surely all the more cogent when directed at the ECB?

Most importantly, though, give him credit for what he has achieved. Faced with collapsing global demand, a financial system in disarray, and a freezing and contraction in the velocity and quantity of money in the economy, extreme monetary and fiscal stimulus were a necessity. The fiscal stimulus and growth of the state that resulted from the crash has meant the UK's and most of the western world's levels of indebtedness have risen hugely too. And the very worst case scenario in a highly leveraged world is a deflationary spiral where prices for everything are falling whilst debts still have to be repaid in full. The lesser of two evils in this case is definitely some controlled or temporary inflation to reduce the real cost of a large debt burden (not to mention that the avoidance of deflation also enables monetary policy to maintain its efficacy). And on these terms, with positive growth, positive inflation, and a recovering housing market, perhaps it is time to praise, not criticise, the MPC for its decision to embark on quantitative easing? The range of decisions we face today as an economy are inestimably preferable to the ones we could have been facing now had we seen monetary policy inaction during the crisis. Well done Mervyn, inflation above a short-term target is a result.

UK money supply shrinks by most ever - QuitE a Dilemma

Thu, 21 Jan 2010 14:48:00 GMT

Today we have seen the preliminary release of M4 money supply (so-called ' broad money'), and it could potentially be a very important piece of economic data. December saw a 1.1% drop in the money supply, the largest monthly fall since records began in 1982. Expectations were for a 1% increase. Year-on-year, expectations were for an 8.9% increase, but this came in at a meagre 6.4%. M4 money supply includes cash in circulation, retail deposits and wholesale deposits at banks and building societies and certificates of deposit.

M4 became a key piece of economic data post the economic crash, since it's a primary concern of monetary policy decision makers if the supply of money ceases and contracts. Trust and credit disintegrate, and monetary policy becomes utterly ineffective. Ultimately, this can lead to drastic deflation post a financial crash, which in a heavily indebted economy, can spell disaster (see here for a blog from early 2008 on the importance of money supply). One of the key motivations behind the Bank of England's decision to implement exceptional monetary policy measures, and in particular Quantitative Easing, was to prevent such a collapse in the supply of money, and so to prevent serious disinflation or deflation. As Mervyn King said in his speech earlier this week, "the unprecedented actions of the Monetary Policy Committee to inject £200bn directly into the economy...have averted a potentially disasterous monetary squeeze" (full text available here).

Mike wrote earlier this week about the rising inflation numbers in the UK. And whilst we feel that most of the cause of this spike was due to base effects, policymakers are likely to find it incredibly difficult to justify a further round of printing money through QE (as Anthony mentioned last month here). Following the higher than expected inflation numbers, there is now a very strong consensus that there will be no QE extension next month, although there is a considerably weaker consensus around whether we could see more QE in the future.

The final M4 figure will be released on 1st February, when we'll get an idea of the breakdown and therefore why the M4 figure was so weak. In addition, it's worth highlighting that the Bank of England prefers to strip out the deposits of 'intermediate other financial corporations', which excludes things like counterparties and SPVs. Nevertheless, today's release is still alarming, because it suggests that QE's efficacy as a tool to increase the supply of money is perhaps not what we thought it was.

It is also potentially alarming that there is less money supply chasing the same number of goods and services, and yet inflation is still quickly rising. It's not our core view, but there's a risk that inflation could be more persistent than first thought, ie imagine what will happen to inflation if or when the money supply starts rising quickly again. This number will also be a concern to policy makers because it suggests an emergence of a monetary policy dilemma : the higher inflation number suggested that QE had served an important part of its purpose, the avoidance of deflation. But concomitantly, now, it appears that it has had less impact than expected on the supply of broad money - the money supply data would argue for an increase in monetary policy stimulus.

So which one of the two measures will policymakers give primacy to in February? Our belief is that the members of the MPC will still struggle to justify an increase in QE with inflation where it is now, but this M4 figure has just presented them with a much harder decision. Mervyn King also spoke of this lack of clarity in his speech;

The headline in the Racing Post of 29 December said it all: “Quantitativeasing Maintains Perfect Record”. Its Newbury correspondent reported that “Quantitativeasing started as a red-hot favourite and had little trouble maintaining his unbeaten record. Ridden with plenty of confidence his task was made easier when Tail of the Bank came to grief at the second last. His trainer said ‘I was delighted with the way he went through that testing ground’”. Rather like the MPC, the owners of Quantitativeasing, winner of all three of his races in 2009, have yet to decide how many outings he will have in 2010. They are waiting for race conditions to become clearer.

