U.S. housing figures

From CR:

New Home Sales Decrease in September

and

New and Existing Home Sales: The Distressing Gap

More on Barclays

From Gillian Tett:

(...) Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).

(...) For the really dirty secret that currently bedevils the whole financial reform debate is that the more that regulators force banks to clean up their “front rooms” (ie regulated activity), the greater the risk that activity will flee to unregulated corners of finance – if nothing else because financiers have little desire to subject their pay to public scrutiny.

Are the banks fine?

I was browsing through Barclays investor presentation and dug out a few numbers. I thought they were interesting because they paint a picture quite similar to what I've heard about many other of the large banks. From page 4, you can see that most activities have posted gigantic declines in profits from last year:

UK Retail Banking: - 61%
Barclays Commercial Bank: - 42%
Barclaycard: - 1%
GRCB –Western Europe: - 73%
GRCB – Emerging Markets: - 86%
GRCB – Absa: - 17%
Barclays Capital: + 100%
Barclays Global Investors: +4% (BGI was sold to BlackRock)
Barclays Wealth: - 59%

Head Office went from minus £ 460 mln to a positive £ 330 mln. This swing of £ 800 mln or so is a contribution to profits that is big time cost cutting: Head Office is a cost center, it's not supposed to make money. So this is non-recurring. A second comment: the only other material positive contribution comes from Barcap: about £ 1bn (up from £500 mln last year) contribution to a total of £ 3bn before tax profits. Barcap is the trading arm of Barclays, so these profits come from very risky activities: on page 47, economic profit from Barcap is slightly negative. Economic profit is profit minus the dollar cost of capital (which should be proportional to the riskiness of the project) needed to earn these profits. This is corporate finance 101: if you need to borrow $100 at a 10% interest rate for a business that is gonna bring $9 a year in profits, well it just doesn't make any sense to invest in that business.

Moving on to page 5: leverage is down from 28x to 20x. Improvement? Yes... but. It still means that a (marked-to-market) 5% drop in the value of the bank's assets would completely wipe out shareholders and render the bank technically insolvent. And this does not include, by definition, off-balance sheet activities. How likely is it that the bank's on-balance sheet assets will again be eventually marked down? From the appendix:

Page 9: loan loss rate (Commercial Bank): still climbing. Page 54: arrears rate (UK mortgages): still climbing. Page 55: net charge offs and deliquency rates (UK cards, US cards, UK unsecured customer loans): still climbing...

Buiter on bubbles and China

Willem Buiter is a very smart and knowledgeable person; however his blog posts are always very (very!) long. No worries dear reader, I am here to select the good stuff for you (from: Beware asset market & credit booms bubbles & busts in emerging markets). I will also highlight a classic rookie mistake he made, much like I did in my previous post.

(...) the world is being flooded with official liquidity by the leading central banks of the overdeveloped world.

First remark: the expression "overdeveloped world" may be the best thing I've heard since "Goldilocks economy". It just explains so much in one single world... this is economic poetry! I don't know if Buiter originated it, it is the first time I see it. It continues:

Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. (...) Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule.  We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and - eventually - busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe.  China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk. (...) The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries. (...) The accumulation of foreign exchange reserves that results is only partly sterilised. The result is externally financed expansion of the domestic money supply and more rapid domestic credit growth. This will leak at least partly into domestic asset markets, creating the conditions for boom, bubble and bust.

And now, on China:

China is especially at risk of booms and bubbles in its stock market, its residential housing market and its commercial and industrial property markets.  That is because the externally funded liquidity injection resulting from Chinese attempts to keep down the external value of the yuan are reinforced by further domestic credit expansion associated with the Chinese fiscal stimulus. (...) China is creating massive excess capacity in export-oriented industries (and indeed in some of the low-tech consumer goods where it no longer is the global low-cost producer).

(My emphasis). Continues:

In two or three years, when these loans will be going into default on a large scale, the central bank or the ministry of finance will recapitalise the banks, using a mixture of government debt, central bank domestic credit and foreign exchange reserves.

