All Things in Moderation

Vital Statistics:

Markets are weaker this morning as Spanish bond yields rose at an auction. The 10-year Spanish bond yield rose 21 basis points to 6.32%. The Italian government bond yield rose to 7.03%. EURIBOR / OIS is about 1.5 basis points higher at 90.9 bps. The UK and Germany are clashing over a proposed financial transaction tax, with the UK refusing to go along with a Euro Financial Transactions tax unless the US and Asian markets institute one. The City of London is in fact the financial center of Europe and the UK estimates that they would end up paying roughly 80% of the tax. British Prime Minister David Cameron cheekily suggested that requiring the UK to institute a financial transactions tax would be like asking the French to institute a cheese tax.

There was a slew of encouraging economic data this morning. The Producer Price Index came in lower than expected, indicating inflationary pressures (at least as measured by the government) remain under control. Retail sales came in better than expected, though the .6% increase is a modest number. I have pointed out that there has been a disconnect lately between the sentiment indicators and the actual spending numbers. Finally Empire Manufacturing came in better than expected as well.

The Wall Street Journal has a story on the state of finances at FHA. The FHA’s reserves have dropped to $2.6 billion which is .24% of the $1.1 trillion of loans it insures. The FHA is actually required to hold 2% reserves. This raises the possibility that FHA will run out of money and need more money from the government. The recent audit of FHA estimates they will squeak by, assuming real estate prices drop 5.6% this year and rise 1.2% in 2012. Fortunately for FHA, they can go directly to Treasury and can bypass Congress.

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Vital Statistics:

Markets are a touch weaker this morning as Italian and Spanish government bond yields back up. The markets are beginning to worry that Spain, with its burst real estate bubble, will be the next to face scrutiny. Luckily for the Spanish banks, they have exposure to the strong Brazilian economy, so they are probably in better shape than the Italian banks. Unicredito is considering a 7.5 billion euro share issue to raise capital. This will become a trend, given the pre-crisis capital levels of the Euro banks.

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On this Veteran’s Day, I want to share a sea story.

I was on the USS Gridley (CG-21) in the Persian Gulf at the end of Desert Storm (early 92). The combat part was over, but we still kept a Tomahawk shooter in the Northern Persian Gulf. The job of the USS Gridley was to defend the Tomahawk shooter (typically a Spruance class destroyer) from air attack. Leahy-Class cruisers and Aegis cruisers have the AAW (anti-air warfare) mission and have something like 100 long-range anti-aircraft missiles onboard.

Anyway, defending a Spruance destroyer is a pretty boring job. We would basically be assigned a 8 nautical mile box and lazily steam back and forth in it, all while dodging fishing boats, oil rigs, and tankers. One morning, the Middle East commander ordered us to investigate a distress signal in the Arabian Sea. We left the Northern Persian Gulf and headed through the Straits of Hormuz.

We eventually found the ship that made the call. It was a Somali cargo ship with a ton of people on it. We couldn’t communicate with the ship, so we sent a couple of engineers in a small boat to take a look at it and see if they could fix it. The seas were really rough, and doing loops around the ship while we waited for the verdict from the engineers was a pain. I was the OOD (Officer of the Deck), and the Captain was on the bridge with me. The engineers reported back that the diesel engine had somehow lost its oil and it was ruined. Unfixable. We reported back to the ME Commander who ordered us to tow the thing back to Somalia.

So, we start getting things ready. We pull the towline on deck, bring out the Underway Replenishment Team, and pass close by. To pass a rope between ships, you fire a shot line (basically an orange bobbin with strong thread) from a rifle, then attach a 1 inch rope to that (called the messenger line) and then attach the towline (which is 5 inches in diameter and heavy as hell). We pass by the ship, and our guy on deck pulls out the rifle and shoots the line over. Everyone on the deck of the Somali ship watches the line fly over their head. Then they look back at us with a “What the hell are you weird Americans doing?” look on their faces. We yell back “PULL! PULL!” They don’t speak English and they don’t get that they are supposed to pull on the orange line. By this time, we have moved enough that the orange line has slipped off the Somali ship and we have to make another pass. Remember, these are ships, not Ferraris and getting close for a loop around in rough seas takes a while.

