Loan Losses and Rumors

We want to briefly comment on recent news about a rise in loan loss provisions at US banks and rumors that have lately made waves in this context.

 

iceberg, ClevengerThe iceberg – an excellent simile for what we know and what we don’t know… or rather, what we don’t know just yet.

Image credit: Ralph A. Clevenger

 

First though, here is a look at the Philadelphia Bank Index (BKX) as well as its ratio to the S&P 500:

 

1-BKXInvestors seem increasingly worried about the banking sector’s prospects – click to enlarge.

 

Contrary to widespread expectations, market interest rates on treasury debt have actually declined since the Fed’s rate hike, and the yield curve’s trend toward flattening (which has resumed in the summer of 2015) has yet to significantly reverse. In short, investors may inter alia well be fretting about the fact that an expected improvement in interest margins has as of yet failed to occur (in fact, bank stocks peaked concurrently with the yield curve reaching its widest point of the year in 2015).

 

2-ten-minus-two-year yield10 minus 2 year treasury yield: while the curve widened from February to July 2015, bank stocks rallied and exhibited relative strength. They peaked right around the time when the yield curve reached its widest point of the year – click to enlarge.

 

However, there is more to it than that. In mid December, on the heels of a secondary peak in the BKX after which the the bulk of the recent leg of the decline occurred, there were two days that saw unusually large trading volume in the stock of a regional bank in Oklahoma, BOK Financial. We suspect that well-informed investors decided to get out while the getting was still reasonably good. As reported by Zerohedge, the bank announced in January that it had to book an unexpectedly large credit loss from loans to just a single energy producer. Although the amount was relatively small from a big picture perspective, the decline in bank stocks promptly accelerated.

 

3-BOKFUnusual trading activity in BOKF shortly after the resumption of the decline in bank stocks, followed by the announcement of energy-related loan losses – click to enlarge.

 

Since then several more banks, including the biggest ones, have stated that they will have to increase loan loss provisions for energy-related loans. ZH reported over the weekend that the Dallas Fed has reportedly advised banks not to “mark energy-related loan losses to market” and to try their best to work out problem loans in the sector without forcing borrowers into bankruptcy (i.e., they are to employ extend and pretend tactics, presumably in the hope that oil prices will recover sooner rather than later). As Mish points out though, given that mark-to-market accounting has essentially been repealed in early 2009 already, the former advice seems superfluous.

We also cannot judge off the cuff whether it is is possible that the potential losses might already be so large as to imperil bank capital adequacy, but this strikes us as unlikely for the time being, at least for the largest banks. It could well be true for a number of small to mid-sized banks though. That banks may have been urged to go easy on struggling energy producers certainly does sound credible.

In principle the banking system should be more insulated against the kind of problems it experienced in 2008, as massive excess reserves have reduced the dependence of banks on interbank markets and have greatly lowered the probability that big withdrawals by depositors will cause trouble (as compared to the pre-crisis era, a far larger proportion of extant deposit money consists of covered money substitutes these days).

Readers may want to review a few of our previous articles on corporate debt. Most recently we have focused on the fact that it would be a mistake to blithely assume that credit stress in the commodities sector will remain “contained” (see “Junk Bonds Under Pressure” from mid November and “Getting Run Over on 3rd Avenue” from mid December). However, more important may be the background information we discussed in a 2014 article entitled “A Dangerous Boom in Unsound Corporate Debt” (with hindsight it has turned out the the junk bond market had peaked out just a few days earlier).

The article sheds some light on the huge expansion in low grade corporate debt up to that point in time. More and more credit has been granted to increasingly less creditworthy borrowers, combined with covenants offering less and less protection to creditors. This suggests that bond investors rather than banks will actually suffer the greatest damage – not least as new regulations have caused banks to vastly reduce their proprietary bond trading activities. As a result there are no longer any big market makers that can ensure a certain degree of market liquidity, which is obviously a big problem for investors who are forced to sell.

With respect to banks, one must keep in mind though that they still have a lot of indirect exposure junk bonds as well, through their funding of leveraged bond investors, who have inter alia been buyers of assorted structured products (for details on the resurgence in such products and the leverage involved, see “Embracing Leverage Again”). The main purpose of such structures is to let low-rated debt masquerade as something better than it is, by means of creating tranches of different seniority based on assumptions of the overall size of likely credit losses in the event of a downturn. Similar assumptions went spectacularly wrong in mortgage backed CMOs in 2008. Leverage used in bond investments is often especially high and has a tendency to increase as yields go lower, because it becomes increasingly difficult to obtain decent returns without it. This means that the greatest amount of risk is likely to have been amassed at precisely the worst possible point in time.

