Saturday, 28 May 2011

Credit Complacency - HELOCs issues and market update.

In addition to last week post about complacency in the market place, it is important to look at the economic figures which were published this week in the US.

They were not great.

Consumer spending in April in the US at 0.4%, against a revised 0.5% in March. Higher grocery bills and gas prices are taking their toll on the US consumer, that's what Wal-Mart has been telling us. Lower gas prices and strong NFP (Non Farm Payroll) could help for higher consumer spending but the deleveraging is strong. We are not there yet. Disposable income is still flat. Saving rates are at 4.9%, lowest since October 2008, meaning US consumers are in fact dipping into their savings, facing higher bills.

Core inflation rose 1% in April, the most since September.

So, the US consumer needs commodity prices to cool down and lower unemployment numbers. We got on the 25th of May the revised Q1 GDP figures, everyone expected 2.2% from 1.8% and we got the small print at 1.8%.
Also, you need to take into account the following fact, millions of Americans who are delinquent on their mortgages are staying in their homes for free about a year and a half on average. This is helping them buying time to restructure their finances. This is currently providing an unexpected support for consumer spending, which still makes up about 70 percent of the US economy. This is the effect of what is called now "squatter's rent". This equates to increase income from withheld mortgage payments for US households.

According to JP Morgan's chief US economist Michael Feroli, the extra cash could represent a boost to spending that is equal to about half the estimated savings generated by cuts to payroll withholding in December's bipartisan tax plan.

27 percent of single-family homeowners with mortgages are in negative equity, this represents according to CoreLogic USD 744 billion of total negative equity. The strategic defaults and the non payment of mortgages is helping to maintain current level of US consumption. More than a third of mortgage defaults were strategic, according to a June 2010 survey by finance professors Paola Sapienza of the Kellogg School.
For more on strategic defaults:

Strategic defaults could get very ugly - Keith Jurow

How to reverse the tide which ultimately will affect the value of mortages still sitting on US banks balanced sheet?
You can find the proposals made by Lewis Ranieri, the pioneer of mortgage securitization in the following link to a Bloomberg article:

Banks Can Fix Crisis by Easing U.S. Homeowner Debt, Ranieri Says

Ranieri's plan urge "banks to reduce debt for qualified borrowers and recognize losses on second mortgages and home-equity lines of credit."
Good intentions, but recognizing losses on home equity lines of credit for some US banks would have for some, a very significant impact. There are roughly 13 million HELOCs outstanding.

The big US banks have USD 147 billion in exposure to >100% CLTV HE Loans (source CreditSights):
Bank of America - USD 47 billion
JP Morgan - USD 41 billion
Wells Fargo - USD 39 billion
Citigroup - USD 20 billion

CreditSights estimate that cost related to a potential mortgage servicer settlement, mortgage repurchases, and second lien home equity write downs could lead to almost USD 95 billion in pre-tax losses for the big banks (USD 33.8 billion for Bank of America, 26.3 for JP Morgan, 24 for Wells Fargo, 10.3 for Citigroup USD). Aggregate earnings impact would be of around USD 62 billion according to CreditSights.

EPS Earnings impact:
Bank of America - USD 2.18
JP Morgan - USD 4.37
Wells Fargo - USD 2.96
Citigroup - USD 0.27

59 billion would be linked to write downs of HELOCS according to CreditSights, assuming 40% writedowns for Helocs with a CLTV above 100%. Given junior position of second liens, CreditSights is assuming 100% severity.

Impact on BASEL III Tier 1 common ratio would be:
146 bps down for Wells Fargo
113 bps down for JP Morgan
106 bps down for Bank of America
56 bps down for Citigroup

I would stay clear of US Bank stocks for the moment, which follows last week post relating to loan growth issues for banks. There is no doubt in my mind that current underprovisioning by US Banks are artificially boosting earnings.

In Ireland, loss recognition has been dramatic even for Foreign-owned banks according to the Irish Time:
Just looking at the cumulative loan losses for Irish banks relating to the property bust, gives me the shivers: Irish Nationwide, total losses amounted to nearly 60% of its book, BoSI 32% and the Rabobank-owned ACC Bank 28%.

Foreign-owned banks count cost of carnage caused at their Irish branches

Pending home sales this month got absolutely whacked: -11.6% down, consensus was for -1%.
What's happening there? It means people are waiting for lower prices, which means than it will take even longer to clear the existing huge inventory I mentioned in last week post.
As a reminder, Short sales and Foreclosures accounted for 40% of existing home transactions in March, up by a third from last year.

New Homes Sales printed at 323000, consensus was for 305000. Nothing great, still in the abyss.

Initial jobless claims at 424K, consensus was for 400K.

University of Michigan consumer sentiment index increased a little to 74.3 from the preliminary reading of 72.4, possibly due to a small drop in gas prices. Please note the consumer sentiment index reading is still in a low area.

Update on bank failures this year: 44 so far. We were at 25, as I posted on the 25th of March 2011. We had 157 banks failures in 2010 according to FDIC.

Meanwhile in the European space, on the CDS sovereign space, spreads are still widening to new records for the peripherals:
Daily Focus Graph

Ireland and Portugal Sovereign CDS are now trading at the same levels, above 600 bps for the 5 year.

The full Greek CDS curve as quoted in the market on the 20-05-11:
That's how a fully inverted CDS curve look like...

Update on peripheral government bonds:
10 Year Greek Governmnent bonds are now yielding 16.57%, up 2.75% this month and 8.79% for the year.
10 Year Irish Government bonds are now yeilding 10.54%, up 0.83% on the month and up 5.89% this year.
10 Year Portugal Government bonds are now yielding 9.9%, up 0.39% on the month and 4.77% for the year.

German Bund 10 Year yield dipped this week below 3%, probably a sign of some sort of flight to quality. Here is an update on the 2-10 year curve for German debt:

We can see a nice ongoing flattening of the 2-10 spread on German government bonds.

Spanish Banks 5 year CDS have widened a bit for the weaker ones but haven't come back to their February levels, Santander and BBVA are still trading in the same range:
[Graph Name]

Itraxx Senior Financial 5 Year index is 60bps wider than Itraxx Main Europe 5 year CDS, 159 bps versus 97 bps. Financials have been widening again since the beginning of the year and single names CDS for banks as well, the worst offenders have been Irish banks CDS so far this year: Bank of Ireland CDS 1425 bps at the beginning of the year, 2415 bps now. Allied Irish, from 3019 bps to 4736 bps.

Continuing sovereign uncertainty means continued volatility for the financial sector, so watch closely the CDS space for banks for both senior and sub CDS 5 year CDS levels.

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