What the Too-Big-To-Fails Think

Is it any wonder that the beneficiaries of Fed monetary mayhem would shrug off the news of the day? It puts their livelihoods at risk, so shrug away, imbeciles!

By Matt Phillips @ WSJ:

The commentary keeps coming, with every market watcher and their aunt Sally offering their two thoughts on what S&P surprise cut of its outlook for the U.S. debt rating from “stable” to “negative.” (The credit rater left Uncle Sam’s AAA rating intact.)

• Barclays Capital: It is important to be clear on this. If the U.S. government were to default on its obligations, a very large financial panic is what we’d get. But as the saying goes, once they’ve exhausted all the other alternatives, US politicians can usually be relied on to do the right thing – and S&P’s move might actually serve as a reminder of what that right thing is. Just as it took two attempts for the US legislature to pass the TARP and save the world, so now we may need to be braced for a prolonged period of brinkmanship before a budget deal gets done.
• George Goncalves, Nomura Securities: We believe that although this news does bring to the forefront the longer-term profligacy of the US, this is something we’ve highlighted several times as a concern and is widely acknowledged by the market. To that extent, aside from the knee jerk reaction, this downgrade contains little new info. The most salient issue for Treasuries currently is the extension of the debt ceiling in the next few months and that is likely to have a greater impact in the near-term than 2012-2013 budget discussions. We had mentioned in the past that fiscal austerity measures needed to be passed, but that these weren’t pressing concerns, given the reserve currency status of the USD. We believe it will be a slow and drawn out process before foreign central banks can start investing their trade surplus reserves in any other currency. Until we reach that point (which is many years away, even by conservative estimates), sponsorship for USTs will continue to be strong from this demand segment.
• Lena Komileva, Brown Brothers Harriman: The S&P move to revise the U.S.’s AAA outlook from stable to negative has been a shot across the bow of market complacency about the U.S.’s medium-term debt outlook. The U.S. will have no problem in financing its deficit, but the role of U.S. government securities as the primary reserve asset in global public sector balance sheets and as the primary liquidity and capital risk hedge in financial balance sheets, means that a fallout from a potential U.S. debt re-rating would reach far outside U.S. borders. It is a low-probability event with high impact. If the AAA backbone of the global financial system is at risk of being lost, what happens to the rest of the credit structure?
• Societe Generale Cross Asset Research: While a credit warning for the U.S. was somewhat expected by the market, it was not anticipated to be so soon. The early threat of a downgrade may help U.S. policy leaders to make progress on agreeing to substantial budget cuts. The Washington Post reports that a deal on Medicare is at hand. It also provides the doves at the Fed further reasons to maintain accommodative monetary policy and hence reinforces the inflation/EM trade.
• Paul Ashworth, Capital Economics: S&P’s biggest concern seems to be that the Democrats and Republicans will struggle to agree on a comprehensive plan to address the medium-term fiscal problems before the Presidential election in late 2012. S&P now puts the odds of a downgrade within the next two years as high as one-in-three. With the Republicans controlling the House and the Democrats controlling the Senate, and both sides proposing radically different plans to cut the deficit, this is a concern we would share. Things could get even messier after the election, if Obama is re-elected but the Republicans capture control of the Senate.
• Goldman Sachs Economics: A rating outlook change has no immediate implications—in particular, it does not make a difference in terms of current bond mandates. It does flag the possibility of an outright ratings downgrade within the next few years, which would have material market implications for investors required to invest a specific portion of their holdings in AAA securities. According to S&P, the negative outlook “signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years.” (Historically, the frequency of ratings downgrades for AAA sovereigns on negative watch is actually much lower than 1 in 3 over this horizon, although there is of course no guarantee that will remain true in the future.)

