Unsustainability, High Beta, and Liquidity Risk Pervade Capital Markets

After several weeks in California, I am back in Michigan and ready to post again.

The head and shoulders pattern I called for almost a month ago seems to be developing and on the verge of completing. Earnings season is coming up so look for big moves. Banks won’t have an extra $1-2B on their trading profits for Q2 from AIG like they did in Q1, so it will be interesting to see how that affects earnings in financials. There were a large number of equity offerings and the banks that underwrote all of those issuances (mainly Goldman and Merrill) are sure to see some good I-banking profits from that (although, again, these are unsustainable in nature– the market can’t stage a 40% rally to sell equity into every quarter). Also, as Meredith Whitney pointed out yesterday to send markets surging, Goldman Sachs (GS) may be set for huge earnings, as lack of trading competition (Bear, Lehman, etc gone), issuance underwriting, and lack of government intervention in its operations (paid back TARP) lead to big revenues offsetting asset depreciation.

Though Goldman may be ready for a big quarter (and it definitely may not, an upgrade ahead of earnings isn’t usually the best signal; not to mention 35% of Whitney’s predicted move up already happened today), don’t expect every financial to follow suit, especially Bank of America (BAC), JP Morgan Chase (JPM), Wells Fargo (WFC), and Citigroup (C), who still have huge writedowns to face, trillions in off-balance sheet assets, big exposure to Option ARMs (which have finally started cracking), and a huge void in loss provisions after last quarter’s accounting shenanigans in bank earnings. Also, it is important to mention interest rates have risen dramatically since their December lows and very dramatically since April, as risk aversion gave way for risk appetite and equity and commodity inflows (S&P 500 40% rally anyone?).

Commodity prices have started their decline, with oil down more than 18% from its June highs. I expect a return to the $40-45/barrel zone. Meanwhile, rates have retraced some of their big ascent since the Fed’s attempt at quantitative easing in March, with the 30-year note down almost 50 basis points from June highs.

CIT Group (CIT) is on the verge of bankruptcy/bailout, which could dramatically affect small businesses in the United States, hundreds of which CIT was a major lender to. At this point, with the deficits we have and the lack of tax receipts anywhere on all levels (state of California is issuing IOUs for God’s sake), more bailouts and spending means higher and higher rates eventually.

This could really mess things up in the context of interest rate swaps. After General Motors (GM) went bankrupt, its interest rate swap exposure (it was on the floating-rate side, which is what allowed GMAC to offer such low financing) resulted in its counterparties being left long the bond. These counterparties (presumably Wall Street banks) are forced to hedge by selling the cash flow, which has led to dramatic aberrations in IR swap spreads since the GM bankruptcy.

But more importantly, the inane government printing and spending will raise rates as Uncle Sam’s credit reputation (and even rating) gets slashed and as inflationary expectations creep up. And with Goldman having 1048% TCE/RBC in IR swaps, you can bet an IR swap-catalyzed implosion as rates rise is imminent, similar to the CDS-catalyzed implosion in AIG as mortgage-backed securities depreciated. Zero Hedge has been at the forefront of the IR swap implosion discourse, suggesting a Goldman-tempted interest rate swap “Black Swan” is imminent. Goldman’s IR swap counterparties (who I’m guessing are long the bond, unless Goldman is dumb enough to be betting on falling interest rates?) are potentially great shorts in this context, as they could easily implode very quickly, similar to the last big derivative counterparty of Goldman’s– AIG. And with half of corporate debt being floating-rate and one-third of federal debt due within the next 12 months and needing to be rolled over, corporate America’s floating-rate exposure is dramatic and rising yields will suffocate those exposed.

But the full IR swap story is for another time. Be expecting a very detailed analysis on IR swaps and derivatives in general coming soon. Until then, back to the current market.

