Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 30 October 2012

UBS Sobers Up

After several years of drunkenly handing out guarantees to build Humpty Dumpty after the fall of 2008, UBS has sobered up. Its strategy is now to be a staid wealth manager and corporate bank rather than a global markets high roller. According to the FT 10,000 jobs, in addition to 3,500 announced last year, are set to go. 

The first thought of those still drinking from the punchbowl is that this might be the contrarian signal which marks the bottom and high rolling days are just around the corner. Recent Q3 results do seem to encourage the belief that we are slowly but steadily marching towards the good old days. Capital market revenues for the top 5 US banks rose 13% over Q2 and 40% compared to Q3 last year.

Unfortunately, the comparison with Q3 in 2011 is flattered by the fact that it was when the European sovereign crisis had flared up. Thus the comparative increase of 40% is more a bounce from the abyss than a soaring flight to the sky. The chart below from the Economist shows clearly the bleak picture that the industry is facing.

Graph 1: Deterioration in investment banking revenues
Source: Economist

Further, one quarter does not a trend make. Revenues are well below the peak and in decline as Graph 2 shows.

Graph 2: Trailing 12-month Revenues at 15 Investment Banks

Banks included: BAML, Barclays, BNP, Citi, CS, DB, GS, HSBC, JPM, Lazard, MS, Nomura, RBS, SocGen, UBS

The decline in investment banking revenue is not surprising given the economic and regulatory environment. Elevated uncertainty in both areas has reduced trading and transaction volume directly impacting revenue. More stringent capital requirements and greater risk averseness has led to a decline in trading book inventory, especially in credit, leading to reduced accrual income. This has been further compounded by the low rates environment. Finally, erstwhile profitable business areas such as structured credit and part of structured rates have either not recovered or have been shuttered to preserve capital.

These are structural not cyclical changes. The economic environment may improve as the cycle gradually comes to an end but the regulatory environment is here to stay. A study by McKinsey last year found that regulation could lead to RoE at major investment banks dropping from a pre-regulation era average of 20% to only 7% (Graph 3). Even this looks optimistic as the 20% RoE starting point is the holy grail which banks aspire to but have never found after the crisis (Graph 4). As more regulations come into force the pressure on RoE will only intensify. 

Graph 3: Impact on RoE

Source: McKinsey & Co.

Graph 4: RoE at major banks

Source: Reuters, *ycharts.com & GS earnings release

Helpfully, McKinsey state that mitigation by banks can increase RoE from the predicted 7% to 11-12%. Mitigation involves the usual cocktail of reduced headcount, increased automation and balance sheet and risk model “optimisation”. (The latter harks back to the good old days, see Morgan Stanley’s latest effort to get an idea). However, 11-12% is barely higher than cost of equity which is around 10-11% for banks. Moreover, it is substantially lower than the RoE target at all banks. For example, despite a revision lower, Deutsche Bank and Credit Suisse are still targeting a 15% RoE. Incidentally, after the cuts UBS is also targeting an RoE of at least 15% from 2015 onwards.

These RoE targets can only be achieved in either one of three ways. First is the UBS way of vigourous cost-cutting and shuttering of businesses which earn sub-par RoE. The impact of regulations on business areas, as calculated by McKinsey, is shown in Graph 5. It makes UBS’s strategy of staying in FX and Equities but exiting everything else crystal clear.

Graph 5: RoE impact per business line

Source: McKinsey & Co.

The second way is to bias the balance sheet towards high yielding assets. This is extremely difficult in the current ZIRP and QE environment with flat yield curves and "safe" sovereign long-rates under 3%. Higher yield can only come at the cost of higher credit and liquidity risk which reduces its appeal. It also attracts higher capital charges dampening its appeal further. Moreover, funding costs have not fallen as much as gross yields leading to a margin squeeze. 

The third way is through the oldest trick in the book; leverage. Pre-crisis, leverage ratios of many banks had reached above 40:1 (meaning that a 2.5% decline in asset value would have resulted in bankruptcy). Although Basel-3 has clamped down on such egregious behaviour by restricting leverage to 33:1, banks do not need to conform until 2018. Levering up nonetheless and letting the next guy handle it would be in the spirit of the go-go years but unfortunately neither regulators nor investors will stand for it.

Therefore, it does seem as if UBS-type swingeing cuts are the only way to meet RoE targets. Sobering news indeed for the several hundred thousand employed in the great game.

