Eye on the Market I

Eye on the Market I October 24, 2011 J.P.Morgan Topic: A biological look at the latest attempt to resolve the European Monetary Union debt crisis; US Q3 earnings The EMU (technical name: Economic and Monetary Union, common name: European Monetary Union) is beginning to bear more and more resemblance to its aviary twin: the flightless, awkward, and bumbling' emu (drornaius novaehollandiae). Europe's long-awaited sovereign and bank bailout package will soon attempt liftoff; we will know more after yet another summit on Wednesday. There are flaws that may weigh this emu down, as annotated in the picture below. Why is this so important? Bank recaps in Sweden (`92), the US ('92, '08), Japan ('99) and Asia ('98) were close to marking the bottom of the equity market cycle....but were not designed using the equivalent of the "Goal Seek" function in Microsoft Excel. Will the EMU bailout fly? The annotated version For purposes of determining bank capital needs. the EU is NOT going to apply a stress test per se, but a simple mark-to-market exercise on sovereign bonds. That's why reported recap needs are only 75-100 bn Euros. Using mark- to-market levels is less conservative than prior EBA sovereign loss assumptions. and the planned exercise does not assign loss estimates to corporate. household and commercial property loans. The process appears Goal-Seeked to maximize EFSF proceeds available to backstop sovereign debt la.bl. Demand (depth. pricing) for Italian or Spanish bonds with a first- loss guarantee from the EFSF is unproven EFSF direct guarantees could be a possible violation of EMU bailout restrictions [c] ► Risks to France's AAA rating from the extension of too many guarantees to either the EFSF or its own banks idl No stress test this time. but we still have reservations about the prior one. as it only assumed 1.3% for household. corporate and commercial property loan losses over 2 years. This compares to the current market-implied loss rates of 3.4%. and the US May 2009 Stress Test assumption of 9%. German bank exposure to GIPSI sovereign debt is 1/5th of their exposure to non-sovereign GIPSI debt. so these assumptions matter. particularly with a recession looming. Markets might require a higher degree of bailout / package "coverage" of Italian and Spanish financing needs in 2012 and 2013 (see page 3) A recession, perhaps confirmed by today's 0,7 7 weak NMI survey (Germany was the only bright spot), could result in higher than expected deficits, increasing government financing needs beyond current expectations Eel Deutsche Bank CEO Ackermann warned that if f asked to substantially raise capital ratios. EU banks might shrink their loan books by 1 trillion instead of raising equity. possibly exacerbating a recession 20% might be insufficient for a first-loss guarantee. given historical Moody's recovery rates of 53% for defaulting sovereigns If less than 50% debt forgiveness is used for Greece in ÷__._-------- order to avoid triggering CDS contracts, the exercise may lose credibility In ECB might be asked to print hundreds of billions of Euros to purchase debt in secondary markets, or finance some other entity that does, exceeding ECB, Bundesbank or public tolerance for monetary expansion 4--- -- - Orwellian proposals by EU regulators to limit the ability of rating agencies to act during "inappropriate moments" borders on the bizarre, could further concern investors [gi Emu notes lal Using the prior EBA stress test and a 9% Tier 1 ratio would result in a capital shortfall of 150 billion, even after including the conversion benefit of convertible bonds and the use of existing loan loss reserves, and without applying sovereign losses to the hold to maturity book. (b] In prior stress tests, the European Banking Authority only applied loss assumptions to bonds in the trading book. The EBA now appears ready to assume losses on hold-to-maturity and available-for-sale bonds as well, but with a kinder, gentler loss percentage assumption. Direct first-loss guarantees from the EFSF may run afoul of Article 125 of the Lisbon Treaty which prohibits member states from being liable for commitments of other states. There are viable alternatives that get to the same place: a country could borrow from the EFSF and place borrowed funds into escrow (collateralizing the guarantee), or purchase zero coupon bonds. [d] With 84% debt to GDP (gross government debt), a large current account deficit, rigid labor markets, lost export competitiveness to Germany and low growth, France is flirting with a downgrade. France is already highly taxed (government revenues and expenditures are already at Nordic levels), making deficit reduction a difficult exercise. EFSF commitments from France are another 8.4% of GDP. S&P wrote last week that a recession in Europe could usher in a round of downgrades for European sovereigns, including France. lel Recent example: Spain, where flow of funds data suggest that the budget deficit could be 8.6% in 2011, higher than the targeted 6%. 19 Less debt forgiveness raise the chances of a voluntary restructuring, which would avoid triggering credit default swap contracts. Larger losses are likely to mean that the restructuring is involuntary. [g] "In order to prevent that credit rating agencies issue sovereign ratings which do no accurately reflect the situation of the country concerned and would cause negative spillover effects to other countries, ESMA should be granted the power to temporarily restrict the issuance of credit ratings in exceptional, precisely defined situations" [EU regulatory draft as reported by the Financial Times]. I remember reading articles like this in Pravda in 1982. Professor Louis Lefebvre at McGill University in Montreal has compiled a Bird IQ Index. The emu (and its cousin the ostrich) rank at the bottom of the list. At the top: crows, ravens, falcons, hawks, woodpeckers and herons. 