Shadow Banking System Is Collapsing, Credit Contracting

from Zero Hedge:

Continuing the analysis of today's Z.1 report, we next focus on recent developments in the shadow banking system. And it's a bloodbath: total shadow bank liabilities dropped by $680 billion in Q2, and a massive $2.1 trillion YTD. If one wonders why Ben Bernanke (yes, it's technically TurboTim) continues to print trillions and trillions of debt, and it is still doing nothing (yet) to stimulate the system, here is your answer.
As credit will only exist if i) it is needed and ii) there are cash paying assets (or at least the myth thereof) to support its existence, the latest plunge in the shadow banking system is merely the most recent confirmation that the deleveraging in America is only just beginning. In fact, from the peak of the credit bubble in Q2 2008, through Q2, total bank liabilities (shadow and traditional) have plunged by $2.6 trillion, from $32.1 trillion to $29.5 trillion. Yet it is the collapse in shadow banking that was responsible, with shadow liabilities falling by a stunning 20% from $21 trillion to $17 trillion in just over two years even as banks have benefitted from the transfer of cheap government cheap on their traditional lending books (think Fed intervention and QE, leading to record low interest rates).
What this means is very clear: the shadow banking system is collapsing, period. Yes, the rate of collapse is slower than in Q1, but the total plunge was still a whopping $4.2 trillion annualized for 2010. And the delta between Shadow Banking and Traditional liabilities has collapsed from $10.7 trillion at the peak in March 2008, down to under $4 trillion. This is a record amount of "money" being removed from the system, and explains why, for now at least, the velocity of money is nothing faster than a crawl.
That said, if and when this indicator plateaus and recommences climbing, will be a very "sensitive" moment for all deflationists and inflationists as it will mark the inflection point from credit contraction to renewed credit creation. Alternatively, the Fed can merely force credit into traditional bank liabilities, which banks can then proceed to use and purchase stocks and commodities, at a zero cost of debt. What that will do to select asset prices, we leave to our readers' imagination.
Chart 1: Total sub-components of the shadow banking system

Chart 2: Comparison of shadow banking and traditional commercial bank liabilities

Chart 3: Consolidated shadow and commercial bank liabilities and sequential change

Consumer Credit Continued Contraction

"Consumer credit contracted a sharp $9.1 billion in May with April revised to show an even more severe $14.9 billion contraction. The April revision is very surprising given the initial reading of a $1.0 billion gain!

Revolving credit contracted $7.4 billion in May and contracted $8.3 billion in April. Non-revolving credit shows a $1.8 billion contraction in May on top of a $6.5 billion contraction in April. Neither category is likely to show much improvement in June given indications from today's soft store sales report and last week's soft unit vehicle sales.

Consumer credit had been leveling earlier this year but now appears to be on a double dip. This report could set stocks in reverse during the last hour of trading. " - ECONODAY

The person who sent me this also said, "Get ready folks, hell is coming to breakfast..."

Impact of HELOCs on Housing Future

More debt deflation coming!

from RealEstateChannel.com:

When the housing crisis erupted in early 2007, banks began to curtail their originations of HELOCs.  In spite of this, a study published by Equifax Capital Markets in October 2009 found that 45% of prime borrowers with securitized first mortgage loans that were still current in July 2009 also had a HELOC.  Worse yet, the average outstanding balance on these HELOCs increased steadily from roughly $83,000 in mid-2005 to $118,000 four years later.

It is very likely that a considerable number of financially-strapped HELOC borrowers are using their line of credit to cover the first mortgage payment and avoid default.  Unfortunately, banks have begun to reduce or eliminate the available line of credit in states where home prices have declined substantially.

Last September, Equifax estimated that there were roughly 13.6 million HELOCs outstanding.  Nearly all of them were second or "junior" liens that stood in line behind the first lien holder in the event of a foreclosure.  When added together, they pose a tremendous financial burden for the vast majority of these 13.6 million homeowners.

Several key analyses of so-called "underwater" homeowners do not include these outstanding HELOCs in determining whether a property is underwater or not.  Some do not include the refinancing of first mortgages which we have looked at.  To omit either or both of them will cause a real underestimation of the number of homeowners with negative equity and in serious danger of defaulting.

It is not an exaggeration to say that the massive refinancing undertaken during the bubble years of 2003-2006 is a burden that will probably push back the housing recovery well into the future.