Wednesday, 24 October 2012

Schauble Says Sell

After reading the headline my first thought was ‘Contrarian indicator’. But looking at the news, it seems that Schauble may be right. The worst is yet to come. Consider the following:

1. It is now confirmed that the banking union will be stillborn.

According to the Handelsblatt, bank resolution schemes will remain national with no obligation for one nation to give funds for resolving another nation’s banking failures. This is equivalent to each state in the USA having an independent version of FDIC with no obligation to pool funds and fight a crisis together. What are the chances of Texas giving money to California?
Of course, the divide over regulatory decision-making power for non-Euro EU states still continues. Offers are being made in which ECB governing council (Eurozone states only) will “explain itself” if it overrules the regulatory body (composed of both Euro and non-Euro states). It will be interesting to see how many agree to surrender actual power in the hope that their decisions will be respected. 

2. While the hopium is wearing off the European Parliament (EP) and the European Commission (EC) think the current year is 2006. Or that austerity begins in someone else’s home.

EC’s demand for €9bn more for 2012 budget commitments has been agreed by EP. MEP’s also called for a 6.8% rise in the budget for 2013. This will really increase support for the EU and reverse the erosion of enthusiasm amongst citizens shown by opinion polls.

3. Meanwhile, states which do not have the luxury of asking for a budget increase are nevertheless adamant that spending should not be drastically curtailed.

Greek leaders have failed to agree to Troika mandated cuts to public sector pay. 

4. Amidst the political squabbling, the economy is now firmly heading down.

Today’s PMI numbers showed “the combined output of themanufacturing and service sectors dropping at the fastest rate since June2009”. IFO numbers from Germany were pretty dire as well with business climate, current conditions and expectations all dropping and worse than expected.

Despite all this, Schauble’s statement at least shows that key decisionmakers are cognizant of the dangers which lie ahead. But this isn’t a contrary indicator marking a 2009-US-style turnaround for Europe. Then bodies were on the road, blood on the streets and a comprehensive plan enacted for bank recaps, easy money and fiscal boost. None of these conditions are true yet for Europe.

Sunday, 21 October 2012

Punchbowl Hopium Levels Running Low

Maybe the markets commemorated 25 years of Black Monday this Friday. But a saner and more rational explanation would be that the hopium is wearing off (again).

Forming conclusions based on one day’s price move is foolhardy especially given the conflicting data (see my earlier piece). However, the S&P500 has failed to make new highs since 14th September, the day after BernanQE injection. Moreover, at 1433 it is now lower than the 1436 close on 12th September. So much for the wealth effect. 

The market’s extreme pessimism in early summer was alleviated by three main factors. First was Draghi’s threat to monetise via OMT. Second was the reappearance of the illusion of European unity and resolve to combat the crisis. And third was BernanQE’s promise to push on a string with greater force. Unfortunately, with all the good news out of the way there are not many positive surprises left.

Draghi’s OMT, though untested, is still respected enough for peripheral yields to be supported. However, it is an unstable equilibrium not least because the exact details are still not known. The degree to which the ECB will intervene, the duration for which it will intervene and the conditionality involved are all unknown. Moreover, it is not certain whether it will hold its promise of accepting pari passu treatment on its bond holdings. This is because of its argument in the Greek case that any writeoffs will be tantamount to monetary financing (which is illegal). The assumption of ECB holdings being pari passu rests on the ECB being able to sell the holdings to ESM/other entities which then take a haircut, helpfully absolving it of blame. However, this requires elected governments to accept and then explain losses to their taxpayers. Not exactly a vote winning strategy (and the reason behind OSI not being seriously considered for Greece).

In addition, the coat of paint on the façade of European unity is peeling off revealing the ugly cracks in the foundation. Divisions between France and Germany have come to the fore in the latest summit. Germany along with Holland and Finland has backtracked on ESM funded bank bailouts for Ireland and Spain. And even the grand bargain over bank supervision has run into trouble. The post-summit communiqué was short on detail and long on the usual fudges. The gist is perfectly encapsulated in the introductory statement: “It [European Council] looked forward to a specific and time-bound roadmap to be presented at its December 2012 meeting, so that it can move ahead on all essential building blocks on which a genuine EMU should be based”. Translation: See you in December, meanwhile keep buying.

Finally, even though monetary policy has been impotent for a while, the anticipation of ‘BernanQE put’ has ensured uglies keep winning the beauty contest. But QE3's weekly buying quota has taken out the anticipation and future positive surprises. While the US economy is resilient and recovering, external shocks (from Europe and China) and falling off the fiscal cliff can yet make for a double-dip recession. And this time there may be little hopium to add to the punchbowl.

Therefore it may be wise to cash in some chips heading into the liquidity constrained final two months of the year. 