We do appear to be living in a two-tier world. One part of this world (banks and investors) is awash with cash as a result of £200 billion of QE, and some of this cash for gilts is being invested in other, higher risk assets, which is bringing significant asset price appreciation and, perhaps, inflation. The other part of this world, the real economy, is in a very different position, and today's money supply data suggests that the cash that has been given to banks and investors is not permeating down into new loans and new credit to the real economy. Worryingly, at some point these two worlds will have to come back into line.

The New Era for Bank Bonds: Send In The Clowns?

Thu, 12 Nov 2009 10:08:00 GMT

The following is a long piece, but we feel it has potentially dramatic implications for the bank bond market.

Last week saw the much anticipated capital raisings from Lloyds-HBOS and RBS. Lloyds has managed to raise £13.5 billion in new shares with HMT's holdings remaining at 43%, whilst RBS has raised £25.5 billion from the Treasury, and a further £8 billion from the Treasury in the form of contingent capital notes. This sees the taxpayer's economic interest in RBS rise to 84%. Lloyds is also raising between £7.5 billion and £9 billion from the exchange of old subordinated bonds (upper tier 2, tier 1 and preference shares) into new contingent capital notes.

Lloyds' total capital raising sees it avoid the Government Asset Protection Scheme, wherein HMT guarantees 90% of losses incurred on a book of toxic assets, although it will have to pay £2.5 billion in break-up fee for the confidence boosting that the implicit support provided by the scheme has given to the company over the last 9 months or so. RBS, though, has not managed to avoid entrance into this scheme, but managed to reduce the amount of assets going into the protection scheme from £325 billion to £282 billion. As a sign of the toxicity of these assets, though, RBS' first loss piece was increased by £20 billion to £60 billion.

But there is a cost to both these companies for their needing substantial government support, and for, indeed, almost bringing down the UK economy. Indeed, last week's actions clearly indicate that RBS remains entirely reliant on the government money for its survival. The EC has ordered Lloyds to shed 4.6% of its current account market share, and 19% of its UK mortgage market share, by 2013, with a clear drive to try to reduce concentration in the banking system and to avoid banks being 'too big to fail'. RBS once again comes off worse from this part of the restructing: RBS will be forced to sell its insurance businesses, arguably the most attractive part of the group at the moment, as well as large numbers of branches in the UK, its payment processing business and its interest in a commodity trading arm. Ultimately, we feel that it is in some way right that Lloyds is given the chance to make a clean break from the APS, given that it bailed out HBOS at the height of the UK banking sector's woes and at the same time decimated its theretofore strong franchise. RBS, in contrast, was not so much a solution as a large part of the problem, and in some way has been and will continue to be treated as the UK banking sector's whipping boy.

But the most relevant part of all this to us as bondholders, aside from the clear and much-needed improvements in the equity positions of the two banks, is the liability management exercise being undertaken by Lloyds to generate £7.5 billion in contingent capital from exchanging existing subordinated noteholders. On top of ordering the two banks to sell parts of the businesses, the EC has also ordered that the two banks cease payments of all discretionary coupons on subordinated debt (to not pay coupons on senior debt or lower tier 2 is, currently, an event of default) from January 2010 to January 2012. This is a very substantial development, and one that we have been expecting to be imposed on problematic banks for quite some time. It appears that large numbers of deeply subordinated bank bonds are going to become non-coupon paying for the next two years, and there will be no calls over that period either. We are a step nearer to zero coupon paying perpetuals!

So the response from Lloyds? Astonishingly, the bond exchange has been designed to take out some of the bonds that the EC would have enforced non-payment on, swapping instead into a must-pay security. But the EC's push to enforce non-payment of coupons was presumably justified by the need to preserve cash within the business rather than leaving it? So either you hold your old Lloyds hybrid notes and take a 2 year payment and call holiday, or you exchange into the new contingent capital, or CoCo, bonds, that must pay coupons unless converted to shares. And in our view, from the banks', regulators' and the taxpayers' perspectives, the new capital notes are a very good idea. Simply put, you get a bond that must pay coupons each year, and that have a definite maturity of 10 to 20 years (like a senior bank bond or a corporate bond). But: if the bank gets into trouble, and its core capital falls below a certain level (5%), then your bond gets automatically converted to common stock. We here think that this is the future of the hybrid capital note market. In times of trouble these subordinated bonds will actually convert to equity (just when banks need it most!). We got into this banking crisis thinking the banks were 'well capitalised', and we soon found out that most of their capital was more bond-like than equity-like, which wasn't much of a help at all to a severely under-capitalised banking system. These CoCo's would correct that. Good.