The Debt Contagion Begins to Spread

May 4 (Bloomberg) -- The euro slid to a one-year low against the dollar and stocks tumbled amid concern the European government debt crisis is spreading to Spain and Portugal. Commodities and shares of their producers slid on a slowdown in Chinese manufacturing and fallout from the BP Plc rig disaster.
The euro weakened below $1.31 for the first time since April 2009. The MSCI World Index of 23 developed nations’ stocks declined 1.8 percent at 9:37 a.m. in New York and the Standard & Poor’s 500 Index dropped 1.5 percent, erasing yesterday’s rally. BP Plc slumped to a seven-month low as the costs of containing an oil spill in the Gulf of Mexico mounted. Copper fell to its lowest level in nine weeks, while oil sank 2.8 percent to $83.75 a barrel as the dollar rose against 14 of 16 major counterparts.
Greece’s 110 billion-euro ($146 billion) bailout, approved by finance ministers over the weekend, is failing to ease speculation the debt crisis will spread to nations such as Portugal and Spain. A Chinese purchasing managers’ index declined to 55.4 from 57 in March, signaling government attempts to cool the world’s fastest-growing economy are working.
“There’s spillover effect from China,” said Stanley Nabi, New York-based vice chairman of Silvercrest Asset Management Group, which manages $9 billion. “Spain and Portugal are both endangered species. The attention could shift to one of those countries. In the U.S., it’s no longer news that earnings are better than expected. The stock market has had a great run. I’ve got a feeling that May is going to be a month of consolidation or even of backing down a little bit.”
The S&P 500 erased most of yesterday’s 1.3 percent rally triggered after Warren Buffett defended Goldman Sachs Group Inc. in the wake of fraud accusations against the firm, while reports on manufacturing and consumer spending signaled the economy is strengthening.
“The biggest concern today remains the European peripheral countries and Spain is the big one because there’s fear of another downgrade,” said Sal Catrini, a managing director for equities at Cantor Fitzgerald & Co. in New York. “That’s shaking things up today.”

New Credit Bubble Forming

NEW YORK (MarketWatch) -- A fivefold surge in the sale of junk bonds, a drop in borrowing spreads to two-plus-year lows, and heightened buzz about a coming wave of leveraged buyouts are the latest signs that credit markets are getting close to their pre-crisis levels -- and, to some observers, sowing the seeds for a dangerous new borrowing binge. 

Companies sold $54.3 billion in U.S. high-yield debt during the first quarter of the year, according to Dealogic, up from $9.6 billion a year ago, as the sharp drop in interest rates made it cheaper to borrow. Including investment-grade debt, bond sales in March rose to their highest level since May.
Last week, the growing debt issuance turned swap spreads, a metric of how issuers adjust their interest-rate exposure, negative for the first time on record.
And borrowing costs measured by corporate-bond spreads have returned to December 2008 levels, though they are still far higher than they were before the housing bust.
Selling debt has become much cheaper for companies as the credit crisis fades into history and investors lay their hopes on the recovery of the economy.
Plus, there's little allure for investors to lend to some of the most stable borrowers, such as the U.S. government.
The Federal Reserve's 15-month policy of keeping rates near 0% alongside a pledge to keep them low for a "extended period" have pushed 10-year Treasury yields (U.S.:UST10Y) to 3.94%, after falling to record lows from around 5.25% when the Fed started cutting in 2006.
Yields on 1-month CDs have fallen to 0.47%, from 2.5% in 2007, according to Bankrate.com.
For some private-sector analysts, as well as Federal Reserve policy makers, this lengthy period of low benchmark rates and investor appetite for higher returns poses a risk of again pushing the economy to an unsustainable reliance on debt -- not far from the situation that led to the credit crisis just a few years ago.
"We look at this as a replay of what happened in 2007," said Walter Zimmermann, chief technical analyst for United-ICAP.
Midway through the last decade, investors increasingly piled into much riskier assets, including mortgage-backed securities. They were hunting for a slightly higher yield after the Fed's decision to keep interest rates at 1% for one year in 2003-04 helped flatten yields on government debt.
That demand for higher yields pushed borrowing costs for companies to extremely low levels by 2007, when problems with too much leverage started to materialize within the massive and various securitizations distributed around the world, eventually leading to the credit crisis.
"The need for yield was felt to counteract otherwise low interest rates," he said. "That turned out to be one of the most disastrous investments of our age."
Some officials, such as Kansas City Federal Reserve President Thomas Hoenig, have warned that the Fed risks "distortions in the economy" and creating an asset bubble by keeping rates very low for too long.

John Hussman: Market Correction 80% Probability

John Hussman:

It's important to recognize that when I quote probabilities, I am generally using a form of Bayes' Rule. So when I say, for example, that I estimate a probability of about 80% of fresh credit difficulties accompanied by a market plunge over the coming year, that figure is based on various combinations of historical evidence, and what has (and has not) happened afterward, and how often. As a side note, a “market plunge” in this context need not be a “crash.” In the context of a credit-driven crash and rebound (which is what I believe we've observed), a typical post-rebound correction would be about -28%, but even that would take stocks to less than 20% above the March lows.