We have retraced to the head and shoulder pattern’s neckline and are bouncing off of it and the 200DMA. Now it’s time for the right shoulder to form. I’m expecting a move up to about 920 or so and then tank time. We will see. If Q2 bank earnings end up beating estimates as well (impartiality and open-mindedness, my friends– surely these BS banks are all toast in the long run, but how’s that Keynes quote about market irrationality and your brokerage account’s solvency go again?), then look for a move through the downtrend line I have drawn in from May 2008. But I find that quite unlikely. The market’s bull/bear battle between its 50DMA and 200DMA is very important here. Be watching for heavy volume around important moving averages. This is a significant point in the market right now.

Gold prices continue to kind of drift around. They’re been staying above $900/oz but a move above $1000/oz should really send gold in its next bullish stage. And it probably has quite the bullish move in store once that occurs.

It is clear to any logical, unbiased market observant that the economy has not turned around. Wells has a $115B option ARM portfolio from its Wachovia acquisition and is marking it at 81 cents on the dollar. Meanwhile, housing prices have plummeted over 50% since most of these loans were written and even still, they are experiencing negative amortization. JP Morgan has over $40B in option ARM exposure, nearly $90B if off-balance sheet vehicles are counted. GE has $450B+ of short-term debt to be rolled over, an $8B immediate payment required in the event of a GECC credit rating cut, a TA/TCE leverage ratio of over 200x, and an “other” asset category worth more than overall GE shareholders equity. Citi still has a TA/TCE of over 50x, $1.8T of assets (almost $3T if off-balance sheet SPVs are included), and $115B in short-term debt that needs to be rolled over by issuing more equity before the 1.7% decline in its assets needed to wipe out out the entirety of its TCE occurs.

Commercial real estate is a $3T problem for CMBS holders, but also banks and insurers, which hold the whole loans that contribute to over 70% of the problem. Mall vacancies over 10% and office vacancies over 15% aren’t helping. The Federal Reserve wrote down losses of almost 30% in commercial mortgages and almost 40% in residential mortgages in its Maiden Lane balance sheet, while Citi continues marking both residential and commercial loans and securities at 90-95+ cents to par. Citi has an enormous CRE book and a further 20-25% write-down on its CRE assets would easily drain all of its equity. All you need to do to see how deep Citi’s valuations are embedded in fantasyland is go check out some strip malls and office space uptown.

So real estate prices have been sliced in half from their peak and banks are still valuing their loans and securities at 85-90+ cents to par. But what about trading losses, like Boaz Weinstein’s for Deutsche Bank in 2008? Well, with the very peculiar recent convergence in asset performances, especially since March equity lows, there is definitely a crowded trade unwinding out there set to implode someone somewhere. Whether it’s through IR swap floating rate exposure or a basis trade in ETF products or just simply a stock decline in a market where participants are long an over 120x trailing P/E, something’s gotta give.

This market has eerily similar characteristics to other market tops. The MSCI Emerging Market Index is trading at 15x reported earnings, the highest since October 2007, the all-time top in the stock market. The confidence-market divergence (as measured by the Conference Board Situation and S&P 500 indices) has also retraced to October 2007 levels, at below a -2.4 sigma. Insider sales outpaced purchases by over 22x in June, reaching levels not seen since… you guessed it – October 2007… and even outpacing them. The point is, even if this isn’t the top, the current move up is unsustainable, as when it reverses, it will reverse hard and fast.

Rates need to be suppressed for any “green shoots” recovery and any asset reflation. That requires money coming into bonds, from somewhere. The Fed tried printing money to send into bonds, otherwise known as quantitative easing. This method “steals” money from taxpayers and holders of Treasuries and agency debt/securities and invests it into Treasury securities. However, rates have risen drastically since then, suggesting people reacted to this by selling Treasuries at a faster rate than Bernanke bought them using printed money. This is a highly bearish development.

Nothing operates in a vacuum. Quantitative easing cannot even function sustainably (or even in the first attempt, in Bernanke’s case), let alone work, because the demand offered by the Fed with printed money can be offset by supply offered by bond investors. And this is a positive feedback system and worsens over time. The only way to suppress rates further is for capital outflows from other assets of higher risk appetite. Back in September and November of 2008, stock market declines led to tons of equity investment to go into Treasuries. Since then, proprtionately less of these equity outflows during stock market declines have found their way to government bonds.

