The Credit Crisis Financial Stocks Short Journal

With the 10 year headed towards a 2% handle, I wanted to resurrect this classic from April 12 when rates seemed headed towards a 4% handle. I particularly like the last line of the piece. Always fade the conventional wisdom. The most exciting returns are to be had from an asset class where those who know it best, love it least.

http://www.nytimes.com/2010/04/11/business/economy/11rates.html?src=me&ref=business

Interest Rates Have Nowhere to Go but Up

By NELSON D. SCHWARTZ

Even as prospects for the American economy brighten, consumers are about to face a new financial burden: a sustained period of rising interest rates.

That, economists say, is the inevitable outcome of the nation’s ballooning debt and the renewed prospect of inflation as the economy recovers from the depths of the recent recession.

The shift is sure to come as a shock to consumers whose spending habits were shaped by a historic 30-year decline in the cost of borrowing.

“Americans have assumed the roller coaster goes one way,” said Bill Gross, whose investment firm, Pimco, has taken part in a broad sell-off of government debt, which has pushed up interest rates. “It’s been a great thrill as rates descended, but now we face an extended climb.”

The impact of higher rates is likely to be felt first in the housing market, which has only recently begun to rebound from a deep slump. The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer.

Along with the sell-off in bonds, the Federal Reserve has halted its emergency $1.25 trillion program to buy mortgage debt, placing even more upward pressure on rates.

“Mortgage rates are unlikely to go lower than they are now, and if they go higher, we’re likely to see a reversal of the gains in the housing market,” said Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk.”

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Mr. Mayer.

The Mortgage Bankers Association expects the rise to continue, with the 30-year mortgage rate going to 5.5 percent by late summer and as high as 6 percent by the end of the year.

Another area in which higher rates are likely to affect consumers is credit card use. And last week, the Federal Reserve reported that the average interest rate on credit cards reached 14.26 percent in February, the highest since 2001. That is up from 12.03 percent when rates bottomed in the fourth quarter of 2008 — a jump that amounts to about $200 a year in additional interest payments for the typical American household.

With losses from credit card defaults rising and with capital to back credit cards harder to come by, issuers are likely to increase rates to 16 or 17 percent by the fall, according to Dennis Moroney, a research director at the TowerGroup, a financial research company.

“The banks don’t have a lot of pricing options,” Mr. Moroney said. “They’re targeting people who carry a balance from month to month.”

Similarly, many car loans have already become significantly more expensive, with rates at auto finance companies rising to 4.72 percent in February from 3.26 percent in December, according to the Federal Reserve.

Washington, too, is expecting to have to pay more to borrow the money it needs for programs. The Office of Management and Budget expects the rate on the benchmark 10-year United States Treasury note to remain close to 3.9 percent for the rest of the year, but then rise to 4.5 percent in 2011 and 5 percent in 2012.

The run-up in rates is quickening as investors steer more of their money away from bonds and as Washington unplugs the economic life support programs that kept rates low through the financial crisis. Mortgage rates and car loans are linked to the yield on long-term bonds.

Besides the inflation fears set off by the strengthening economy, Mr. Gross said he was also wary of Treasury bonds because he feared the burgeoning supply of new debt issued to finance the government’s huge budget deficits would overwhelm demand, driving interest rates higher.

Nine months ago, United States government debt accounted for half of the assets in Mr. Gross’s flagship fund, Pimco Total Return. That has shrunk to 30 percent now — the lowest ever in the fund’s 23-year history — as Mr. Gross has sold American bonds in favor of debt from Europe, particularly Germany, as well as from developing countries like Brazil.

Last week, the yield on the benchmark 10-year Treasury note briefly crossed the psychologically important threshold of 4 percent, as the Treasury auctioned off $82 billion in new debt. That is nearly twice as much as the government paid in the fall of 2008, when investors sought out ultrasafe assets like Treasury securities after the collapse of Lehman Brothers and the beginning of the credit crisis.

Though still very low by historical standards, the rise of bond yields since then is reversing a decline that began in 1981, when 10-year note yields reached nearly 16 percent.

From that peak, steadily dropping interest rates have fed a three-decade lending boom, during which American consumers borrowed more and more but managed to hold down the portion of their income devoted to paying off loans.

Indeed, total household debt is now nine times what it was in 1981 — rising twice as fast as disposable income over the same period — yet the portion of disposable income that goes toward covering that debt has budged only slightly, increasing to 12.6 percent from 10.7 percent.

Household debt has been dropping for the last two years as recession-battered consumers cut back on borrowing, but at $13.5 trillion, it still exceeds disposable income by $2.5 trillion.

The long decline in rates also helped prop up the stock market; lower rates for investments like bonds make stocks more attractive.

That tailwind, which prevented even worse economic pain during the recession, has ceased, according to interviews with economists, analysts and money managers.

“We’ve had almost a 30-year rally,” said David Wyss, chief economist for Standard & Poor’s. “That’s come to an end.”

Just as significant as the bottom-line impact will be the psychological fallout from not being able to buy more while paying less — an unusual state of affairs that made consumer spending the most important measure of economic health.