But there is a plethora of problems and inconsistencies with these new bonds. Regulators have agreed to allow these CoCos to be mandatory pay securities, so cash will continue to exit the business to pay coupons, which is exactly what the EC wanted to stop. Furthermore, to entice old bondholders to exchange into the new notes, and to reflect the increased risk of a mandatory conversion to common equity, Lloyds is offering coupons on the CoCos that are 1% to 2% higher than the old subordinated bonds. So even more cash will be leaving the business than before! Moreover, the bonds have been classifed as lower tier 2 for purposes of seniority of payment and in liquidation, but regulators will consider them at the same time as contingent core tier 1 capital: isn't that a contradiction in terms? It seems to us that regulators are being overly accomodative to get this deal done, and to help recapitalise Lloyds, and to open this new CoCo market. We do expect other banks to explore the feasibility of similar issuances once the market has got used to this one. From bond investors' points of view, though, these look like bonds until distress, in which case you are automatically converted to common stock (unlike convertible bonds, where it is generally your right, not obligation, to convert). So they don't naturally fit into the fixed income universe. At the point of conversion, given distress, the shares will be worth very very little. And the risk of Lloyds-HBOS' core capital falling to or below 5% is non-negligible, in our view, especially in the next 3 years. Finally, given how high the coupons are going to be, isn't a management team or regulator at some point going to be incentivised to manipulate their capital levels to force conversion of this expensive debt into cheap equity?

We don't think that these bonds naturally fit into the fixed income space, although the yields do look attractive. Thus, if other, stronger banks bring similar deals, where there is a premium paid for potential equity conversion over existing tier 1 yields, and where we feel the risk of exchange to equity is sufficiently remote, we will consider them carefully. However, there are still several potentially large issues for these notes, nicely exemplified by a certain index provider's excluding them from the index on Tuesday, then re-including them, and then yesterday re-excluding them. This shows how difficult is it to know whether they should be classified as fixed income or equity. And that would suggest that the powers that be are worried about who exactly will buy these new CoCo The Clown notes. Are these clowns happy, or are they sad? Are they bonds or are they shares?

The UK Residential Mortgage Backed Security market reopens

Tue, 29 Sep 2009 07:38:00 GMT

It's been quite some time since we have seen a new public issue in the UK RMBS market. In fact, it's probably been closed for new deals since the beginning of the crisis. As property prices plummeted, and as everyone fled risk assets for cash and gilts, RMBS bonds saw large price falls. Liquidity in these bonds actually suffered almost as much as subordinated bank bonds, because unlike corporate bonds where you generally know the company you are buying into and the terms on which you are agreeing to invest in them, with RMBS you have to know about all the structural idiosyncracies of the bond, including its ranking, which assets it is secured against, what the triggers of the structure are (that can sometimes protect you as an investor, and sometimes impede you), and so on. Given these addtional layers of complexity in contrast to a traditional corporate bond, and given that they are largely secured upon financial assets, which everyone hated during the onset of the crisis, liquidity fell off a cliff.

Last week, though, we saw the issue of Permanent Master Trust 2009-1, the RMBS issuing platform of Halifax Bank of Scotland (now owned by Lloyds TSB). The government, having provided all the support it has to prop up the entire banking system (including capital injections, debt guarantees, liquidity facilities, and asset purchase schemes (almost!)), was keen that the banks in return offer to make new loans to its voters. So banks on the one hand had to delever urgently, but on the other now owed their very existence to the government who were telling them to keep lending. In fact, even, to increase lending over 2007 levels!

Whilst banks have not been able, let alone willing, to originate many new loans of any type, even secured, they have clearly made some, and have built up meaningful balances of mortgages and other loans that are sitting on balance sheet, or being financed on repurchase agreements with the Bank of England or the European Central Bank. It felt that the old master trust system had well and truly broken. Until Wednesday.