Tuesday, 16 October 2012

The Maginot Line of Sovereign CDS Ban

On 1st of November, the EU ban on buying sovereign CDS will come into effect. This long march against ‘evil speculators’ began with the BaFin ban on ‘naked’ sovereign CDS in May 2010. Wiser council prevailed for a while but could not stop the European parliament tilting at windmills. Therefore about a year ago, the ban was agreed. At that time, there were significant loopholes in the proposals which would have made the ban fairly ineffectual. However, these have since been tightened. For example, earlier any correlated position could be used as justification for buying sovereign CDS. Now buyers have to demonstrate “justifiable” correlation and the position has to be in the country on which sovereign CDS is bought.

Whether the ban will help fund Greece, Portugal, Italy, Spain and at some point France is debatable. The history of short-selling bans provides scarce comfort. But this is more about the political message than anything else. The only problem is that most ‘evil speculators’ have long moved on from CDS. The uncertainty and official vilification which began with the BaFin ban led people to other products to express their views. The subsequent Greek drama did nothing to dispel the dangers of CDS. Moreover with Draghi announcing OMT (the monetisation that dare not speak its name) the probability of a default which triggers CDS dropped sharply. In any case, sovereign CDS only acts as a hedge when the situation becomes distressed but not irreparably damaged. This is because official backlash in the event of collapse will ensure that CDS holders are left holding worthless contracts. 

Interestingly this behaviour is reflected in sovereign CDS market positioning. The net notional, i.e. effective economic interest, on sovereign CDS increased from the beginning of 2010 when Greece slid into crisis. But as the crisis started to spiral out of control by mid-2011 and official scrutiny and talk of banning CDS became more intense, the net notional started to decline. It cratered this September ahead of the November ban and has reached levels which prevailed at the start of 2010 (Graph 1).

Graph 1

Source: DTCC
Ultimately the EU has created a pointless Maginot line to defend against market attacks. The danger is not that high CDS spreads or bond yields will create panic and lead to investor flight since this has already happened. And it has led to increasing fragmentation of financial markets along national lines. This is one of the reasons why ECB is losing control of rates across the Eurozone. If fundamentals don’t recover the optimism created this summer is going to ebb away exposing the EU to further attacks. These would be via capital flight where non-domestic and even some domestic investors withdraw from equity and debt markets. In addition these attacks would be more severe since foreign investors who have been lured back by the OMT are not long-term holders. Prices have moved higher on low trading volume, thus exaggerated price reversals can still take place with or without a ban. Draghi’s OMT gambit is to prevent rather than defend an attack. The OMT will take pressure off CDS and bond yields but at the risk of leaving the Euro exposed. If the ECB is outflanked on the Euro then its defence of Euro-denominated assets is going to prove futile. The Asian crisis showed this in 1997. However it will give European politicians another opportunity to meddle with a heavy hand. Capital controls are the nuclear option.

Monday, 15 October 2012

I feel beary bullish

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us…” In short, Dickens could have been writing about the current market.

We seem to be caught in a Hegelian bind where every positive is counterbalanced with a negative. Take the US first. Economic data has been broadly positive recently including the critical employment numbers. However, the fiscal cliff is looming which has the potential to deliver a nasty negative shock. Bernanke’s QE is providing a psychological uplift but with the monetary transmission mechanism broken it has little real impact (apart from distributional consequences). Stocks are holding on but earnings estimates are being revised down. So is there going to be a recovery or a double-dip?

In Europe the optimism of ESM’s safe passage through the Constitutional Court and Draghi’s bluster still remains. Everyone’s making the right noises, visiting the right countries and awarding the right prizes. But behind the scenes the schisms are not healing. Eurozone is undertaking austerity and has adopted the fiscal pact but now the doctor (IMF) says that austerity is counterproductive. The ESM is in place. But no agreement has been reached on it recapitalising banks. To the shock of recipients northern Europeans want sovereign guarantees on bank recaps and no retroactive bank recaps. There is going to be a banking supervisor. But no agreement has been reached on banking supervision. Draghi’s OMT is the ultimate weapon. But it is so controversial that neither the bailer-in-chief (Germany) nor the bailoutee (Spain) want it activated. So rumours about imminent requests for rescue have to keep hopes and markets up. Meanwhile, Greece is unable to meet bailout conditionality potentially leading to the next aid payment being withheld. But a fudge will allow disbursement of the next tranche. However, the ECB will not take losses on its bond holding (but it will have pari passu status in future). There is a funding gap but there will be no OSI or additional bailout funds. There is nothing to worry about though as the German finance minister has assured that Greece will remain in the Eurozone. On the other hand the Swedish finance minister thinks that it may leave in the next six months. 