So this time, we pass by slowly, shoot the line over, and pantomime pulling. Somehow the light bulb goes off on the other ship and they start pulling on the shot line. They pull the shot line up, grab the 1 inch messenger line and tie it to the bow and signal they are ready to go. They don’t realize there is another rope tied to the 1 inch rope. Towing a 8,000 ton ship with a 1 inch line isn’t going to cut it. We pantomime pulling again. They don’t get it. We finally get them on the radio. We pass the word on the ship for anyone with foreign language skills to report to the bridge. That covers Spanish and Tagalog. No dice. We call up to the SIGINT spooks. Get an Arabic speaker, but the Somalis don’t understand. They just don’t get it.

We finally give up and decide to try and tow the ship with the messenger line. We go slowly (like 1.5 knots) and take them back to Mogadishu. It took us forever to get back. When we finally got them to port, we asked the Port Manager where he wanted these guys. He didn’t want them and told us to take the ship somewhere else. We didn’t want a diplomatic incident, so we called up the Commander of the Middle Ease and told him the story. We were told to just leave them anyway. We told Mogadishu”the Adele II is your headache now.” The Adele II dropped anchor, and we headed back to the Persian Gulf.

In our wrap-up report to the Commander Middle East, we included a “lesson learned” – translate “Heave Around” in every known language.

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Vital Statistics:

Markets are rallying due to Italy’s vote to adopt austerity plans and a better than expected University of Michigan Consumer confidence report. Italian government bonds are rallying again. That said, EURIBOR / OIS is wider, signalling all is not well in the banking system. The chart below explains why:

Chart: Comparison of Euro and US banks

(source: European Central Bank / US Federal Reserve)

This chart shows the nominal value (in local currency) of the banking system assets and equity of both the US and the Eurozone. It shows how much more levered the Euro banking system is than the US system – 19.2 in Europe vs 8.8 in the US. These are pre-crisis numbers, so the state of the Eurozone banking system is even worse.

The University of Michigan Consumer Confidence report showed an uptick in November, bouncing back from the summer lows. Retailers are outperforming the broader market on the news.

Chart: University of Michigan Consumer Sentiment Index:

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Vital Statistics:

Markets are rebounding after a successful Italian bond auction overnight. Italy sold 5 billion euros of government debt at 6.09%, which put a bid in the 10-year, which rallied to below 7%, nearly erasing yesterday’s losses. Essentially the Italian 10-year did a round trip from 86 1/2 to 82 1/4, which is a 5% move. For government bonds, that is nearly a year’s pay. It is a strange world we live in when normally staid government bonds exhibit the sort of volatility usually reserved for stocks and commodities.

The permanent rescue fund has hit a roadblock as French and German finance ministers clash over provisions to force haircuts on bondholders. As I mentioned before, it appears the French banks are holding the old maid and the government is resisting plans that impose losses on creditors because the last thing they want to do is to have to bail out the French banks (again). This could become an issue.

In the US, there has been a battle royale going on between Green Mountain Coffee Roasters (Nasdaq – GMCR) and hedge fund manager David Einhorn. For those who don’t know, Einhorn runs Greenlight Capital and has be very publicly short the coffee company. Einhorn has cited a number of accounting issues as well as concerns over market size and patents. GMCR announced lower than expected earnings last night, and the stock is down about 30%. These sorts of battles between value hedge-fund managers and growth mutual fund managers make for interesting stories. Usually, the mutual fund managers (by sheer size of dollars invested) steamroll the value guys who are shorting the high-flyers. Once in a while the value guys win one too.