Bank Credit Card Losses Still Rising

US credit card debts written off as uncollectable rose in November, following two consecutive months of decline, though early-stage delinquencies dropped for the month, Moody's Investors Service said Tuesday.

SXC Credit card charge-offs rose one-half percentage point in November.

Credit card charge-offs rose by about one-half percentage point in November to 10.56 percent, and is likely to continue to rise to a peak of between 12 percent and 13 percent in mid-2010, Moody's said in a statement.

Delinquencies, which measure the proportion of accounts for which a monthly payment is more than 30 days late, also increased to 6.2 percent in November, though early-stage delinquencies fell to 1.6 percent for the month, Moody's said.

Bank Losses Still Getting Worse

Is this becoming too big to bail out?

from WSJ:
Wall Street is growing concerned that financial firms including Citigroup Inc. are at risk of facing stiff losses from some complicated tax-related assets that could soon fall in value and hurt the firms' capital.
When lenders and financial firms book quarterly losses, as many have repeatedly during financial crisis, they are allowed to book credits against future tax bills they will face in the future once they return to profitability. Portions of those complex assets, known as deferred tax assets, or DTA, can be added to firms' capital, which serves as an assurance against losses for depositors, and against dilution

Lending Still Losing

from WSJ:

A Wall Street Journal report that GMAC Financial Services and the Treasury Department were in advanced talks to prop up the lender with its third helping of taxpayer money was adding to the cautious tone, serving as a reminder of how some battered financial firms remain dependent on government lifelines. Dow Jones Industrial Average futures recently rose three points in screen trade.

Large Bank Losses Triple

And this is an increase from 2008 levels? Ouch!

CHARLOTTE, North Carolina (AP) -- U.S. regulators said total losses from large loans at banks and other financial institutions nearly tripled to $53 billion in 2009, due to a deteriorating economic environment and continued weak underwriting standards.

According to an annual report released by the four federal bank-regulatory agencies on Thursday, credit quality deteriorated to record levels this year.
The report said total identified losses of $53.3 billion in 2009 surpassed last year's total of $2.6 billion, and nearly tripled the previous peak in 2002, when losses totaled $19.1 billion.
"While we expected a year-over-year increase in problem assets, given the weak economic environment, declining (commercial real estate) values, and previously weak underwriting, we were surprised by the magnitude of the increase," wrote FBR Capital Markets analyst Scott Valentin in a research note to clients Friday.

Credit Card Defaults Reach New Record

from Bloomberg:
Sept. 23 (Bloomberg) -- U.S. credit-card defaults rose to a record in August and more losses may lie ahead as delinquencies climbed for the first time since March, according to Moody’s Investors Service.
Write-offs rose to 11.49 percent from 10.52 percent in July, Moody’s said today in a report. Loans at least 30 days delinquent rose to 5.8 percent from 5.73 percent. “Early- stage” delinquencies, or loans overdue 30 to 59 days, surged to 1.65 percent, from 1.41 percent, signaling higher losses in coming months. Banks typically write off loans after 180 days.
JPMorgan Chase & Co.,Bank of America Corp. and Citigroup Inc., the biggest U.S. credit-card lenders, said in federal filings on Sept. 15 that defaults climbed in August as the unemployment rate jumped to 9.7 percent and the impact of income tax refunds waned. Credit-card defaults typically track the U.S. jobless rate.

California Credit To Take Another Hit

from Bloomberg:
California’s credit rating, already the lowest among U.S. states, may be cut several levels by Moody’s Investors Service as government leaders seek ways to eliminate a $24 billion budget deficit.

The move would affect $72 billion of debt, Moody’s said in a statement today. California’s full faith and credit pledge is rated A2 by Moody’s, five steps above junk.

Standard & Poor’s put California on watch for a possible reduction earlier this week, and Fitch Ratings did the same thing May 29. The rating companies cited the most-populous state’s deficit -- more than 20 percent of the general fund -- and lawmakers’ inability to agree on how to close the gap.

“If the Legislature does not take action quickly, the state’s cash situation will deteriorate to the point where the controller will have to delay most non-priority payments in July,” Moody’s said in a report today. “Lack of action could result in a multi-notch downgrade.”

