Saturday, July 24, 2010

The Debts of the Spenders: The Dodd-Frank Wall Street Reform and Consumer Protection Act (“WSRCPA”)

Just a quick overview of the recent US financial reform laws. The changes are sweeping and this is not meant in any way to be comprehensive. Updates will be posted as changes are made.

The law is formally known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (“WSRCPA”). Readers interested in the Too Big To Fail aspect should focus on Title 2 (see below).

The Banking Lobbyists' perspective:

For a timeline of when the rules will be effective:

The other ABA (American Bar Association - which is not to be confused with the American Bankers Association) also has its own views and is having several upcoming programs:

One of the biggest changes is the introduction of the OLA, or Orderly Liquidation Authority, which REPLACES Bankruptcy Court under the auspices of the FDIC (the OLA is part of the FDIC) under Title 2. The OLA will be responsible for probating the "living wills" of too big to fail institutions. All legal challenges will fall under the APA (Administrative Procedure Act) which governs nearly all federal agencies - (you can be sure there will be plenty of legal challenges being filed in the coming months).

Also, many of the aspects covered in the Cadwalader (a major white shoe law firm) legal memo made it to the final law.

Saturday, July 17, 2010

The Debts of the Lenders: How Much Further Can the Yen Rally?

The Yen has been on a wild tear in recent days, notching impressive gains against the dollar on safe haven flows. Additionally new laws on Japanese leverage limits are imposing margin calls on speculators.

The introduction of leverage caps on foreign exchange margin trading in Japan in the coming month is likely to place pressure on the Australian dollar/yen cross rate, according to research by the Royal Bank of Canada.

The Japanese regulator will impose a cap of 50 times leverage on collateral for margin trading at the start of August to curb currency speculation by retail investors. The cap will be further lowered to 25 times from August 2011.

So, where does support and resistance lie? There is still further room for a rally. Up to 85 or 118 on the corresponding $XJY index which closely matches the CME and Globex price quotes. This represents the currency's 14 year low which was reached late last year.

At these levels, it is likely that the BOJ will take steps to intervene. The bank has already released official statements that they are watching the situation closely.

July 15 (Reuters) - Bank of Japan Governor Masaaki Shirakawa said on Thursday he was continuing to watch currency and stock price moves carefully.

"Yen rises hurt exports short-term while stock price falls have a negative impact on capex and consumer spending," Shirakawa told a news conference.

"While the yen's rise and stock price falls may affect Japan's economy I expect it to remain on a recovery trend."


Tuesday, July 13, 2010

The Debts of the Spenders: Chinese Rating Agency Downgrades USA

Along came a Beijing-based rating agency--Dagong International Credit Rating Co. Its first order of business is to downgrade sovereign debt ratings on some major Western nations, while slamming its Western counterparts.
"The reason for the global financial crisis and debt crisis in Europe is that the current international credit rating system does not correctly reveal the debtor's repayment ability."
Dubbed as the world’s first “non-Western” sovereign credit rating agency, in its debut international report, Dagone (means Big Justice in Chinese) downshifted the US to AA with a negative outlook, while UK and France were given AA-; Belgium, Spain, Italy with A-.

Wednesday, July 7, 2010

Correction on Prior Post

*Credit: Tjemme

I confused yield chasing with the effects of inverted yield curves.

The economics textbook explanation was a bit dry so I went and looked at a multi-year chart of the 30 year bond instead. If you go back to the early 1980s, the 30 year yield was hovering around 10% and hit a high of 15% in September 1981. Then it went progressively lower past 1984.

So, those investors who bought at double digit yields reasoned that rates were going even lower in the future. They bet that was their last chance to lock in rates before the bottom fell out. Past 1984, they turned out to be right.

So far, the current scenario does not look like a repeat of the early 1980s. Right now, the Fed is intent on keeping low rates for a while longer instead of tightening. This is not the correct environment for an inverted yield curve.

The 'move up the curve' does not put upward pressure on short-term rates. Chasing yield only in this way only works when long-term yields are higher. Chasing yield effect works by slowing pushing down the yieldcurve starting from the beginning. Inversion contradicts chasing yield.

The Debts of the Spenders: The Dangers of an Inverted US Yield Curve

Economists and traders believe that inverted yield curves are a sign of impending recession. It is possible but rare for the longer end to have lower yield than the front end of the curve. Potential causes include direct US Federal Reserve intervention, Chinese and Japanese sovereign buying, and finally yield chasing by funds. It is this last point that I want to bring my attention towards.