And there it is - the rookie mistake: recapitalising the Chinese banks with foreign exchange reserves. I've seen that countless times but I didn't expect Buiter to fall into that trap. Let me explain: you cannot use foreign exchange currency (in that case, mostly dollars) to recapitalise a domestic currency (yuan) balance sheet. Have you ever heard of a company having equity in foreign exchange currency ? It is just silly ! Now, what you could in theory do is convert this dollars in yuan, and use the proceeds to recapitalise the banks. But that would entail a large appreciation of the Chinese currency: remember, if the central bank just stopped buying dollars, the renmibi would most likely increase by 20% to 40% rappidly. What would happen then if the central bank started to sell dollars ? A very destabilizing overshoot in the exchange rate. Now, would you like to see that happen to your country, if at the same time your country's banking system is in need of being recapitalized ?

Let's continue with Buiter, who is otherwise right to the point:

The boost to domestic demand is overwhelmingly in the form of fixed investment, much of in the the wrong, old industries.  Without a miraculous recovery of export demand growth, excess capacity will re-emerge with a vengeance in the export industries.

(...) Other emerging markets too are likely to be faced with domestic asset market booms and bubbles, in particular the oil and gas exporting nations of the Gulf Cooperation Council (GCC).  These countries still peg to or shadow the US dollar quite closely, despite a number of attempts, through basket-pegging and similar manoeuvres, to loosen their ties to the US dollar. (...) The credit and asset market boom, bubble and bust I foresee for the rapidly growing emerging markets is not inevitable.  It is a policy choice.  If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows. For China, preventing excessive credit growth and asset booms and bubbles is more difficult, as in addition to the external liquidity injection, the government is, through the banking system, injecting massive amounts of domestic liquidity into the economy.  This would become unnecessary if China were able to switch the composition of production and of domestic demand towards consumer goods and services and non-traded goods and services.

2010 outlook

I briefly mentionned PIMCO's New Normal, which is the company's secular outlook, in my last stock market comment (PIMCO is one of the largest bond management companies). Here are some some excerpts from their latest cyclical outlook. I will then criticize one of their points, well, because it's by bettering the master that one becomes a master... (already attempted here and here).

Here is their cyclical outlook:

Consider the notion of an “escape velocity” for the economy – a forward movement that is significant enough for a sustained economic expansion to set in. There are three contributors. The first is the unprecedented amount of global fiscal and monetary stimulus. This is now in play in a big way. The second is the inventory rebuilding cycle, which is starting to take hold. While these two factors are necessary for reaching escape velocity – and are very much in play, contributing to seemingly robust growth numbers for the third and fourth quarters – they are not sufficient. We also need sustainable private sector demand.
In PIMCO’s Investment Committee deliberations, Bill came up with an analogy of a rocket, which has fired two boosters but needs to fire a third in order to escape the earth’s gravitational force. That third booster, which is the final component necessary to achieve escape velocity, has to come from a source of private demand: either consumption, investment or exports.
When we look at the extent to which the major economies, especially the U.S., are challenged by their balance sheets right now, we are not yet expecting that the third booster is going to fire. As a result, we question the expectations in the marketplace for a V-shaped recovery.

I am holding back on using my model to compute 2010 GDP forecasts until next week (I am waiting for the Q3 GDP release), but for now it does paint a similar picture: relatively "strong" growth (around 2-2.5%) in the next few quarters, followed by a drop later in 2010. But more on that next week. What I want to talk about now is the following, from the same PIMCO piece:

The extraordinarily low fed funds rate has pushed money out of low-risk and “risk-free” assets into higher risk assets, which has led to the bounce in asset prices.