Earlier this week, Republican Governor Arnold Schwarzenegger said he would refuse to back any tax increase as Democrats proposed a budget that would raise $2 billion from cigarette consumers and oil companies to help the state deal with declining revenue. The veto threat signaled an escalating battle over the deficit just a month and a half before the most- populous U.S. state is forecast to run out of money to pay its bills.

‘Clear Warning’

“I don’t think I’ve ever seen the phrase multi-notch in a ratings write-up,” said Schwarzenegger’s budget spokesman H.D. Palmer. “It’s another clear warning from the financial markets that there will be costly consequences if the Legislature doesn’t’ quickly send the governor a budget plan that he can sign.”

Rising Credit Card Defaults Endanger Bank Rebound

from CNBC:
U.S. credit card defaults rose to record highs in May, with a steep deterioration of Bank of America's lending portfolio, in another sign that consumers remain under severe stress.

Delinquency rates—an indicator of future credit losses—fell across the industry, but analysts said the decline was due to a seasonal trend, as consumers used tax refunds to pay back debts, and they expect delinquencies to go up again in coming months.

Bank of America—the largest U.S. bank—said its default rate, those loans the company does not expect to be paid back, soared to 12.50 percent in May from 10.47 percent in April.

In addition, American Express, which accounts for nearly a quarter of credit and charge card sales volume in the United States, said its default rate rose to 10.4 percent from 9.90, according to a regulatory filing based on the performance of credit card loans that were securitized.

Credit card losses usually follow the trend of unemployment, which rose in May to a 26-year high of 9.4 percent and is expected to peak near 10 percent by the end of 2009.

If credit card losses across the industry surpass 10 percent this year, as analysts and bank executives expect, loan losses could top $70 billion.

Credit Card Losses Spike 10% -- In One Month!

from Clusterstock:
Credit card losses continue to get worse. Card issuer Capital One (COF) said in an SEC filing this morning that its annualized charge-offs hit 9.41% in May, which is up 10% from an 8.56% rate in April.

Worse, as noted by Reuters, is that the rate of deterioration would have been worse had it not been for an accounting change.

Here's the note from the SEC filing:

A change in bankruptcy processing resulted in an improvement in the U.S. Card charge-off rate that is reflected in the May results. The impact was approximately 50 basis points. While our internal guidelines require bankrupt accounts to be charged off within 30 days, our practice had been to charge off customer accounts within 2 to 3 days of receiving notification of bankruptcy. Due in part to an increase in the volume of bankruptcies, we have extended our processing window to improve the efficiency and accuracy of bankruptcy-related charge-off recognition. The new process remains within Capital One’s internal guidelines, as well as FFIEC guidelines that bankrupt accounts must be charged-off within 60 days of notification.

Credit Crisis Watch from John Mauldin -- Signs of Improvement

from John Mauldin's Outside the Box, written by Dr. Prieur du Plessis:

Credit Crisis Watch: Thawing – noteworthy progress

Are the various central bank liquidity facilities and capital injections having the desired effect of unclogging credit markets and restoring confidence in the world's financial system? This is precisely what the "Credit Crisis Watch" is all about – a review of a number of measures in order to ascertain to what extent the thawing of credit markets is taking place.

First up is the LIBOR rate. This is the interest rate banks charge each other for one-month, three-month, six-month and one-year loans. LIBOR is an acronym for "London InterBank Offered Rate" and is the rate charged by London banks. This rate is then published and used as the benchmark for bank rates around the world. The higher the LIBOR rate, the greater the stress on credit markets.

Interbank lending rates – the three-month dollar, euro and sterling LIBOR rates – declined to record lows last week, indicating the easing of strain in the financial system. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.66% on Friday. LIBOR is therefore trading at 41 basis points above the upper band of the Fed's target range – a substantial improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Importantly, US three-month Treasury Bills have edged up after momentarily trading in negative territory in December as nervous investors "warehoused" their money while receiving no return. The fact that some safe-haven money has started coming out of the Treasury market is a good sign.

The TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) is a measure of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. On the other hand, when the risk of bank defaults is considered to be decreasing, the TED spread narrows.

Since the peak of the TED spread at 4.65% on October 10, the measure has eased to an 11-month low of 0.48%. This is a vast improvement, although still somewhat above the 38-point spread it averaged in the 12 months prior to the start of the crisis.