Where is this money going? Precious metals and commodities, as evidenced by gold near all-time highs and commodities outpacing equities and bonds since November. This is blatant inflationary expectation and quantitative easing only worsens that, save for a drastic worsening of economic outlook. And with more stock declines will come more equity outflows, but proportionately less into Treasuries and more into dollar hedges. Nothing short of an all-out stock and commodity market crash will suppress rates back to last year’s levels. And nothing short of large, drastic, volatile declines in stock and commodity markets will provide the organic investment into Treasuries necessary for any asset bubble reflation (the Bush and Obama administrations’ agendas).

With so much asset correlation right now and basically every market showing high positive beta to the S&P, a liquidity event is imminent. By now everyone knows about the whole quants ordeal and how market liquidity providers have gotten owned and had to deleverage heavily into this rally. So once supply is offered in volume to this market, look for a sharp spike in volatility. The 870-875 support level is the zone where, once broken, lots of big volume supply will enter the stock market. And with talk of China’s equity and Chinese demand-driven commodity markets getting bubbly, you can bet the technical catalysts for mini-Black Swans are aplenty.

Q2 and/or Q3 bank earnings should be terrible. It will be interesting to see how Q2 earnings are boosted by the insane issuance underwriting that occurred into this 40% unsustainable market rally and how well they offset asset writedowns and equity drain for maturing debt repayment. But after these Q1 AIG profits and the Q2 underwriting revenues allowed by the Q1 AIG profits and subsequent unsustainable market rally, Q3 could really hold in store the unwinding of this mini-bubble in banks and their earnings. We will see when and how it occurs. But unsustainability is the name of the game right now.

And lest we forget, the Federal Reserve’s balance sheet stands at $2.03T with a new high of $912B of currency in circulation, while the budget deficit expectation for Septmber 2009 exceeds $1.8T by the Obama administration itself. I have repeatedly said this but it warrants further mention– monetizing deficits this large requires a level of quantitative easing never before attempted by the United States and after the bond market’s response to Bernanke’s first attempt in March, a significant deflationary force is required for the Fed to be able to purchase enough Treasury securities for rate suppression without being offset by bond holders offering supply.

Low borrowing costs aren’t only needed for decreased foreclosure rates, padded housing prices, and nominal economic recovery. Much more importantly, they’re needed for the United States Treasury to roll over its debt, for US states (which do not have the power to print money) to roll over its debt (without issuing IOUs for tax returns, seriously, what the hell), and for the United States to escape a complete implosion and hyperinflationary (or Great Depression-like) disaster. This can only happen with a strongly deflationary force, like a bank failure and/or market crash. There will be another “crisis event,” I am sure of it, whether in the arena of insurers, banks, or subsidiary financial corps (e.g. GECC), something has to happen and the Fed will let it.

A true economic turnaround cannot occur without goods expansion backing monetary expansion. This requires real incomes to rise. This requires organic earnings, innovation, efficiency, capitalism. America’s carry-trade economy is unsustainable and is a blatant Ponzi scheme, borrowing short to invest long. This is evident on all levels of economy: federal government ($11T national debt and $60T unfunded liabilities), state governments (blatantly insolvent California issuing IOUs for tax returns), corporate America (repo market and FDIC/Fed liquidity programs vital to survival of some of America’s biggest names), and households (credit cards, second mortgages, house ATMs, car loans, etc). And with the average maturity of Treasury debt under 48 months, the gig is up. And the only way left for the government to prevent implosion is theft. Which it will do through the inflation tax and quantitative easing. Deleveraging on every level of society and a return to free markets is necessary for the ideal of sustainable economic growth to return.

I leave you with the S&P 500’s 2-year chart with important trendlines drawn in. The May and August 2008 highs connect to form a trendline that should be offering resistance right around where we are and indeed the June bull flag in stocks broke down near that trendline resistance. Watch for how the market react around this trendline resistance, its 200 DMA support, its 870-875 support, its 950 resistance and its 50DMA resistance.

