Below we're re-publishing our Financial team's conference call with Peter Atwater last week and a transcript of his key takeaways. By way of introduction, Peter has run JPMorgan's asset-backed securities business, has been Treasurer of Bank One, CEO of Bank One Private Client Services, and CFO of Juniper Financial among other high-profile roles through the Financial Services Industry.
On the call Peter offers his view on such topics as the EU debt crisis, ratings downgrade ramifications both at home and abroad, and various other trends within the Financial sector.
If you'd like to learn more about the work of our Financials team, headed by Josh Steiner, please contact sales@hedgeye.com.
The ideas below are Peter Atwater's.
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Key Takeaways From Our Call Yesterday with Peter Atwater
For those interested in listening to the replay of yesterday's call, click the following link:
https://app.hedgeye.com/feed_items/16722
Materials (slide deck) from yesterday's call:
Europe
- It's the willingness, stupid! EFSF and other mechanisms are predicated on the willingness, not just ability, of Germany et al. to support them. Willingness is increasingly at risk, at the same time that ability is threatened by ratings downgrades.
- EFSF leverage isn’t a realistic option at this point. Things are moving too fast to get the necessary approvals.
- No risk has been mitigated by actions so far – only moved.
- EBA capital shortfall numbers are a pipe dream. They assume a pan-European deposit insurance scheme, which doesn’t exist. Moreover, since the end of September, sovereign debt prices have deteriorated significantly, further reducing the validity of the shortfall estimates.
- China as bailor! China is better served by picking up assets at fire-sale prices after Euro breakup than preventing it.
- Banks will concentrate on lending in their home countries and may walk away from foreign branches. There’s no reason to think that a withdrawal has to be orderly.
- Bailouts are bailouts of creditors (not debtors). That’s now the view, and it changes the debate.
- What’s ahead? A period of extreme turbulence, followed by significant opportunity on the other side.
- Ratings contagion: sovereign downgrades lead to bank downgrades, and back again in a vicious cycle.
- Both Greece and Italy will leave the Eurozone in short order.
- What would be a positive sign? An unconditional support agreement.
US Ratings
- Supercommittee failure will trigger “at minimum, cautionary words, if not a further downgrade” at the same time that further spending (supporting banks, boosting economy, stemming European contagion) will be increasingly necessary.
US Housing
- Migration to a nation of renters – 50% homeownership looks more stable in the long term (vs. 66% today)
- Many questions remain on the structure of housing finance in 5 years. Congress will pressure a re-syndication of risk back to the private sector. Expect a fight around the GSEs when their Treasury Support Agreement expires at YE 2012. Fannie/Freddie now the release valve on the housing market.
US Banks
- Stay away from deeply interconnected "Empire" financials.
- Consumer product pricing (e.g. debit card fees) increasingly political.
- Market no longer accepting “net hedged” for an answer. The importance and focus on gross exposures is growing – just look at Jefferies. “Net hedged” assume orderly & liquid collateral markets – which may not be there.
- Nations will secede from Basel when it becomes inconvenient to comply. Nationalism will increase in bank regulation.
- The market will demand subsidiary-level and geography-level loan and derivative disclosures from corporates and banks, as capital restrictions mount.
The Following are More Detailed Notes from Our Call
Europe in flux
- Stepping back – October breakthrough “merely whack-a-mole” – risk was only moved, not eliminated
- Lots of conditionality behind promises; don’t underestimate that going forward
- G-20 and IMF support will come with significant strings attached (progress payments, conditions)
- Binary outcome – it works or it doesn’t, since all the efforts to stem contagion have been risk-transfer, not risk reduction.
- Since October, the question of a disorderly disintegration looks very real
Hardwired Ratings Contagion
- Can’t emphasize enough the hardwired ratings contagion between sovereigns and banks. Bank ratings drop due to elimination of ratings uplift/moral hazard; recognition that countries are less willing even if able (and some are unable).
- Willingness to implement austerity is not growing – leaders will require a populist component or referendum to support their policies
- EFSF and other mechanisms are predicated on ongoing willingness of France, Germany, Netherlands to support the system. Willingness is increasingly at risk, and AAA rating vulnerability puts ability at risk with a downward-spiraling “ratings vortex”
US Ratings
- Supercommittee gridlock will bring ratings agencies back out with “at minimum, cautionary words, if not a further downgrade” – meanwhile, the US economic situation will provoke requests for fiscal action (domestically or in Europe) and will see need for bank support and FDIC support
- AA is a certainty - the question is what happens then. How do depositors view FDIC insurance in AA US?
- Bank assets, bank liabilities – all woven into US debt ratings
- Over 30% of bank assets reflect US government obligations, directly or indirectly.