This is a classic rookie mistake which has me thinking that maybe Gross and El-Erian (the PIMCO heads) didn't write that piece themselves, but rather had an intern do it for them (I should have his job). You see, there is no such thing has money flowing out or into anything. Consider this: one day, the whole earth population wakes up and decides to buy (flow into) equities. Well if the transaction is to take place, someone has to sell equities to them, and will thus necessarily flow out of equities. And this, by the exact same amount of money. Another way to say this is that supply equals demand, always. To go further, imagine that all this money that the buyers spent on equities was previously in money market funds. When they sold these money market funds, someone had be there to buy them: in the end, no net amount of money whatsoever has left the money markets. What can change though, is the price at which buyers and sellers can agree to make the transaction, which depends on their respective eagerness to hold (or not hold) equities.

Reconciliation of residual income and free cash-flow models

I wasn't satisfied with the usual method of showing how the residual income model is equivalent to the free cash-flow or dividend discount model (see Ohlson & Juettner-Naworth, 2005). It is a stretch mathematically. So a few months ago, I decided to make my own method, which is now available online at http://ssrn.com/abstract=1492062. Reading advised to finance students and anyone interested in the theory of equity valuation (others will probably find it boring and useless...).

Stock market update

Here's my analysis of the U.S. stock market. Not having to study anymore for CFA exam or dissertation does leave me with a lot more free time.

First we have very high valuations by historical standards, which imply unrealistic expectations for a recovery in profit margins and revenues (see Bill Hester, as well as various PIMCO commentaries on profit margins in what they call the "New Normal" economic landscape). Thus, long-term returns from buying equities at this level are likely to be low, at best, and this kind of valuations imply a lot of downside potential in case of renewed economic problems.

Second, on the technicals front we have a quite overbought condition (see this and this).

Third, on the economics front, we have an inventory rebuilding growth boost that will probably fade by next spring, and a still-climbing unemployment rate which, together with a wave of Alt-A and Option-ARM mortages problem, imply renewed stress on banks and households.

Fourth, we also have Fed officials becoming more hawkish in the face of a falling dollar.

All in all, not a pretty picture.

I would wait to see deterioration in market internals and breadth before shorting this market though: you don't want to be short a climbing market that is exhibiting Soros reflexivity. Other signs of a top would include: increasing corporate bond yields / CDS spreads, a climbing dollar (hopefully accompanied by a drop in treasury yields), a non-confirmation (divergence) between the Dow Industrials and the Transports, relative underperformance of financial stocks, etc.

On the limitations of the yield curve as a recession predictor

The yield curve has an amazing track record at predicting U.S. recessions: it basically predicted all of them, giving only a few false signals which still turned out to foresee slowdowns. In the current environment however, its predictive ability may be seriously lowered : Wright's model B tells us we would need to see a yield of 0.7% or less on the ten-year T-Bond to have a recession probability of at least 50%... I would bet we could fall back in a recession without ever getting even close to that yield level. Ask the Japanese.

My GDP forecast...

... for last year, as computed by the model, called VAR(30), that I am presenting as a Master's Dissertation. Excerpt from the results section, followed by the forecast the model would have made back in December of 2007:

The annual pseudo out-of-sample forecasts (performed as of December of each year) were compared to the (December) Wall Street Journal Economic Forecasting Surveys since 2004. VAR(30) would have been the only one to predict a 2008 recession in December, 2007. Over the short, four year period (2005 through 2008) available for a benchmark, VAR(30) outperforms on average all of the private-sector forecasters polled by the Wall Street Journal. This figure is however skewed to the upside by the 2008 extreme outperformance: excluding the 2008 recession year, the rank falls to the 16th place, out of 42 (only forecasters who provided GDP growth estimates for all of the four years were included in this ranking, and thus there can be survivorship bias in the list). This illustrates the importance of Renshaw’s “right ballpark estimate”. Specifically, VAR(30) ranks 15th out of 59 for the 2005 GDP forecast, 41st out of 59 for 2006, 20th out of 63 for 2007, and 1st out of 54 for 2008.
Also presented are fan charts of each yearly pseudo out-of-sample forecasts made each December. Fan charts represent the 90%, 75% and 50% confidence bands around the central GDP forecast.


(click to enlarge)