It is enough to make a grown investor cry.

The rest of the world is in the same state. One day Chinese data beats expectations signalling a soft landing; another day it disappoints. But disappointment raises hopes of a massive stimulus. However, pundits opine that another massive stimulus isn’t going to happen and the government’s actions thus far have not contradicted this opinion. At least the emerging world has scope to cut rates to boost growth. But the developed world’s monetary easing has tied their hands with inflation. 

No wonder this is the period for fence sitting and flip-flopping. The essence of capitalism, the market, has become egalitarian. It supports both bulls and bears and it supports neither. Turning the old saying on its head, currently the pigs are making money (at least looking at hog price inflation in China).

Tuesday, 9 October 2012

Money Illusion in London Housing Market

It is a truth universally acknowledged that London property is a sure bet. The fact that property prices are at back at the peak is testament to the inherent strength of the market. Unfortunately neither of the two “facts” is correct. I've talked about why it isn't a sure bet earlier. Let’s deconstruct the myth of prices reverting to peak.

The London House Price index (Graph 1) certainly seems to indicate that the pre-crash peak has been surpassed.

Graph 1: London House Price Index

Source: www.landregistry.com, Author

However, the index is based on nominal prices. What matters to both house buyers and investors is real return. After all if you wish to fund your child’s education or your old age care costs through selling/mortgaging what is usually the biggest asset on your household balance-sheet then you need house prices to at least keep up with inflation. No point celebrating a doubling of house price if a cup of coffee triples in price. The London housing picture is no longer so ebullient if you look at the real house price index (deflated using UK RPI – Graph 2).

Graph 2: London House Price Index – Nominal vs Real

Real house prices are 8% higher than the post-crisis low but still 11% below the peak. Worse, they seem to have hardly budged over the last decade.

For non-UK based investors or those for whom London property is only a small portion of their global portfolio holdings, UK-inflation does not matter as much as the exchange rate. A large part of foreign buying of London property is based on the ‘flight to safety’ thesis. Whether capital flees economic turmoil (Europe) or possible expropriation (oligarchs/politicians from across the world), the assumption is that money in London property is safe and can be taken out whenever the need arises. This assumption is falsified if property prices increase but the Sterling plummets. Therefore one way to look at how global investors have done is to translate the HPI into dollar terms (Graph 3). Foreign investors are still 21% away from the peak even as European turmoil and Chinese capital flight have strengthened the Sterling and raised prices 36% above the post-crisis trough. In addition, real returns (based on an inflation rate appropriate to the foreign investor) are going to be lower.

Graph 3: London House Price Index – Nominal, Real, US$-denominated

Source: www.landregistry.com, http://www.ons.gsi.gov.uk, www.oanda.com, Author

It is not just money illusion which is responsible for the prevalence of the belief that London property is back at the peak. Selection bias is also responsible for influencing the post-crisis recovery story. The data presented to the general public is designed to capture attention rather than to aid analysis. The nominal HPI for London is often quoted. However, the aggregate house price index hides the radically different performance of various London areas. Newspaper stories of pricy mansions and foreign investors stampeding to London also sway perception towards the view that London property has made back all losses and more. Data show that house prices are at a peak in only 12 out of 32 London boroughs. And these are nominal peaks. Only 2 boroughs are at real HPI peaks and only 1 from the perspective of Dollar investors (Figure 1). The numbers would be marginally higher at 3 and 2 respectively were it not for a small decline in the HPI for Chelsea and Kensington in August.

Figure 1: London Boroughs at Peak HPI

Source: www.landregistry.com, Author

Effectively three boroughs - City of Westminster, Hammersmith and Fulham and Royal Borough of Chelsea and Kensington - are skewing the London housing market. This is apparent from tables 1&2 below which show how the best, worst and median boroughs performed over the last decade and since the crisis.

Table 1: Return over the last decade – Jan 2003 – August 2012
Return (annual)
In US$ (nominal)
Royal Borough of Chelsea and Kensington

Top-3 average
City of Westminster, Hammersmith and Fulham, Royal Borough of Chelsea and Kensington
Bottom-3 average
Barking and Dagenham, Croydon, Sutton
Source: Author, www.landregistry.com

Table 2: Post-crisis return – Jan 2009 – August 2012
Return (annual)
In US$ (nominal)
Royal Borough of Chelsea and Kensington
Barking and Dagenham

Top-3 average
City of Westminster, Hammersmith and Fulham, Royal Borough of Chelsea and Kensington
Bottom-3 average
Barking and Dagenham, Bexley, Croydon
Source: Author, www.landregistry.com

Foreign buyers focusing on a narrow-end of the market (Figure 2) have caused a widespread misperception that London property is back at the peak.