US Housing
- We’ve made “baby steps” in terms of what needs to happen. We need a “comprehensive solution” and re-syndication of risk. Nothing seems final yet. You’ll see pressure from Congress & the agencies to come to a resolution where risk is placed in the private sector. How that syndication takes place is critically important for bond investors. Right now, GSE Treasury support agreement expires at YE 2012. What happens then to US support of agencies?
- We are witnessing the beginning of a significant migration to a nation of renters, including homeownership rates well below current levels. 50% seems more likely and more sustainable.
- Litigation – still an operating expense. Until the markets bottom, volumes of litigation will continue to expand.
- Most vulnerable: home equity lenders and bondholders most exposed to financial repression/public policy intervention. Lots of D.C. hostility towards preference to keep HE lines current – will start to see credit card flows be impacted as well. Card DQs are historically low, yet mortgage delinquencies are well above that.
Becoming more nationalistic, and Basel is a great example.
- Sovereign nations will secede from Basel and develop their own risk-weighting schema.
- Financial repression across capital/labor/goods mounting in Europe and will continue.
- Consumer product pricing is increasingly political – BAC had material Washington oversight to their debit card fee
- Empire banks most vulnerable politically & socially – don’t underestimate Bank Transfer Day last weekend. There’s underlying sentiment that benefits small, local, mutually owned institutions.
- Don’t underestimate the MF Global/Jefferies message either – what it means for hedging.
- 3Q earnings jargon du jour was “net hedged.” Moved pretty quickly away from that on gross disclosure mandates (e.g. Jefferies). Just as banks had to disclose mortgage exposure in greater granularity, same thing will happen with derivatives and sovereign exposure.
- Sovereign and super-sovereign intervention will make hedging questionable as hedges don’t pay out. Don’t underestimate the potential for disorderly collateral markets – “net hedged” assumes liquid and orderly collateral markets.
- Potential for interruption of intercompany flows within companies themselves. Look at Dexia’s de-consolidated balance sheets to see the mismatch in assets and liabilities. Consequences will flow into non-financial space, as corporates may decide that bearing market risk is better than trying to explain to analysts what their exposure is like.
3Q earnings fundamentals
- PTPP earnings are extremely vulnerable
- Limited opportunity for further cost-cutting
- Credit cycle has peaked - don’t discount the message coming out of HSBC today. They were early in recognizing issues in 2007, and they’re forward in risk management.
- Earnings since 2009 show little improvement – it appears random.
- Prior issues on credit front (litigation, etc.) will come back to bite them
- Little to prevent deterioration in credit from flowing straight through (no room for Fed cutting, etc.)
- Deterioration in social mood decreases GDP and economic activity, and it also makes collective solutions in Europe difficult and engenders need for further bailouts from the strong. Generosity is more a function of confidence of the donor than the need of the recipient – US investors have underestimated this point. Germany’s willingness to help was finished in October, and it’s hard to imagine Germany stepping up again given what happened immediately afterward with Greece calling for a referendum.
Q&A
Europe & European banks - Capital shortfalls
A: EBA capital numbers – figures were as of the end of October, and merely looking at the market since then, that number is something like 50% light already. Further, the EBA assumed in those figures that Europe would come up with some pan-European deposit insurance plan. That appears very unrealistic at this point. The EBA numbers are “unfortunately a pipe dream.” The reality will be dramatic reshifting of priority to home country lending support by European banks. Massive garage sale and/or actual departure from foreign markets. We’ve all expected orderly disengagement like HSBC’s retreat from the US, but it doesn’t have to be so – the banks could just cut their losses and walk away. Don’t underestimate the national pressure that may exist for banks to do that – political expedience
France’s AAA & ratings agencies
Question for Sarkozy is “how would you like to be downgraded? On your own merits, or because you stepped up to support Europe?” In this political environment, there’s a disincentive to trigger a ratings default tied to stepping up support for other countries. “They’re going to be downgraded … the EFSF will be downgraded to AA+ as a consequence.” Does that ultimately bother people, or is AA the new AAA?
Ratings themselves are vulnerable – Europe may “go black” on ratings altogether, which would also facilitate dropping Basel.
With Draghi’s appointment, Italians needed to raise some amount of capital. But at this point, sovereigns will allocate funds to support their banks – can they capitalize them enough to decouple them from the sovereign? I don’t think that’s likely, without major contractions in the banking system.
Will countries be allowed to leave?
Greece is leaving. Italy is leaving. There are WSJ articles about how to prepare for Greek secession. The question is whether it’s orderly or in a “crisis weekend.”
Plans to expand or leverage EFSF/China to the rescue
Leveraging the EFSF isn’t a realistic solution at this point – Italy is moving too fast. Given the political constraints, you just can’t get the approvals in place to do that. On China, I wonder if they realize that the real opportunities are after a country’s exit from Europe. Expect them to aggressively extend credit to countries that have exited. And you bet China is looking at assets to purchase.