The difference between the LIBOR rate and the overnight index swap (OIS) rate is another measure of credit market stress.

When the LIBOR-OIS spread increases, it indicates that banks believe the other banks they are lending to have a higher risk of defaulting on the loans, so they charge a higher interest rate to offset that risk. The opposite applies to a narrowing LIBOR-OIS spread.

Similar to the TED spread, the narrowing in the LIBOR-OIS spread since October is also a move in the right direction.

Further evidence that the convalescence process is on track comes in the form of data showing a sharp decline in borrowing by primary institutions at the discount window – down by almost 65% since the "panic peak" recorded during the week of October 29, 2008.

The Fed's Senior Loan Officer Opinion Survey of early May serves as an important barometer of confidence levels in credit markets. Asha Bangalore (Northern Trust) said: "The number of loan officers reporting a tightening of underwriting standards for commercial and industrial loans in the April survey was significantly smaller for large firms (39.6% versus peak of 83.6% in the fourth quarter) and small firms (42.3% versus peak of 74.5% in the fourth quarter) compared with the February survey and the peak readings of the fourth quarter of 2008."

"In the household sector, the demand for prime mortgage loans posted a jump, while that of non-traditional mortgages was less weak in the latest survey compared with the February survey. At the same time, mortgage underwriting standards were tighter for both prime and non-traditional mortgages in the April survey compared with the February survey," said Bangalore. In other words, more needs to be done by the lending institutions to revive mortgage lending.

The spreads between 10-year Fannie Mae and other Government-sponsored Enterprise (GSE) bonds and 10-year US Treasury Notes have compressed significantly since the highs in November. In the case of Fannie Mae, the spread plunged from 175 to 26 basis points at the beginning of May, but have since kicked up to 37 basis points on the back of the rise in Treasury yields.

After hitting a peak of 6.51% in July last year, there was a marked decline in the average rate for a US 30-year mortgage. However, the rise in the yields of longer-dated government bonds over the past nine weeks – 92 basis points in the case of US 10-year Treasury Notes – resulted in mortgage rates creeping higher since the April lows. Also, the lower interest rates are not being passed on to consumers, as seen from the 434 basis-point spread of the 30-year mortgage rate compared with the three-month dollar LIBOR rate. According to Bloomberg, this spread averaged 97 basis points during the 12 months preceding the crisis.

Fed Chairman Ben Bernanke said earlier in May that "mortgage credit is still relatively tight", as reported by Bloomberg. This raises the possibility that the Fed will boost its purchases of Treasuries to keep the cost of consumer borrowing from rising further. [The Fed has so far bought $95.7 billion of Treasury securities from $300 billion earmarked for this purpose. Similarly, purchases of agency debt of $71.5 (out of $200 billion) and mortgage-backed securities of $365.8 billion (out of $1.25 trillion) have taken place.]

As far as commercial paper is concerned, the A2/P2 spread measures the difference between A2/P2 (low-quality) and AA (high-quality) 30-day non-financial commercial paper. The spread has plunged to 48 basis points from almost 5% at the end of December.

Similarly, junk bond yields have also declined, as shown by the Merrill Lynch US High Yield Index. The Index dropped by 44.4% to 1,213 from its record high of 2,182 on December 15. This means the spread between high-yield debt and comparable US Treasuries was 1,213 basis points by the close of business on Friday. With the US 10-year Treasury Note yield at 3.45%, high-yield borrowers have to pay 15.58% per year to borrow money for a 10-year period. At these rates it remains practically impossible for companies with a less-than-perfect credit status to conduct business profitably.

Another indicator worth monitoring is the Barron's Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been a solid improvement in the ratio since its all-time low in December, showing that bond investors are growing more confident and have started opting for more speculative bonds over high-grade bonds.

According to Markit, the cost of buying credit insurance for American, European, Japanese and other Asian companies has improved strongly since the peaks in November. This is illustrated by a significant narrowing of the spreads for the five-year credit derivative indices. By way of example, the graphs of the North American investment-grade and high-yield CDX Indices are shown below (the red line indicates the spread).

In summary, the past few months have seen impressive progress on the credit front, with a number of spreads having declined substantially since their "panic peaks". The TED spread (down to 0.48% from 4.65% on October 10), LIBOR-OIS spread (down to 0.45%% from 3.64% on October 10) and GSE mortgage spreads have all narrowed considerably since the record highs.