In order to get the investment community interested once more in the UK RMBS space, the Permanent deal had to come with an array of structural concessions in favour of the buyer. Whilst there are too many protections built in to mention here, there are a couple that are worth mentioning. The first was that traditionally you bought a master trust RMBS bond that had two maturity dates, the first being an expected maturity date, and the later being a legal final maturity date. The difference between these was that in the event that everything was working fine, your bond would pay out at expected maturity as cash flows from all the mortgages started to be trapped to build up your expected principal. But if there was some kind of problem with the market, the master trust, or the bank, and the principal couldn't be built up within the master trust, then you knew you had the risk of extension of your bond to legal final maturity date. This new bond, though, came with a new put option at the expected maturity date, which means that after 5 years if the master trust hasn't been able to trap the cash to pay our principal out (at expected final), we as investors can put the bonds to Lloyds and get our principal back. So the new RMBS deal has eradicated extension risk, and is now essentially a bullet bond. The other new feature of this issue was that Lloyds-HBOS replenished the master trust's reserve fund, which is the most subordinated part of the trust, from c.2% to c.8%. In other words, the issuing banks felt they needed to improve the credit enhancement of the trust to get a new deal done.

Well, these improvements to the old structures worked. The deal was upsized (ie they issued more than planned) given the high interest, and even after increasing the size of the deal, the books were 2 times oversubscribed (orders for 2 bonds for every one being issued). Lloyds-HBOS issued euro and sterling denominated tranches, both coming at around Libor + 1.8%. The deals have performed extremely well in the last couple of days, and are now quoted at spreads of around Libor +1.3%, meaning the bond is priced almost 2 points higher in only 2 days!

Our feeling is that at this level of funding for new mortgages (somewhere close to 1.5% over Libor), the banks are once more, and after a considerable period of time, economically able to finance mortgage loans. We thus anticipate more deals to come from other master trust issuers in the coming weeks. Ultimately, if this genuinely represents the reopening of the RMBS market, and doesn't turn out to be just a fillip, then mortgage availability to all of us is about to improve dramatically, and that just can't be a bad thing.

Does deflation always result in a low and flat yield curve?

Fri, 25 Sep 2009 15:11:00 GMT

We've had a huge rally in risky assets since we wrote a comment about Turning Japanese almost a year ago, and while diminished, the risk of a 'lost decade' is still very real. I thought it would be worth another look. Now I am not out to compare and contrast the prevailing conditions that led to deflation and QE between Japan and the UK, but what I want to do is ask whether deflation, which led to QE in both countries, necessarily means stubbornly low and flat government bond yield curves, as it did in Japan?

As a brief reminder, the Japanese experience began with the property and equity bubble bursting in 1989, followed by weak growth and deflation through most of the 1990s. As people know, the Japanese response was much slower that what we've seen. The Bank of Japan (BoJ) hiked rates to 6% half a year before the economy entered recession in March 1991, and cut incrementally towards zero over the next 4 years, well into the country's contraction. The BoJ waited almost 3 years after entering deflation before beginning QE. And, as a comparison, the Bank of England has bought back a bigger percentage of the gilt market in only six months than the BoJ did at any stage, and has approval to do even more.

As we have discussed in previous blogs, deflation is a dire scenario for central bankers and policymakers, destroying the efficacy of monetary policy. But when the deflationary psychology sets in to an economy and its agents, it could also have horrific consequences for the economy through consumer spending (which represents about 70% of our economy's output), as people cease spending. Why would we buy a new fridge, say, today, if we know that in 1 year's time it will be cheaper? It is really with these fears in mind that authorities in the US and UK in particular have reacted so quickly and substantially, and why we are repeatedly told they would "rather do too much, than too little".

Looking at the difference between 10 and 2 year government bond yields in the UK and Japan when QE started, we can clearly see that the UK curve is substantially steeper than Japan's yield curve. This suggests that the markets are as yet not expecting the curve to flatten a la Japan. Why might this be? Well, firstly, it may be because unlike Japan, the Bank of England has been quick to react to deflation and has been aggressive in its response. So the markets have perhaps interpreted the level of stimulus as being sufficient to stave off anything like a lost decade of growth due to a fall in aggregate demand leading to a deflationary spiral. In other words, QE may have done enough to reignite inflation.

However, I think a significant reason is to do with the constitution of the two markets, namely the proportion of government borrowings owned by foreign investors. In Japan at the time of QE, approximately 3.4% of JGBs were held by foreigners. This is a sharp contrast to the government bond markets the US and UK. Today, 36% of outstanding gilts are owned by foreigners. This is a huge difference, and it adds to my hunch that deflation, even if it were to persist in the UK, would not necessitate very low and flat yield curves. With only 3.4% of JGBs owned by overseas investors, Japan could proceed with an inflationary stimulus programme and not worry about an exodus of foreign demand for their bonds, or about an influential foreign buyer network demanding higher JGB yields for the (perceived rising) risks.