There is thus a significant danger that the so-called “portfolio channel” effect that central banks have encouraged with their loose monetary policy after the GFC will substantially reverse. This will eventually affect an ever wider circle of borrowers and creditors if forced selling and disappearing liquidity continue to feed on each other in a vicious cycle. In spite of the presumed greater resiliency of the banking system, banks will definitely not be immune to such a development. Their direct exposure to energy loans is only one of several potential problems.

 

Remarkable Equanimity and Ominous Patterns

We get the feeling from reading articles in the mainstream financial press that there is still a lot of complacency in the markets. For instance, we have come across sotto voce assertions that “this is not 2008” or variations thereof several times already. This is of course true, as every downturn is inherently different (even though Tom McClellan shows that there is an eerie similarity between the 2007/8 and the 2015/16 chart patterns).

We feel however reminded of something Paul Singer of Elliott Management pointed out a while back in this context. He noted that the 2008 experience has probably taught investors to act more quickly once they sense that danger is in the air. In other words, once a decline in risk assets that looks like it is not a run-of-the-mill pullback is underway, it could very easily and quickly accelerate.

As we have recently mentioned, the currently still prevailing complacency is also reflected in “fear measures” such as the VIX. Meanwhile, the deterioration in market internals, the market’s overall technical condition, as well as long term positioning and sentiment indicators continue to look quite dangerous – even if the market is oversold in the short term.

John Murphy of stockcharts has recently pointed out that a well-known bearish technical pattern has become visible in the S&P 500 Index over the past 18 months. Specifically, since October of 2014, the SPX has formed what looks like a slanted head & shoulders pattern. We would add to that observation that the “head” of the pattern looks like a diamond pattern to boot. Both of these patterns are reversal patterns of some statistical significance. Naturally, they can and do occasionally fail (which is bullish if it happens), but their appearance definitely increases the likelihood that a major trend reversal is underway.

 

4-SPX h&sSlanted H&S pattern in the SPX. The “neckline” has already been slightly undercut – click to enlarge.

 

Murphy also reminds us that the “All World ex-US” index is by now clearly in a bear market, after having put in a widely spaced double top:

 

5-All World-ex-USThe FTSE All World ex-US Index has declined below both its October 2014 and August 2015 lows. Recently it has even fallen below the lowest close of 2013, to a level last seen in late October 2012. This was incidentally shortly before the beginning of the Fed’s QE3 program – click to enlarge.

 

It is a bit incongruent that there is seemingly still so much nonchalance about the market’s prospects while so many obvious warning signs are in evidence. One aspect of the stock market’s recent move strikes us as a bearish confirming indicator, namely the fact that stocks are now finally catching up to the trend in risky corporate debt.

A lag between the trend of the latter and the trend of the former is typically seen at every important market peak. Once stocks do begin to follow junk debt lower, it is basically an “endorsement” that shows that one has to take the trend in bonds seriously. In other words, if it was ever contained, it isn’t any longer.

 

6-SPX and HYGThe S&P 500 compared to junk bond proxy HYG (an ETF holding high yield bonds, not adjusted for dividend income). Junk bonds have been leading the way lower since mid 2014 – click to enlarge.

 

Conclusion

Based on the fact that the recent decline in junk bonds and stocks is different from the 2007/8 event in terms of the fundamental backdrop, it is widely held that has to be less serious. This assessment may turn out to be wrong. In fact, we believe that the crisis has never really ended – it has merely been masked by papering it over with enormous money supply inflation (US money TMS-2 +116% since 2008) and deficit spending (total federal debt +92% since 2008). Some of the risks have been shifted from the banking sector to the government and new risks have been incurred by other market participants.

Broad money supply growth remains relatively brisk, which normally lowers the prospects of a very large decline in risk assets, but then again, growth in narrow money AMS (resp. TMS-1, close to M1) has slowed considerably more. The slowdown in its growth rate may already suffice to capsize the bubble boat (we plan to soon discuss in these pages in what way these measures differ from an analytical perspective).

It was easier to pinpoint the weaknesses and guess what could happen prior and during the 2008 event, as the bubble was concentrated in a single highly important sector. By contrast, the echo boom has been somewhat more opaque, as bubble activities seem to be spread across numerous sectors – aside from the fact that malinvestment in commodities and especially in the energy sector has obviously gone through the roof in recent years. In this sense, what is happening in energy sector debt strikes us as likely just the tip of the iceberg.