In addition, corporate bonds have seen a strong improvement, although high-yield spreads remain at elevated levels. Credit derivative indices for companies in all the major geographical regions have also shown a marked tightening since the November highs.

Most indications are that the credit market tide has turned on the back of the massive reflation efforts orchestrated by central banks worldwide and that the credit system has started thawing. However, although the convalescence process seems to be well on track, it still has a way to go before confidence in the world's financial system returns to more "normal" levels, liquidity starts to flow freely again, and the economic recovery can commence.

Here Come Commercial Mortgage Downgrades

from FT:

Fears among credit investors have risen that threatened ratings downgrades of commercial property debt might thwart US government efforts to revive the markets that help fund office blocks, shopping centres and other commercial real estate.

Standard & Poor’s warned this week that it was likely to downgrade tens of billions of dollars in triple A securities backed by recent real estate loans – with 90 per cent of the securities backed by 2007 mortgages likely to face rating cuts.

The State of the Banks

from Bonddad blog:
Over the last few days the FDIC has released the quarterly banking profile. I'm going to tackle this in two parts. In the first I'll look at the report. In the second we'll look at the graphs:

Sharply higher trading revenues at large banks helped FDIC-insured institutions post an aggregate net profit of $7.6 billion in the first quarter of 2009. Realized gains on securities and other assets at a few large institutions also contributed to the quarter’s profits. First quarter earnings were $11.7 billion (60.8 percent) lower than in the first quarter of 2008 but represented a significant recovery from the $36.9 billion net loss the industry reported in the fourth quarter of 2008.1 Provisions for loan and lease losses were lower than in the fourth quarter of 2008 but continued to rise on a year-over-year basis. The increase in loss provisions, higher charges for goodwill impairment, and reduced income from securitization activity were the primary causes of the year-over-year decline in industry net income. Evidence of earnings weakness was widespread in the first quarter; more than one out of every five institutions (21.6 percent) reported a net loss, and almost three out of every five (59.3 percent) reported lower net income than in the first quarter of 2008.

The first part of this overview indicates we've got a statistical blip. "Realized gains at a few large institutions" were the primary reason for the overall jump. The last sentence indicates there are still problems out in the financial sector. 21.6% of all institutions reported a net loss and 59.3% lower year over year results. Those that the figures that should cause us concern.

Insured institutions set aside $60.9 billion in loan loss provisions in the first quarter, an increase of $23.7 billion (63.6 percent) from the first quarter of 2008. Almost two out of every three insured institutions (65.4 percent) increased their loss provisions. Goodwill impairment charges and other intangible asset expenses rose to $7.2 billion from $2.8 billion a year earlier. Against these negative factors, total noninterest income contributed $68.3 billion to pretax earnings, a $7.8-billion (12.8 percent) improvement over the first quarter of 2008. Net interest income was $4.4 billion (4.7 percent) higher, and realized gains on securities and other assets were up by $1.9 billion (152.6 percent). The rebound in noninterest income stemmed primarily from higher trading revenue at a few large banks, but gains on loan sales and increased servicing fees also provided a boost to noninterest revenues. Trading revenues were $7.6 billion higher than a year earlier, servicing fees were up by $2.4 billion, and realized gains on securities and other assets were $1.9 billion higher. Nevertheless, these positive developments were outweighed by the higher expenses for bad loans and goodwill impairment. The average return on assets (ROA) was 0.22 percent, less than half the 0.58 percent registered in the first quarter of 2008 and less than one-fifth the 1.20 percent ROA the industry enjoyed in the first quarter of 2007.

The bottom line: there was some good news. But the bad news outweighed the good news. Loan loss provisions and goodwill impairments are increasing. These factors outweighed the increased revenue from servicing and trading.

For the sixth consecutive quarter, falling interest rates caused declines in both average funding costs and average asset yields. The industry’s average funding cost fell by more than its average asset yield in the quarter, and the quarterly net interest margin (NIM) improved from fourth quarter 2008 and first quarter 2008 levels. The average NIM in the first quarter was 3.39 percent, compared to 3.34 percent in the fourth quarter of 2008 and 3.33 percent in the first quarter of 2008. This is the highest level for the industry NIM since the second quarter of 2006. However, most of the improvement was concentrated among larger institutions; more than half of all institutions (55.4 percent) reported lower NIMs compared to a year earlier, and almost two-thirds (66.0 percent) had lower NIMs than in the fourth quarter of 2008. The average NIM at institutions with less than $1 billion in assets fell from 3.66 percent in the fourth quarter to 3.56 percent, a 21-year low.