Japan could print money, thereby putting negative pressure on the Yen without overdue concern about not being able to borrow the requisite funds. Contrastingly, the US and UK are constrained in regards to inflating out of a large debt burden and devaluing the currency, since foreign owners fleeing government bonds would put huge upwards pressure on government bond yields. This is a big issue for the US at the moment, with China owning over $800bn of US Treasuries (see here for full list).

Painful adjustments undoubtedly lie ahead as government expenditure is cut, as taxes rise, and as the nation's balance sheet is rationalised and delevered. And if this is done sufficiently and appropriately, there is no reason foreign holders will flee the currency or the government bond markets. And we actually take our hats off to the authorities for recognising the dangers of a deflationary spiral that could so easily come from the complete shut-down of the credit mechanism in an economy. Now for the second, and every bit as important part: withdrawing the stimulus at the right time so as to avoid hyperinflation and a collapsing currency.

UK housing : firm foundations, or a rally built on sand?

Tue, 30 Jun 2009 12:33:00 GMT

Recent data releases in the UK have been interpreted as suggesting that the housing market may be showing signs of some form of recovery. Our interpretation, though, would be that the releases suggest merely that the pace of decline is slowing. On top of this important difference in interpretation, we would like to highlight the risk of a potential further turn down in housing market data.

In the event that current data do sustain and we are on a trajectory back to house price appreciation, we should see consumer and bank balance sheet repair, an increased willingness of banks to lend, and an improvement in profitability and general economic activity.

In the event that they do not, we will continue in the current situation in which banks are reluctant to lend even to those who view property as sufficiently affordable to be attractive, and the number of people in negative equity will continue to rise. Interest rates will have to remain low for some time, in this latter case, especially given the largely variable rate nature of UK mortgage loans.

The Nationwide House Price index today reported a 0.9% month-on-month increase in house prices in June, following a 1.2% increase in May, and a 1% rise in March, punctuated by only a very small drop in April. Continuing this positive, or better-than-expected, theme, the Hometrack Housing Survey published yesterday, reported that June prices remained stable versus May, after May also showed no deterioration when compared to April. So might current data be taken as evidence that house prices have found a floor? Mortgage approval data has been supportive of this, rising every month this year since January, from around 32,000 approvals to 43,400 in May.

Year-on-year comparisons, unsurprisingly, tell a different story: Nationwide house prices are down 9.3% versus June 2008, and mortgage approvals at the end of 2008 were 57% lower than at the end of 2007. The question is, then, can the monthly figures sustain their current and short-lived trajectory enough to start improving the longer term trends?

This morning we have seen the release of consumer lending in the UK, and particularly the net lending figures secured on dwellings. The market had expected to see a figure of £1 billion of new credit secured on property, and today's figure disappointed at £324 million. This represents a staggering 64% decline in credit extended to mortgage borrowers in the month of May compared to April. The May number is also the lowest figure of new mortgage credit on property since the index began in 1993. It is data of this type that frames our conservative view on the housing market in the UK. The credit mechanism in the UK is broken. Banks are only willing to lend at their terms, and these terms are drastically tighter than they were between 2003 and 2007 (inclusive). The lending on 10% or even 0% deposits at very low margins that characterised banks' willingness to lend in 2006 and 2007 is now a distant memory.

A cursory glance at major UK mortgage lenders' websites reveals some dramatic changes: let's look at the widespread and popular 2 year fixed rate mortgage (which then turns to standard variable rates). 2 year gilt yields are at 1.15%, and 2 year swap rates, the rate at which banks should be able to borrow, are at 2.21%. So let's say you are a customer who's looking to refinance and either have 15% equity remaining in your property after recent falls, or you are a new buyer with a 15% deposit: such clients can probably take a 2 year fixed mortgage at 5.5% to 5.75%. So the banks are taking at least 3% in margin on a mortgage loan (assuming banks can fund at or near swaps). What if you only have a 10% deposit, one of the most popular products in the UK in recent years? You will probably have to pay between 6.5% and 7%. This means banks are charging between 4% and 4.5% of margin for these mortgages with less equity in them. BUT: if you are someone with a healthy balance sheet and a good deposit of 25%, then you can get the above mortgage for between 3.5% and 4%, at an affordable margin of 1% to 1.5%.

This differentiation by the banks in terms of pricing risk, and their unwillingness to lend, leads us to believe that there is a possibility that recent housing market data is benefiting from a wave of buying interest from those with large deposits of 20% or 25%. These investors have seen properties fall by 15% to 20%, and have decided that in the long term, and with attractive financing still available to them, now represents an attractive entry point into the market.