In economic data, initial jobless claims came in at 390k, slightly below the street estimate of 400k. The trade deficit shrunk to 43 billion from 45 billion.

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Vital Statistics:

Added a new vital statistic – the Italian 10 year government bond yield.

S&P futures are getting crushed as investors focus on Italy and the rise in Italian government bond yields. Overnight, LCH Clearinghouse increased the margin requirements on Italian government debt by 75%, triggering a sell-off in Italian bonds. Spanish and Irish yields are wider as well. Both EURIBOR / OIS and LIBOR / OIS are signaling stress in the financial system. One problem for the banking system is that government bonds form the basis of Tier 1 (risk-free) capital. So if the “safe stuff” is suspect, all of the banks are suspect.

Luckily the US credit markets (with the exception of the mortgage space) have been largely insulated from the problems emanating out of Europe. US banks raised a lot of capital during the crisis and have been de-levering for years. Two big corporate issues priced yesterday and hedge funds are raising money for distressed debt vehicles. The US government bond is back under a 2% yield.

The European experience is instructive for the US. Slow-moving train wrecks can lull investors into a false sense of security. Simply because investors are not focusing on a well-advertised problem at the moment doesn’t mean things are fine. These sorts of things typically coalesce in a short period of time. In other words, it doesn’t matter until it matters, and then it is the only thing that matters.

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Vital Statistics:

Today is a “risk on” day, as Euro markets rally on Vodafone’s positive earnings announcement and Germany’s unexpected increase in exports. Later today, Italian lawmakers will vote on Prime Minister Silvio Berlusconi’s budget. EURIBOR / OIS (a measure of stress in the banking system) is declining again after spiking last week, but is still elevated.

There is an interesting article in this morning’s WSJ discussing the decline in Chinese real estate prices. Prices fell .23% MOM (about 23 basis points) in October after falling .03% (or about 3 basis points) in September. The Chinese authorities have been trying to cool the real estate market for two years, and it appears that they are finally getting some traction. Of course, letting the air slowly out of a financial bubble has proven to be a nearly impossible task. The article discusses how the financing of projects has dried up, which presages a hard landing about 110% of the time.

“Real-estate developers are having greater problems finding financing to complete projects or start new ones. Trust-investment vehicles—a key part of China’s shadow lending system—have become a major source of funding for developers, after bank lending all but dried up this year.”

This sounds a lot like the US in July, 2007. That was when the credit markets started seizing up. Of course the financial press referred to it as a “buyer’s strike” – meaning a temporary phenomenon. Main Street and Washington didn’t even notice there was a problem until Fall of 2008. My point is that these things have long lead times, and this time next year, the Chinese economic implosion may dominate the headlines.

In the “bursting Asian bubbles” category, a couple of Japanese blue chips have been getting roughed up lately. Olympus Optical (the maker of cameras and diagnostic equipment) was limit down last night as news of accounting issues dating back to the 1990s come out. Olympus hid losses from securities in the mid 90s, by holding them off balance sheet. They then tried to use inflated M&A acquisition costs to launder these losses. The problem came to light when Olympus tried write off a 27% M&A fee for the Gyrus acquisition. Nomura (Olympus’s banker) was also in the doghouse and hit a 37 year low.

Part of the reason why the Japanese implosion was such a slow-motion event stems from this. Because of the Japanese keiretsu system, most Japanese companies had holdings in other companies, typically suppliers, customers, etc. These holdings dated back to the WWII era. Japanese accounting has these investments carried at cost, not market, which means that companies always had a “slush fund” they could draw upon to manage earnings. If earnings are going to be in the red, sell a part of your equity holdings and buy it back at market. The gains on that sale (the difference between the stock price today and the cost basis, which for all intents and purposes was close to zero) drop to the bottom line. Presto! Profitability. This allowed the Japanese corporate sector to avoid facing reality for a decade. As a matter of fact, the Ministry of Finance used to conduct “price keeping operations” where they would instruct the banks to support the equity markets. The Japanese believed equity prices and real estate prices were too important to be determined by a mere market.