The increased net interest margin was better for the bigger banks. Period.

First-quarter net charge-offs of $37.8 billion were slightly lower than the $38.5 billion the industry charged-off in the fourth quarter of 2008, but they were almost twice as high as the $19.6 billion total in the first quarter of 2008. The year-over-year rise in charge-offs was led by loans to commercial and industrial (C&I) borrowers, where charge-offs increased by $4.2 billion (170 percent); by credit cards (up $3.4 billion, or 68.9 percent); by real estate construction loans (up $2.9 billion, or 161.7 percent); and by closed-end 1-4 family residential real estate loans (up $2.7 billion, or 64.9 percent). Net charge-offs in all major categories were higher than a year ago. The annualized net charge-off rate on total loans and leases was 1.94 percent, slightly below the 1.95 percent rate in the fourth quarter of 2008 that is the highest quarterly net charge-off rate in the 25 years that insured institutions have reported these data. Well over half of all insured institutions (58.3 percent) reported year-over-year increases in quarterly charge-offs.

Here is the key takeaway: The annualized net charge-off rate on total loans and leases was 1.94 percent, slightly below the 1.95 percent rate in the fourth quarter of 2008 that is the highest quarterly net charge-off rate in the 25 years that insured institutions have reported these data.

The high level of charge-offs did not stem the growth in noncurrent loans in the first quarter. On the contrary, noncurrent loans and leases increased by $59.2 billion (25.5 percent), the largest quarterly increase in the three years that noncurrent loans have been rising. The percentage of loans and leases that were noncurrent rose from 2.95 percent to 3.76 percent during the quarter; the noncurrent rate is now at the highest level since the second quarter of 1991. The rise in noncurrent loans was led by real estate loans, which accounted for 84 percent of the overall increase. Noncurrent closed-end 1–4 family residential mortgage loans increased by $26.7 billion (28.1 percent), while noncurrent real estate construction loans were up by $10.5 billion (20.3 percent), and noncurrent loans secured by nonfarm nonresidential real estate properties rose by $6.9 billion (40 percent). All major loan categories experienced rising levels of noncurrent loans, and 58 percent of insured institutions reported increases in their noncurrent loans during the quarter.

First loans become non-current, then banks charge them off. In other words wven though banks are charging off a ton of loans, there are more defaults in the pipeline. That is terrible news. In addition, the rate of increase appears to be accelerating. None of this is good.

Housing Could Get Worse

from Accrued Interest Blog:

It was shades of 2002, only in reverse today. Mortgage servicers sold intermediate/long rates, which drove rates higher, which brought out more mortgage hedge sellers. Now we are set with some very basic problems.

The Fed can't keep mortgage rates at or below 5% with the Treasury market where it is. Can't happen.

In addition to this, we need to keep in mind that starting in 2010, mortgage resets will begin to rise again, and will continue to rise to a peak in 2011.

FDIC List of Problem Banks Continues to Grow

from WSJ:

The Federal Deposit Insurance Corp. put out its quarterly profile of the banking industry on Wednesday.

Among its highlights:

• The number of “problem” banks rose from 252 at the end of the fourth quarter to 305 at the end of the first quarter.
• The 21 bank failures in the first quarter is the most since the fourth quarter of 1992 (15 have already failed in the second quarter).
• The average size of problem banks grew as well, up from an average of $631 million in assets to $721 million in assets per bank.
• The deposit insurance fund fell from $19 billion to $13 billion in the quarter, and it is expected to continue falling through 2009. The fund backstops roughly $4.8 trillion in deposits.
• Higher trading revenue at large banks pushed the industry to an aggregate profit of $7.6 billion in the first quarter.
• Banks charged off $37.8 billion in the first quarter, slightly less than the $38.5 billion charged off in the fourth quarter.
• Noncurrent loans and leases grew by $59.2 billion (or 25.5%), and the percent of loans that were bad rose from 2.95% to 3.76% during the quarter.
• FDIC officials said they did not believe losses to commercial real estate and construction and development loans had peaked yet.