Those without such cash cannot get attractive financing, as shown above. And moreover, there is the small issue of those that bought with 15% or less deposits in the last two years or so. Many of these people will find themselves in a position of negative equity, when the value of the loan they took on their mortgage is greater than the value of the property. For many of (most of?) these people, the deposit on their property will have been their biggest investment. The majority of these people probably won't have enough resources to stump up the additional amount needed to refinance their current deals at attractive rates. So the majority will have to accept the standard variable rate route at the end of their 2 year term.

These issues highlight two major factors that we believe will be detrimental to UK housing: firstly, there is a large proportion of the UK housing market that is 'stuck' in their current mortgage deals, unable to refinance, which will substantially reduce demand for housing and mortgages going forward (likewise, rates available to buy-to-let investors are highly punitive, and will only be made to those with 25% deposits, so this has removed another large source of demand for housing and mortgages). Secondly, if inflation rises and interest rates follow, there will be many SVR-borrowers who see their monthly payments rise, and who may find great difficulty in keeping up with payments (see previous blog here).

In terms of how drastic these influences could be, Fitch released a research report last week in which it estimates that 15% of UK mortgages are in negative equity at April 2009. The agency forecasts that this figure will rise to 34% based on its assumption of a 30% peak to trough decline in house prices. In terms of RMBS, the agency notes a huge disparity by issuer in the proportions of master trusts of mortgage loans that are in negative equity, so care must be taken here. Whilst being in negative equity is not a necessary and sufficient condition of entering default, it does increase the probability of default by a borrower, and it clearly directly influences the probability of a bond taking a loss on default.

As we've stressed over the past few years on this blog, the housing market is key to the strength of the UK and global economy. A prolonged weak housing market makes it very difficult to have a sharp bounce in economic activity.

Monetary Forbearance, and the threat of a double dip financial crisis

Fri, 17 Apr 2009 15:30:00 GMT

With first quarter results out of Wells Fargo, JP Morgan and Citigroup this week in the US, and Barclays over here, you might be forgiven for starting to think that the financial crisis is well along the bumpy transition to the next phase, ie a global 'real economy' crisis. To some extent, I think we'd have to agree. We have come a long way from the week that Lehman went, when it felt like AIG would go the very next day. But we also firmly believe that the transition will not be smooth. And I would also like to point out a substantial risk that current measures are likely to meet further down the road.

Regulatory forbearance is a term that gained currency during the savings and loan crisis in the US of the 1980s and early 1990s, and a variant of it was also used during the Japanese banking crisis. It is essentially the relaxation of accounting rules and regulations applied to banks in regards to recognition of losses on bad assets. The idea is that relaxation enables banks to delay recognising losses, which in turn provides the banks with the time and flexibility to return to profitability. This enables banks to start increasing internally generated capital through retained earnings, which enables them to better cope with the latent losses they have on their balance sheets. The recent relaxation of fair value accounting methods by FASB in the US is a form of just this policy.

But this time round, I think we can coin a new phrase for the forbearance of bad assets: monetary forbearance. Interest rates across the western world are at historically low levels, and our view is that rates are likely to stay at or near zero for quite some time yet, given our deflationary outlook. Financial crises simply are hugely deflationary. The direct consequence of this is that yield curves are steep, particularly in economies where quantitative easing programs are underway, because the market's expectation is that yields will eventually rise when the bonds are sold back to the market, and because QE should, all else equal, be inflationary. Banks borrow short term and lend long term, so with policy rates being so low and yield curves reasonably steep, they are able to post very decent profits. Wells Fargo's results best demonstrated just this fact.

Another advantage banks gain from low rates is that loan defaults are minimised for those borrowers who have variable rate debts. So the banks get a double-whammy: an excellent net interest income portion of their income statements from low rates and the yield curve, as well as the added benefit of borrowers finding it easier to pay. That is monetary forbearance, here defined. Banks are getting the opportunity to start to earn their way out of the crisis, and low rates mean fewer loans are going bad.