Unfortunately the Obama administration believes house prices to be too important to be determined by a mere market and is focusing on trying to support house prices at an unsustainable level. And that remains an anvil on the economy.

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Vital Statistics:

Greek Prime Minister George Papandreou stepped aside to allow the formation of a new Unity government which will implement the required measures to receive 130 billion euros in financing. Holders of Greek debt will receive 50 cents on the dollar. Surprisingly ISDA (who oversees derivative contracts) will not consider this to be a “credit event,” so if you had hedged your Greek sovereign debt holdings with credit default swaps, you are out of luck. This adds a brand new risk element to debt / CDS investing – interpretation risk – or the risk you can get crammed down and have it not be considered a credit event. It will be interesting to watch the dynamic here – CDS levels might start giving misleading indications. Since credit default swaps are basically puts, their put value will decline as investors factor in the possibility that they won’t get paid if, say, Italy or Portugal does a similar cramdown plan. Watch the bonds, not the swaps.

Earnings season is more or less over. While companies generally reported strong results, analysts are taking down 2012 estimates. FWIW, there has been a “V” shaped recovery in corporate profits, but that has not extended to employment. From my perch overlooking the mortgage market, I am seeing companies miss out on business because they don’t have the staff to handle it. They are pulled in different directions from increased activity, and paralysis from having no clue how the regulatory environment is going to look. Strange times indeed.

We have a few minor economic data releases this week, but nothing really market moving, except for Initial Jobless claims on Thurs morning. Europe will continue to dominate the market until the January fiscal retailers report Q3 numbers in a few weeks.

-ashotinthedark

I thought Triumph the Insult Comic Dog’s visit to OWS was too funny not to share.

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Vital Statistics:

Stock Index futures dropped dramatically after the IMF and G20 failed to come to a deal over IMF resources. EURIBOR / OIS (a measure of stress in the European banking system) hit a post-crisis high yesterday, although some of that may have been due to MF Global. LIBOR / OIS (a measure of stress in the US banking system) has been steadily rising since August.

Lots of economic numbers released this morning. The unemployment rate came in at 9.0% vs expectations of 9.1%. October payroll numbers were a touch light, but September numbers were revised higher. Average Hourly earnings and hours in line with expectations. Markets are rallying slightly on the news, as investors focus on the revisions and bet that the disappointing Oct payroll numbers will end up being revised upward in the future.

The MF Global saga is interesting on a number of fronts. At the moment, it appears that $633 million of customer money is missing. Co-mingling customer and firm accounts is a big, basic no-no. In addition, it looks like they moved customer funds around in order to fool the auditors. CEO Jon Corzine has resigned this morning and chosen to forego his severance package. If the Occupy Wall Street really wants a perp walk, here is a golden opportunity. It will be interesting to see if the Obama Administration decides to go after Corzine, a well-respected Democrat. So far, they have exhibited zero interest in going after ex-Clinton Budget Director Franklin Raines who paid himself tens of millions or dollars in salary and bonus based on fraudulent accounting, so I am not optimistic. But hey, you never know.

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Link to the Federal Reserve FOMC statement

The Fed has noted the increase in consumer spending that has become apparent in the economic data. This is new. They anticipate moderate economic growth with subdued inflation and slowly declining unemployment levels. The Fed reaffirmed its commitment to maintain low rates through 2013.

Operation Twist will continue, and the Fed intends to continue to maintain its overall exposure to the mortgage market by re-investing cash received from maturing paper. There was no mention of QEIII.

Interestingly, we had a dovish dissent. Charles Evans supported additional monetary policy accomodation at this time. I am sure Barney Frank is preparing a statement condemning dissent at the Fed. /sarcasm.

Overall, markets aren’t reacting to the statement at all. FWIW, I take the official statement that the consumer is returning as bullish for the equity markets.

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