Disclosure: Long GS, short BAC

Comments

[greedcanbgood:]

Your analysis is pretty good. Watch for the commercial banks to report good, even outstanding, Q2 earnings primarily due to mortgage volume. The bottom falls out in Q3 when mortgage volume has waned, the consumer "hunker-down" gets even more serious (e.g. consumer spending) and unemployment hits existing mortgages harder.

Jul 14 10:31 AM

[Naufal Sana...:]

Rising rates Q2 lead me to believe mortgage volume and decreased foreclosure rates may not have indeed prevented big losses in banks or allowed big revenues from new mortgages.

We will see.


On Jul 14 10:31 AM greedcanbgood wrote:

> Your analysis is pretty good. Watch for the commercial banks to
> report good, even outstanding, Q2 earnings primarily due to mortgage
> volume. The bottom falls out in Q3 when mortgage volume has waned,
> the consumer "hunker-down" gets even more serious (e.g. consumer
> spending) and unemployment hits existing mortgages harder.

Jul 14 11:19 AM

[conceptwizard:]

Great Job! So the exit plan for the FED is written on the wall.

You said:
"There will be another “crisis event,” I am sure of it, whether in the arena of insurers, banks, or subsidiary financial corps (e.g. GECC), something has to happen and the Fed will let it."

This will be the second drop in the markets to a new low when this happens. We are waiting for the next crises event to trigger the drop. Its just a matter of time and time is measured in short intervals in this atmosphere. This market is unsustainable.

Jul 14 11:21 AM

[TheFounder:]

Excellend analysis and clear thinking. Almost all arrows pointing in the same direction. I am not convinced that this rally is over and we are heading down to re test the March lows.

Jul 14 06:08 PM

[KIT:]

At about 6500 DJA Insurance companies have to convert to cash to cover policies ( law ) the govt is not required to bail them out so they will have to sell their holdings. No suprise plunge prevention kicked in just as we hit this level in March.


On Jul 14 06:08 PM TheFounder wrote:

> Excellend analysis and clear thinking. Almost all arrows pointing
> in the same direction. I am not convinced that this rally is over
> and we are heading down to re test the March lows.

Jul 15 12:23 AM

[Barking:]

Naufal,
Great work....I have a pretty substanial position in the gold/silver miners ...do you think that when we see this next leg down they will follow the general market lower ...or will they decouple and gain as investors seek the safety of gold/silver ??

Jul 15 09:41 AM

[Trent Hauck:]

I would have to agree that the economy is still facing a lot of problems - I however tend to think that we're more likely to tread water for a while. Earnings so far haven't been great, but certainly haven't been bad and I think the consumer is starting to get it back in the game. Also I would have to disagree on gold too, I feel that until the economy shows signs of recovery causing inflation to kick in (and it'll kick hard) gold will be range bound.

But overall great article - its nice to see stuff us Gen-Yers start to make some moves.

Jul 15 12:49 PM

[irrational ...:]

You are underestimating the big financial institutions ability to cook their books. The recent earnings reports prove that.
And talking about cooking the books, the Treasury, GAO and other government entities will continue to do that to cover up the true state of the U.S. government and the economy.
Monetizing inflation and the deficits will cause the Fed to shoot itself in the leg. If they want - and they do - to continue with the QE, they can't bring down rates, with massive purchases of T-notes. The Fed can't inflate its balance sheet enough to fight the bond market. They tried, it worked for a while, and then rates shot up again.

Something has got to give, and when that happens, the recent stock market crash will be a child's play compared to the bond market crash.
China and Russia publicly stated that the reckoning day is close. When that day comes, the dollar will be virtually worthless and gold will be the de-facto tender vehicle.

Jul 18 06:21 PM

[Brent Forsland:]

I think your confused. If CIT goes belly up the small business you refer to would be effected if they were lenders to CIT. CIT lending to them would not adversely effect them as you would lead us to believe.

Jul 22 10:59 AM

[Naufal Sana...:]

Small businesses that rely on short-term financing from CIT would go bankrupt. I have no idea what you are talking about.

Jul 23 02:55 AM