But rates will not stay low forever. Indeed, for investors who believe that QE will be very inflationary, then rates will have to rise, and rise aggressively to control price increases. In the US, where the majority of the mortgage market is on fixed rates, this inflation will be a welcome development, since inflation dramatically increases the affordability of long-term fixed rate obligations. But in the UK most of our borrowings are floating or variable. When inflation returns we can expect the MPC to hike rates aggressively if needed, and this could well spell doom for UK borrowers, whose cost of borrowing will rise along with interest rates. At this point, monetary forbearance will be a warm but distant memory for UK banks, because higher rates will be directly correlated with a rise in defaults on banks' assets. And this could be a quite brutal period for the economy and the financial institutions. Perhaps, even, a double dip in the financial crisis?

Unfortunately, it seems unlikely that this kind of outcome only comes in the event of severe inflation, and the resulting aggressive tightening of monetary policy. Disposable income is plummeting right now as jobs are being lost and bonuses are shrinking or disappearing. Enforced pay-cuts are likely to spread. Furthermore, an enormous part of the mortgage market was financed during the heady days of 2003 to 2007, which means the average size of existing loans is too large, as property was severely overvalued. This means that all the people who borrowed in this period are particularly sensitive to the size of their interest payments, and therefore particularly sensitive to rising interest rates. So, small rises in rates, along with fewer employed people and less disposable income, could have dramatic effects on people's ability to pay their debts. This is bad for the consumer, and bad for banks.

How can we avoid this outcome, now we are engaged in QE? Well, if you want to assume an inflationary outcome to all this, the best way would be to move quickly towards the US mortgage market model of fixed interest rates. I don't see this happening any time soon. The availability of credit at affordable terms has gone: where you could once get a mortgage for more than 100% of the value of the property,you now need around a minimum deposit of about 25%. But huge swathes of homeowners are now in negative equity, so these people are unlikely to have that kind of deposit available to them. If you instead assume that inflation is harder to regenerate, even with QE, then this solution would be a nightmare scenario because fixed rate obligations in deflation become more and more expensive to the borrower.

The outcome to all of this is so unclear as to make this mere conjecture. But it seems that, on all the cases considered above, the outcome is likely to be unpleasant for borrowers and for banks. And it is hard to see how banks' large reported 'accounting' profits can be continued over the medium term.

Frankly A Step Backwards (for the US)?

Fri, 03 Apr 2009 09:52:00 GMT

Yesterday the Financial Accounting Standards Board (FASB) has voted to 'relax' fair-value or mark-to-market accounting rules. This is, in our view, a big step in the wrong direction. We believe that it has done this under huge pressure from politicians, lawmakers, and, particularly, financial institutions. In essence, the reversal means that companies will no longer have to value their assets at available market prices (real prices), but will be able to use some amount of 'judgement' in their valuation. Why do we have a problem with this? Quite simply and quite clearly, if you have a company valuing its own assets, there's a clear incentive to value assets for management's purposes. And this is when assets are valued incorrectly.

Since 1993, with FAS 115, financial statements have been put together with certain large components of companies' balance sheets reported at market, executable, fair values. But not all assets have to be valued in this manner. If you can argue successfully to your independent auditors and your audit committee that you are likely to hold a security to maturity, then there are other methods of valuation which do not require current market prices, and so which avoid volatility in earnings and capital.

However, companies (especially financial institutions) will be able to value many more assets than hitherto at other-than-fair-values. These are values that depend on 'judgement' from management, and perhaps some black-box computer model for illiquid securities. And if the financial sector is rallying, as it is, and companies are trying to reinforce confidence in them by posting profits, then there is a clear incentive for these companies to use 'judgement' in valuing their assets.

Rather than reflecting market illiquidity in pricing their assets, as you would expect in times of crisis, and so marking assets down in value, we now expect banks to avoid doing this by recategorising these investments as held to maturity, and so value them at a depressed, stale value, and only recognise a loss or a gain when the asset actually defaults or pays you back. So effectively this accounting change will present the banks with a means to draw a floor value level below large swathes of assets. We are losing the transparency that FASB as well as IFRS worked so hard to gain.

We have now seen $1.3 trillion of realised losses at financial institutions around the world this cycle. According to some we are closer to the end than the beginning. According to others we are closer to half way through. Whichever camp you sit in, yesterday's event will mean we won't know who is right for a lot longer than we would have done had this change not been made. After all, how many assets that default had a market value of par the day before they default? None. In almost all cases, the day before an asset defaults, its value would have been at a steep discount to par. So we are losing a very important piece of information. Sure, banks can't avoid recognising losses on the assets that default, but they can avoid having to recognise large movements in value if the markets take another deep turn down.