“We’ve gotten spoiled by the idea that interest rates will stay in the low single-digits forever,” said Jim Caron, an interest rate strategist with Morgan Stanley. “We’ve also had a generation of consumers and investors get used to low rates.”

For young home buyers today considering 30-year mortgages with a rate of just over 5 percent, it might be hard to conceive of a time like October 1981, when mortgage rates peaked at 18.2 percent. That meant monthly payments of $1,523 then compared with $556 now for a $100,000 loan.

No one expects rates to return to anything resembling 1981 levels. Still, for much of Wall Street, the question is not whether rates will go up, but rather by how much.

Some firms, like Morgan Stanley, are predicting that rates could rise by a percentage point and a half by the end of the year. Others, like JPMorgan Chase are forecasting a more modest half-point jump.

But the consensus is clear, according to Terrence M. Belton, global head of fixed-income strategy for J. P. Morgan Securities. “Everyone knows that rates will eventually go higher,” he said.

 

The subprime crisis is contained, round 2

“Sovereign debt crises have been with us for many, many years. There is nothing intrinsic about such crises that they need to become important shocks to the broader, global macroeconomy.”

http://www.bloomberg.com/apps/news?pid=20601087&sid=auO4l5cU99uE&pos=4

 

"1805 GMT [Dow Jones] Given the fast moving troubles of Europe, the discount rate meeting minutes from last month showed a growing but still minority interest in hiking the central bank's emergency lending rate. The Fed has expressed interest in raising that rate back to its normal relationship with the funds rate target, but it has not yet fully done so, in part because the first move to raise the rate was misinterpreted by markets. Central bankers may now be more reluctant to raise this rate because of rising strain in financial markets that could actually drive some banks to the emergency facility. Put differently, this isn't the time to make emergency borrowing more costly. (michael.derby@dowjones.com)"

lmao

 

Looks like there are more bullets left to the central banks.
http://online.wsj.com/article/SB10001424052748703341904575266722784462634.html

-Fed can cut its rate on the swap lines with the ECB(Currently OIS+100bps)
-Fed can re-initiate TAF for longer maturities
-ECB can cut rates

Meanwhile Lacker, Fisher and Bullard want a higher discount rate, returning it to 'pre-crisis levels'. Apparently a libor-OIS blowing up doesn't signal any type of financial crisis to them

 

As I understand EU banks hold sovereign debt at cost and they dont have to market it to market as interest rates change. A possible solution that might be adopted is to restructure greek debt by extending its maturities, this wouldn't hit the banks(at least not officially) and it would resemble the FASB mtm changes that allowed US banks to zombie their way into equity offerings. In a real world of course the present value of that debt would drop(maybe a lot) but the 2009 rally showed that reality might not necessarily drop bank stocks, people might just look the other way

 

There's no question that gov'ts have the ability to create their own reality. The US has pushed the limits of this w/purchase of crap assets, the suspension of mark to market, phony stress tests, and the continued acceptance of off balance sheet vehicles. Thus far, it appears to be working. At some point, it won't and then we'll have another crack-up and then the Geithner and Bernanke types will try it again.

I don't know if anyone was watching CNBC this morning and Liesman and Kernan circle-jerking each other to the "enormous success" of Geithner's programs and the stress tests. These guys have become nothing more than government mouthpieces. Watching that channel is about as close as I ever want to come to watching state-run TV.

 

Great discussion Daal and Ralph.

Although I think the key difference between the PIIGS and the USA (and Japan) is the willingness of investors to fund the huge amount of sovereign debt.

ie, Japanese citizens continue to fund the massive amount of JGBs. (Yes, I am aware of the Kyle Bass thesis, but that has not happened as yet).

and Japan / China / every central bank and their dog is willing to finance US Treasuries.

However PIIGS debt is another thing altogether. Yes there could be some extending and pretending, but ultimately the financial markets are quickly realising that it's much safer to own US Treasuries or German bunds than it is to own PIIGS debt. This is true despite the silly 1 trillion bailout a few weeks ago.

 

Its funny that Japan was criticized for not reforming their banking system but more and more developed countries are using the japanese banking plan. Banking systems now resemble Thriller, I'm sure if Geithner convince them to do a stress test that test will say 'everything is fine' otherwise results wont be published, if they say things are ok only time will tell if they will get the same results(a large short-squeeze followed by sending the bill to the private sector through equity offerings)

I have no intention of trying to short their stocks, if I'm going to play this it will be by shorting the EUR(which I failed to do last friday)

 

Yes although I am short AIB, NBG, STD and BBVA I am reluctant to add to these positions because of the potential for bailouts and the resultant massive share price increases.

Although having said that AIB is still a good short story (depending on your risk / reward and entry point) because the Irish govt has mandated a capital raise (see the AIB thread where I've posted a lot recently) and there is potential for a NYSE:BIR type decline once the details of the capital raising are known.

 

Why not simply short all currencies trough the gold play?

Or would you say that trade feels to crowded for you at this point in time?