 

Charts by: StockCharts, St. Louis Federal Reserve Research

 

 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Gold Sector: Positioning and Sentiment
      A Case of Botched Timing, But... When last we wrote about the gold sector in mid February, we discussed historical patterns in the HUI following breaches of its 200-day moving average from below. Given that we expected such a breach to occur relatively soon, the post turned out to be rather ill-timed. Luckily we always advise readers that we are not exactly Nostradamus (occasionally our timing is a bit better). Below is a chart of the HUI Index depicting the action since the January...
  • India: The next Pakistan?
      India’s Rapid Degradation This is Part XI of a series of articles (the most recent of which is linked here) in which I have provided regular updates on what started as the demonetization of 86% of India's currency. The story of demonetization and the ensuing developments were merely a vehicle for me to explore Indian institutions, culture and society.   The Modimobile is making the rounds amid a flower shower. [PT] Photo credit: PTI Photo   Tribal cultures face...
  • The Long Run Economics of Debt Based Stimulus
      Onward vs. Upward Something both unwanted and unexpected has tormented western economies in the 21st century.  Gross domestic product (GDP) has moderated onward while government debt has spiked upward.  Orthodox economists continue to be flummoxed by what has transpired.   What happened to the miracle? The Keynesian wet dream of an unfettered fiat debt money system has been realized, and debt has been duly expanded at every opportunity.  Although the fat lady has so far only...
  • March to Default
      Style Over Substance “May you live in interesting times,” says the ancient Chinese curse.  No doubt about it, we live in interesting times.  Hardly a day goes by that we’re not aghast and astounded by a series of grotesque caricatures of the world as at devolves towards vulgarity. Just this week, for instance, U.S. Representative Maxine Waters tweeted, “Get ready for impeachment.”   Well, Maxine Waters is obviously right – impeaching the president is an urgent...
  • Welcome to Totalitarian America, President Trump!
      Trump vs. the Deep State If there had been any doubt that the land of the free and home of the brave is now a totalitarian society, the revelations that its Chief Executive Officer has been spied upon while campaigning for that office and during his brief tenure as president should now be allayed.   Image adapted from the cover of “Deep State #5” - depicting an assassin from the future   President Trump joins the very crowded list of opponents of the American...
  • Searching for Truth
      Heresy or Truth? RANCHO SANTANA, NICARAGUA – In the fifth century, Christian scholars counted 88 different heresies. Arianism. Eutychianism. Nestorianism. If there was a way to “offend” God, they had a name for it. One group of “heretics” argued that there was no such thing as “original sin.” Another denied the trinity. And another claimed Jesus was not divine. Which one had the truth?   Depiction of the first Council of Ephesus in 431 AD, convened by Emperor...
  • Why the 21st Century Sucks - Turtles All the Way Down
      A Truly Sucky Century BALTIMORE – What an awful century! Worst we’ve ever seen. Household incomes are down. Employment is down, with 7 million people in the U.S. of working age without jobs. Productivity growth is down. GDP growth is down – to only about 0.5% per capita last year. Even life expectancies are down. Drug overdoses are up. Suicides are up. One out of every eight children lives in a family getting food stamps. One of out every eight adults takes psychoactive drugs...
  • Gold and the Fed's Looming Rate Hike in March
      Long Term Technical Backdrop Constructive After a challenging Q4 in 2016 in the context of rising bond yields and a stronger US dollar, gold seems to be getting its shine back in Q1. The technical picture is beginning to look a little more constructive and the “reflation trade”, spurred on further by expectations of higher infrastructure spending and tax cuts in the US, has thus far also benefited gold. From a technical perspective, there are indications that the low at $1045.40,...
  • The Unstable Empire – A Campfire Tale
      Campfire Tale   Caesar: The Ides of March are come. Soothsayer: Ay, Caesar, but not gone. — Julius Caesar, Shakespeare   GRANADA, NICARAGUA – Today, we stop the horses and circle the wagons. For 19 years, we have been rolling along, exploring, discovering. We began with the assumption that we didn’t “know” anything - so we kept our eyes open. Now we know even less.   Famous people who knew nothing and were not shy to admit it: Sergeant Schultz...
  • Off the Beaten Path in Mesoamerica
      Greeted by Rooster There’s an endearing quality to a steadfast rooster call at the crack of dawn when overheard from a warm country farmhouse.  There’s a reassuring charm that comes with the committed gallinaceous greeting of daybreak that’s particularly suited to a rural ambiance.  The allure of a morning cock-a-doodle-doo somehow falls flat in all other settings.   Good morning everyone! Before meteorological forecasts were available on TV and smart phones, people...
  • Why Silver Went Down – Precious Metals Supply and Demand
      Rumor-Mongering vs. Data The question on the lips of everyone who plans to exchange his metal for dollars—widely thought to be money—is why did silver go down? The price of silver in dollar terms dropped from about 18 bucks to about 17, or about 5 percent.   Reportedly silver was already assassinated in the late 19th century... so last week they must have assassinated its corpse. [PT] Illustration taken from 'Coin's Financial School'   The facile answer is...
  • Systematic Trading - Unwrapping the Onion
      Lumpy but Robust   [ed note: this article has originally appeared at the Evil Speculator and was written by trader and ES contributor Scott. We provide a link to Scott's past articles below this post for readers who want to get more familiar with his ideas and/or any unusual terminology used in this article]   One continual theme in my trading is that every time I think I have it figured out, I get punched in the face by an unexpected problem. The tendency is to go more...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com