This accounting change would not have prevented the $1.3 trillion of realised losses that financial institutions around the world have taken so far. But if these banks want to own so many securities, then the market values of those securities should be recognised in the accounts for all to see. It gives an indication of risk appetite and risk management, two key measures of bank strength at all times. And just as banks lending to us want to have all information on their borrowers as is possible, so do we as their clients and investors want to have some up-to-date, real, current information on them. Yesterday's action is a blatant double-standard in this regard. We really hope that this US action does not gain global traction. It's remarkable how the banks managed to get themselves mark-to-market accounting through the boom years, and so were able to recognise huge gains to asset values on the way up, and now in a downturn are allowed to relax these rules so as to avoid downward valuations. What is desirable above all at this moment is a regulatory system which ensures that banks are capitalised adequately for all markets: if the banks were capitalised appropriately, then we wouldn't have seen this change today.

Finally, is it not particularly striking that whilst banks are arguing strongly and successfully for an end to mark-to-market accounting on their assets, which are falling in value, these very same firms are exploiting market value accounting rules of their liabilities by buying their subordinated bonds at a discount to par and recognising a gain to equity? And does it not make a bit of a mockery of the Public Private Investment Program (PPIP) initiative, in that banks are clearly less likely to sell assets at distressed prices in order to cleanse their balance sheets when they have greater control over the levels they can mark their portfolios? It seems that what the banks want, the banks get.

Equitisation of bank capital bonds

Mon, 30 Mar 2009 08:53:00 GMT

Over the past week or so we have seen an interesting development in bank bonds as around a dozen institutions across the UK and Europe have announced that they are tendering for their subordinated debt. Essentially this means they are offering to buy their bonds back from investors. Bank sub debt is usually issued with call dates (typically after 10 years) when the issuer can either repay the bonds, or extend their life and suffer an increase in the coupon rate. Banks have historically been expected to call their bonds at the first call date and there was a huge outcry in the market when Deutsche neglected to call a Lower Tier 2 bond back in December (as Jim documented here). The other extremely important feature of this type of debt is that the issuer can choose to skip coupon payments if they're not paying an equity dividend, and this does not count as a default as it would with any other type of bond. So, firstly, tendering for the bonds makes sense from the issuers' perspectives because it means they avoid having to decide whether to call the bond or to skip coupon payments. Although it might make sense from an economic perspective to not call the bond, and to skip interest payments, such action could potentially be very damaging to their reputation and ability to raise finance in the future. Secondly, tendering for the bonds also means they no longer have to pay out to service the debt. These two concerns are the main short-term drivers for wanting to buy back bonds with these options in them.

But what is really going on is this. Bank subordinated debt has been languishing for some time now. Banks can buy back 100p worth of their subordinated bonds at a premium to their current price to persuade investors to let them go, and yet generally only have to pay 40p to 50p in the pound (because they have been priced at 20p to 40p). And what this means in accounting terms is that, for example, cash has fallen by 40p for the bonds they buy back, and liabilities have fallen by 100p. The net result of this on capital is that the bank has a 60p 'gain', which goes straight into core equity, into the retained earnings account. And this is the highest quality form of capital. So investors make a small and quick profit, and the bank gets a very big boost to core capital. A further positive is that the banks can buy back Tier 1, Upper Tier 2 and Lower Tier 2, which are all different types of 'hybrid' capital, and get an accounting boost to core capital, which these days is the only type of capital that anyone cares about.

For the past few months there has been virtually no liquidity at all in subordinated debt. The only bonds changing hands were the cheapest, because for 10p you could buy 100p of bonds...it was basically option value. Now, though, there is at least some liquidity, and to that extent these buybacks are a positive for everyone. The news has led to a small rally in subordinated bank debt (see chart), but is not significant taken in the context of the past six months or so, during which period deeply subordinated debt has returned around -60%.

So at what prices are they offering to buy these bonds back? Well, prices vary from instrument to instrument but in all cases are significantly below par value, so those taking up the offer will be locking in substantial losses if they bought at anything other than distressed levels. By accepting 40p or 50p for their subordinated bank investments, investors are giving the banks equity (as explained above), and, although it may be happening in a different guise, this is a clear equitisation of bank capital securities, something that we recently argued was highly likely (as I wrote here). Investors seem to be willingly crystallising principal losses on their bank debt to exit the investments. From the banks' points of view, these exchanges are the direct equivalent of buying back subordinated bonds for 40p in cash, plus the remaining 60p in equity. But in these exchanges, investors don't even get the upside potential from the equity. Many have long been arguing Tier 1 is really worth 100p in the pound. We still don't think it is.