Which banks are most vulnerable?
All are vulnerable to uplift reversals – uplifts were “hallucinogenic.” Do banks simply cut the ties to their southern European affiliates? We’ve operated with a banking system with global branches and capital and liquidity sitting elsewhere. Worry about the French banks, and Belgian financial institutions still dwarf GDP – ditto the Netherlands.
What would make you more optimistic?
The fiscal union many leaders are discussing isn’t a necessity. What I think Europe needs to demonstrate isunconditional support for each other, rather than this “mother may I” process featuring big headlines but footnotes full of preconditions. If Europe is serious about saving itself, it’s got to have “a bazooka that can actually be fired.” There’s nothing like that on the horizon now, nor from the G-20 or IMF.
Disorder in counterparty netting
Doesn’t necessarily require failure of a major bank. What we’ve seen in JEF was “a strip search at gunpoint by the market” (quoting WSJ article) – we are now operating without net hedged as an underlying principle. The days of clamoring for gross data is now upon us, and financial institutions need to be prepared to provide it. You don’t need another failure.
Dexia – had exceptionally poor ALCO risk management. They were operating as a consolidated entity amid dis-integration of firms left and right. Much like “net hedged,” we should start to see demand of investors at a legal entity/geographic level – funding, capital, liquidity.
Liabilities come out of the woodwork, and investors demand greater granularity, and big companies have trouble coping with these kinds of information requests.
Change in leadership in Greece & Italy – how does it alter the outcome?
In both cases, what we have is an interim government in a protracted period of re-formation not unlike what we see in Egypt, Libya, etc. Ousting an existing regime is easy – coming back together has any number of risks. In Western Europe, for the last 20 years there’s been a belief that political leaders could commit their populations to various things (sovereign debt, austerity, etc.) The real message from Europe is that political leaders can make a commitment but it might be different tomorrow depending on the political will. I don’t think the raters of sovereign debt considered willingness. What’s the value of AAA (EFSF) if tomorrow the willingness to support it just evaporates?
Iceland – be careful what you ask for. What we have in Italy today is far greater uncertainty.
Near-term catalysts
What we’re seeing in Italy is more likely to result in a Euro dissolution. Barrosso talking about “euro deviance” – members of EU who are not Euro users – there’s little to stop that kind of departure. The expectation was that Greece would go first, but now it looks like Italy might go first, and Greece thereafter. Bailouts are bailouts of creditors. That recognition skews the debate from here.
Mechanism – countries lie, lie, lie, devalue. If you look at currency flows, they’ve become unsustainable. To slow the process, FX controls within the EU would have to develop – but that’s a momentary lapse before dissolution.
US growth
Growth we’ve seen has been much more commodity price inflation and less actual growth. There hasn’t really been growth since 2009. High correlation between markets (denominated in Gold) and consumer confidence back to 2000. Bright spot to the economy is at the high end. Risk now (flowing back to banks) is a very asymmetric, barbelled economy. Dependence on high end since 2009 has only grown in both real economy and in bank portfolios. Just look at card – spending huge money on acquisition side.
US Housing
Lobbies entrenched – housing finance policy changes?
PA: policymakers need to look less at homeownership and more at home occupancy. Alternatives that encourage rent-to-own, rental solutions need to be developed. We don’t want to own homes now even with record affordability – we want a roof over our head. Can’t keep people in a mortgage even cutting the rate in half – they’re thinking like owners, not renters
Financial repression and burden-sharing in housing
2008 was a clear public policy decision to support existing mortgage industry infrastructure. Relief valve became the balance sheet of Fannie and Freddie. That’s an unsustainable sinkhole for losses. You can’t have mortgage default rates rising concurrent with record-low credit card default rates. I expect a dramatic change in consumer default laws – the reallocation of funds within a failing consumer’s portfolio. Student loans will also come into that equation. Mounting nationalism will encourage policies that shift risk & losses out of the country.
Underappreciated indicators
Consumer confidence – worry that right now we’re 11 years into a recession for the average American.
Metrics of generosity/selfishness on the government level – much more protective of funds – it now appears to be a zero-sum game. Look at growing hostility to military spending. Also pay attention to consumer credit extension (G.19)
Black swans
Vulnerability of FDIC – how do depositors react to FDIC fund backed by a Government with a falling credit rating?
Recommendations
What we have is a “relatively short period of extreme turbulence” to get through – we can’t drag this one out a la 2008. So what will the opportunities be on the other side of this? The thunderstorm is bearing down, so put up the umbrellas, but also consider what’s on the other side. Prudently managing risk will be paramount in the next 9-12 months. I’m much more hopeful about opportunities on “main street” than I have been in a long time- we’re going local.
Joshua Steiner, CFA
Allison Kaptur