In theory, lower yields are supposed to push businesses towards renewed economic activity by lowering their borrowing costs. The private sector is then able to finance expenses like plant and equipment, back office updates, and labor costs more cheaply than if rates were higher.

Unfortunately, reality is a different story. Generally, the US business sector remains leery of renewed spending and has instead slashed costs to the bone by enacting their own fiscal austerity measures - firing unnecessary workers, gutting expense accounts, and deliberately slowing payment to creditors while pushing for timelier payments towards their own customers. This is a normal reaction to a recession.

Instead of pushing business borrowing up, the current easy monetary stance is pushing speculators to borrow money at lower short-term interest rates and invest it in higher return assets - either in equities (which is Bill Gross' latest argument) or higher yielding debt (such as private sector high yield, emerging market bonds, or Greek government debt). However, because the buying mandates of many institutional funds require managers to buy investment grade only, they will inevitably turn towards longer dated US government debt. This effectively puts upward pressure on short-term rates and downward pressure on long-term rates.

The end results will not be pretty when rates do rise. Whoever bought all this high yield debt will lose a lot of money . . . even comparatively speaking if they were to hold until maturity.

My final cause of concern is that Bernanke himself believes that inverted yield curves are nothing to worry about. Bernanke has been wrong about a lot of things so whenever he's championing a particular idea I tend to be suspicious about it. When Bernanke made this speech it was in 2006 - then the height of the credit bubble. Well, we both know what happened in the 4 years since then.

The Debts of the Spenders: European Stress Tests A Joke But Fiscal Austerity Measures Are Working

Apparently, EU ministers believe that CDS traders and European bond desks are stupid. Their stress tests do not account for any sort of default scenario. This is ironic considering how a potential Greek default has led to a freeze on interbank lending among the PIIGS. Besides the more obvious triggers of outright bankruptcy and delays, please also note that the legal language of most CDS contracts states that a debt restructuring CAN lead to a default. Such catalysts are referred to dryly by lawyers as "credit events" and WILL drive the CDS spreads wider.

Of course, when the market tries to act efficiently traders will somehow be blamed for lower prices and higher yields.

FRANKFURT (MNI) – Planned stress tests for European banks will cover their resistance to a crisis in the market for European sovereign debt, but not the scenario of a default of a Eurozone state since the EU would not allow such an occurrence, a German newspaper reported Wednesday.

But not everything is bad in Europe - for one thing, the British, Greeks, and Germans seem able to pass an austerity budget - a fact that forex markets have noted with optimism by driving up the value of the GBP and Euro in recent days. If only the US could learn that lesson. Unfortunately, our politicians' bad behavior is being subsidized by the Chinese, who continue to buy treasuries blindly.

While default risk remains virtually non-existent at the federal level, the same cannot be said of state and local finances. The US muni market which consists of state and municipal finance is facing severe funding problems.

"Commercial lenders added more than $84 billion to their holdings since 2003, according to the Federal Reserve, pushing total investments to $216.2 billion at the end of the first quarter. Bank regulators and ratings companies are ramping up scrutiny of banks most at risk of being forced to raise more capital should debt prices slide.

“There is a huge untold problem here,” said Walter J. Mix III, a former commissioner of the California Department of Financial Institutions who closed 30 banks during the last banking crisis in the 1990s. “The economics lead to the conclusion that there will be downward pressure on these bonds.”

Default speculation and a move by investors to the safest securities drove municipal bond yields to a 13-month high relative to U.S. Treasuries in the first half of the year. Now, the Federal Deposit Insurance Corp. has asked analysts to look into the issue, according to spokeswoman Michele Heller.

U.S. states are likely to face $140 billion in cumulative budget gaps in the coming year, according to the Center on Budget and Policy Priorities. Last year, 187 tax-exempt issuers defaulted on $6.4 billion of securities, the most since 1992, according to data from Distressed Debt Securities in Miami Lakes, Florida.

“It’s a market where it’s clear that the underlying fundamentals are lousy,” said Michael Aronstein, chief investment strategist at Oscar Gruss & Son Inc., a New York- based brokerage. “People can say fundamentals don’t matter but I’ve been doing this for 32 years. They do.”