Figure 2: Demand for London Property

The theory of peak price is not true even on a nominal basis in most boroughs. On a real basis, only Camden apart from the three cited above are anywhere near the peak. Excluding these four, on average real prices are 15% below the peak (13% below including the four).

So the next time someone says that London property is back at the peak, do disabuse them of their money illusion.

Thursday, 4 October 2012

The sorry state of the CDS market

The days when every banking graduate wanted to be on the credit trading or structuring desk are long over. From being feted as sophisticated tools which dispersed risk and contributed to “enhanced resilience” of banks, CDS became the chief culprit behind the financial crash. AIG’s mindless use of CDS not only sealed its fate but also crystallised public perception of CDS which continues to this day. CDS are now the evil speculator’s weapon of mass destruction.   

This perception problem coupled with the collapse of the structured credit machine has largely contributed to the CDS market declining to new low (as measured by gross notional outstanding). As Graph 1 shows, gross notional outstanding is the smallest it has ever been since the end of 2005.

Graph 1

Source: ISDA, DTCC

Of course, it can be argued that gross notional is misleading due to the post-crisis trend towards trade compression and central clearing (see box).

Assume 3 banks (A, B, C) and 1 hedge fund (H) trading CDS on Company X.
H buys $10m notional of CDS from A and A then buys from B who buys from C.
Gross notional = $30m = $10m(H&A trade) + $10m(A&B trade) + $10m(B&C trade)
Net notional = $10m (On a net basis, H has bought and C has sold. A & B are neutral)
What trade compression does is cancel out the 2 trades: A & B and B & C leaving H facing C directly on the CDS.
Similarly central clearing will automatically cancel out the 2 trades as all trades are made with the central clearer so A & B’s buying and selling to the clearer will cancel out.
Therefore compression and central clearing can lead to gross notionals falling even though the market has not shrunk.

However, DTCC data on the top 1,000 traded entities shows that net notional has been falling since the crisis even as gross notional fluctuates. In October 2008, the earliest data is available on DTCC, net notional was 10% of gross notional. The most recent data on 14-September-2012 shows that net notional shrunk to 7.5% of gross (Graph 2). This implies that the fall in net notional, and hence the market, has been even more severe than Graph 1 shows.

Graph 2

Source: DTCC

As the market has shrunk there has been a consequent decline in liquidity. Although quite apparent to traders, it can also be gauged from the maturity profile of outstanding CDS (Graph 3). In fact, the maturity profile is quite interesting. It indicates how trading has moved almost exclusively to the 5-year contract while both 5 and 10-year contracts were traded earlier. 

Graph 3

Source: DTCC

The 2008 maturity profile (yellow, red) shows two humps at 2012-13 (the then 5-year contract) and 2017-18 (the then 10 year contract). Post crisis recovery did not lead to a revival in 10-year trading. This can be plainly seen from the June 2010 profile (purple, brown). The 2017-18 outstanding contracts and notional remained almost the same as 2008 and the 2015 (then 5-year) increased. Now the hump in contracts has shifted to 2016-17 (corresponding to 5-year in 2011 and now) with notional and contracts in earlier maturities being fairly constant from June 2010. This is consistent with the fact that barring a few ‘whales’, everyone else is primarily trading the on-the-run 5-year contract. And there are fewer trades going through. The outstanding 5-year contracts in 2010 were lower than 2008 (compare 2013 vs 2015). And lower still in 2012 (were it not for the legacy 10-year deals, both notional and contracts in 2017 would be lower than 2015). 

So what does it all mean? Reports on the death of CDS may be exaggerated but the market is definitely caught in a downward spiral. The good news is that financial products once created seldom die. CDS do play a role in risk mitigation and distribution as long as institutions do not attempt to emulate AIG. Although much has been made of the fact that CDS is primarily traded between dealers but this is to be expected since institutions which run the largest credit risk (apart from the ECB) are banks. The bad news is that regulation, collateral requirements (due to central counterparties and more stringent CSAs) and capital charges are going to limit CDS use on bank trading books. Moreover, the whale’s demise is also going to curtail their popularity as hedges for unrelated risks (one hopes this to be the case but the primary purpose of hedging is regulatory gaming not reducing risk so a whale here and there may be ignored as a tempest in a teapot).

After an exponential rise, a logarithmic decay seems to be in store for these vilified financial weapons of mass destruction. For the incoming batch of banking graduates, they are this decade’s equivalent to ‘equities in Dallas’. Politicians would do well to choose another scapegoat quickly in case a crisis flares up again.