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The Institutional Risk Analyst

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Q1 '17 Earnings & the Yellen Recession

JPMorgan (NYSE:JPM) boss Jamie Dimon says there’s something wrong with the US economy and he is obviously right. Here’s our short list:

* too much public and private debt

* too little income and growth

* monopolies in banking and other industries

* oppressive regulation for all businesses

* political muddle and lack of national purpose

* confused, irrational monetary policy

A couple of weeks before Mr. Dimon was waxing effusive on the state of the American political economy, New York Fed President Bill Dudley told an audience that excessive student debt was holding back the US economy “despite efforts of the Federal Reserve to stimulate economic activity.”


We thought that the Fed was engaged in an effort to manipulate asset prices in a desperate attempt to increase consumption. Since economic expansion is a function of population growth and increases in productivity, both of which are basically the flat, the Fed has never had any real bullets when it comes to encouraging growth save orchestrating debt driven asset bubbles.

More, unlike the 1970s and 1980s, today simply lowering interest rates has no apparent impact on consumer spending. The past eight years of near-zero interest rates and massive bond purchases by the FOMC has merely put the key issue of debt temporarily on hold while asset bubbles have bloomed around the economy.

Which brings us to the ongoing implosion in demand for automobiles. US automakers including Ford (NYSE:F) and General Motors (NYSE:GM) have seen demand for once-popular sedans basically collapse. More, as we noted in a previous post on David Einhorn’s sudden interest in GM, the residual value of used cars is also falling. Key concept: the upward surge in new car purchases was driven by irrational exuberance (aka credit expansion), which in turn was driven by the FOMC’s policies.

But apparently the party in less-than prime auto ABS is over. Mark Wakefield of Alix Partners told Bloomberg News he sees volumes falling by at least 300,000 units from the 18 million peak in 2016, but we’d be surprised if the industry can break 17 million units this year given current trends in the industry and, more important, in credit markets.

Part of the problem for automakers is that the surge in new credit that enabled consumers to buy cars in part came from captive leasing units and independent auto lessors that are facing growing losses on existing loans and leases. Nearly one in five cars was leased last year and residual valuations are plummeting, especially for passenger cars. The new arrivals in the below prime auto lessor community are going to take a big hit.

The next step will be for these smaller leasing firms and banks focused on providing credit to below prime customers to withdraw credit from the system, which will in turn cause auto sales to fall further. Originating and selling prime auto paper has been a break even prospect at best, thus all of the focus of Wall Street was on below-prime originations over the past year or more. Tales of mortgage market in the mid-2000s? Yes. Repeat after we: “Gain on Sale.”

Names like AutoNation (NYSE:AN) and CarMax (NASDAQ:KMX) may be able to survive the credit losses likely this year and next, but smaller players in the leasing channel will pull back quickly on risk exposures, reducing the ability of the automakers to move inventory. Needless to say, even as Yellen & Co try to belatedly raise interest rates, the credit cycle has already turned sour. If anything, the Fed should be pondering when to ease. But hold that thought...

Bank Earnings

Meanwhile in the world of banks, the prospect of Q1 ’17 earnings is hardly causing great joy among Sell Side analysts, especially for the big universal banks with significant securities operations. In Q1 '17 the bond market has again set new records for investment grade (IG) bond issuance, but the economics of debt deals is significantly thinner than for equity offerings. Initial public offerings have dwindled under the social engineering of Janet Yellen and the FOMC. Simply stated, why issue public shares when you can tap private equity or float a bond deal at what are still historically low rates?

For those who think that rising short-term interest rates will somehow boost earnings, it is interesting to note that the majority of US banks saw net-interest margins decline in 2016 – this as the yield on the 10-year Treasury was rising following the election of Donald Trump. Only trouble, as we wrote for Kroll Bond Rating Agency at the time, is that IG and even high yield bonds were rallying as the T-bond sold off. Hmmm.

Below is our famous chart showing the cash components of NIM for all US banks through year-end 2016, using data from the FDIC. Notice how low that the Fed pushed the cost of funds for US banks in order to keep the zombie girls dancing -- just $11.5 billion in the middle of 2015. The same figure was almost $15 billion as of Q4 ’16. Note that income rose more, but only because of the bank lending spree in 2016 which is now ended.

Swelling balance sheets enabled the big zombie banks to pretend that they are making more money on good old fashioned leverage, but if you look at the impact on the return on earning assets, the picture is different. The chart below shows net interest income divided by earning assets, which clearly shows that the past eight years of extraordinary Fed policy have been bad for bank asset returns and income.

On a risk-adjusted basis, the large bank sector looks about as cyclical as the large US automakers. And since mid-March, spreads on high-yield debt have been widening as investor confidence in the Trump Bump has started to wane. Credit losses for US banks are starting to rise, albeit from a very low base. As the chart below suggests, loss rates on the $9 plus trillion in US bank loans bottomed in 2015 and are slowly starting to increase as the great asset bubble created by Janet Yellen and the FOMC begins to deflate.

Ask yourself a question: Are the C&I and commercial real estate credits on the books of the largest US banks and, in particular, in asset backed securities (ABS), significantly better quality than the growth of auto exposures to consumers over the past half decade? The answer is clearly “no” as evidenced by the fact that the major rating agencies are all starting to walk back their ratings on post-crisis commercial real estate exposures.

As we wander into Q1 '17 earnings next week, we can’t help but notice that those generous souls at KBW decided to upgrade Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) on the theory that lighter regulation and rising interest rates will boost earnings. Really??

Read our comment on Citi from last week if you have not already done so. The gross spread on C&I and CRE loans at Citi is so low that cash flows from both of these enormous portfolio components could be wiped out by charge offs in a stressed scenario.

We differ on both points used by KBW to justify the upgrades of Citi and WFC. First, any reduction in capital requirements is a medium term exercise, in other words, no impact in 2017. Capital is THE solution of choice for the political class when it comes to avoiding the dreaded specter of “systemic risk,” even among conservative Republicans. Don’t hold your breath for significant changes in capital requirements.

Second, a flat yield curve sinks all boats. Without a serious change in mind on the part of the FOMC, rising short-term rates and falling 10s to 30s sure does not look like a winner to us. Indeed, if the FOMC goes forward with three more short-term rate hikes in 2017 without starting to sell MBS from the $4 trillion portfolio, look for NIM for the whole banking industry to take a swan dive.

In the latest FOMC minutes we see this important tidbit: “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.”

This passage from the FOMC minutes illustrates that the members of the Fed’s policy making body clearly do not understand what is happening in the bond market. Agency issuance is down dramatically compared with 2016, like minus 15-20% YOY ($300-400 billion) over the course of 2017.

If the FOMC really wants to see long-term yields rise in concert with short-term benchmark rates, then selling at least $50-100 billion per month in MBS from the Fed’s portfolio is entirely necessary. If the FOMC keeps to its current plan, however, the curve will flatten, bank earnings will suffer and the US economy will start to contract. Details aside, it will be called the Yellen recession for a reason.


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