1 EFTA01071164 Eye on the Market I October 24, 2011 J.P.Morgan Topic: A biological look at the latest attempt to resolve the European Monetary Union debt crisis; US Q3 earnings We consider the universe of oversold European stocks mentioned 2 weeks ago, and portfolios of loans sold by deleveraging European banks at deep discounts, as the best value in Europe. We are not positioning for a broader recovery in European financial assets, and retain our overweight to the US. Q3 S&P 500 earnings look to be around 14%2 vs 2010, continuing the run of US corporate profits growth to a new all-time high. As a reminder, profits are holding up since manufacturing is 60% of the S&P 500 (compared to 15% of the US economy), and labor costs are at their lowest levels in 50 years relative to revenues. There are some negative trends in play: both margins and earnings surprises are beginning to flatten out. In addition, estimates for Q1 2012 profits have fallen from 10.2% y/y on October 3 to 7.6%, consistent with declines in manufacturing and service sector surveys. Silver lining: there's room for disappointment when the S&P is priced at 11 times earnings. Left to its own devices, we expect the S&P to close up on the year, but the situation in Europe and the outcome of the US Joint Select Committee on Deficit Reduction are two substantial wild cards. The other animal of the week: the Sloth We had a client conference in Istanbul two weeks ago. Iliad the opportunity to interview Jin Liqun, the Chairman of the Board of Supervisors of China Investment Corporation. Most of the discussion focused on the challenges that CIC faces in investing its accumulated reserves at a time of fiscal and economic weakness in the West. Normally I would not disclose comments made in a closed session, but as reported below by the London Telegraph, Mr. Jin made the following comments, which were similar to what he said at our conference in Istanbul: Oct. 20 (Telegraph) -- Britain's "sloth-inducing" work ethic and dependence on benefits are to blame for the current economic downturn, a senior Chinese official has claimed. Jin Liqun, chairman of China Investment Corporation (CIC), the nation's sovereign wealth fund, warned that Europeans should "work a bit harder" if they want to pull the Eurozone out of recession. He said people in the West are too reliant on welfare payments and the benefits system, looking for external solutions to the debt crisis rather than tackling the problem from within. Mr Jin also said the long-term economic slide could only be solved by amending the restrictive labour laws that mean Western workers are unable to compete in global markets....."The root cause of the trouble is the over-burdened welfare system, built up since the Second World War in Europe — the sloth-inducing, indolence-inducing labour laws. People need to work a bit harder, they need to work a bit longer, and they should be more innovative. We (the Chinese) work like crazy. European countries have a lot of advantages. They just need to tap these advantages and they will be back on their feet." Ouch. For the benefit of our urban clients, a sloth (megalonychidae) is a slow-moving, tree-dwelling animal that sleeps 15 hours a day and is covered in beetles. There are many ways to react to this: a wake-up call for the West; an unfair diatribe, given China's currency intervention which arguably contributes to the economic challenges facing the US and Europe; or a reflection of inevitable wage convergence, driven by 2.6 billion people in China and India entering the global workforce after decades of self-imposed isolation. Whatever the truth is, Jin's comments seem in sync with other Chinese assessments of Western fiscal policies (see August 6th article in Xinhua: "China, the largest creditor of the world's sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets."). To stress-test Jin's assertion, we recreated a chart from Eugene Steuerle, former Deputy Assistant Treasury Secretary for Tax Analysis, now with the Urban Institute. He calls the chart a measure of "fiscal democracy": the degree to which Congress can spend revenues not already committed to mandatory programs. A measure of Fiscal Democracy shows there isn't much In 2009, for the first time, all US government revenue was % of U.S. govemmentrevenue not already committed to pre-committed to mandatory spending (social security, mandatoryprograms healthcare entitlements, farm subsidies, unemployment 70% insurance) and interest. After a brief rise over the next couple 60% of years (due to projected declines in unemployment insurance), SO% it is estimated by the CBO to fall back to zero again. The chart 40% confirms the post-war shift to a more entitlement-heavy 30% economy, a shift former U.S. Comptroller David Walker 20% describes as crowding out the kind of productive discretionary 10% spending needed for the US to compete against China and India. 0% Michael Cembalest -1 o% Chief Investment Officer 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016 Solace< COO, J.P. Morgan Private Bank. 2 S&P 500 earnings for the third quarter look to be overstated by 3%-4% due to "debt valuation adjustments" by banks. These adjustments require banks to mark some of their own debt issuance to market. As a result, when their spreads widened in Q3, it resulted in a gain on their income statements (when spreads rally, banks record a loss); Bank of America and Morgan Stanley had the largest ones. Looking forward, C&I loan volumes and credit quality are now improving, providing some support for better organic bank profitability in 2012. 2 EFTA01071165 Eye on the Market I October 24, 2011 J.P. Morgan Topic: A biological look at the latest attempt to resolve the European Monetary Union debt crisis; US Q3 earnings Appendix. Here is an abbreviated version of the model we use to assess the adequacy of the European Financial Stability Facility. There are multiple scenarios; we show a few of them below. The bottom line is that the proposed package appears to just about cover contingent funding needs for Spain and Italy through 2013, assuming that Germany and France recap their own banks and don't draw on the EFSF to do so; and assuming that T-bills do not need any backstop. IMF participation would further increase the EFSF's potential capacity. Throwing 2014 into the mix, adding Belgium, or requiring a larger (more realistic) bank recap makes the math more difficult, and results in coverage ratios close to 1.0x. The best scenario is the one where all countries are assuming to return to debt markets in 2013, the 20% first loss guarantee works and the IMF helps out. EFSF vivisection table Eur bn Line Item 1 Bilateral funds available 500 2 Disbursed so far to Ireland and Portgual 37 3 To be disbursed to Ireland and Portgual 55 4 To be disbursed to Greece post-default 50 5 Funds remaining 358 6 Funds required for bank recap 44 7 Funds remaining 314 8 First loss guarantee from EFSF 30% 9 Implied sovereign issuance capacity 1.047 10 Funding needs for Spain and Italy 11 Funding needs for Spain and Italy Other scenarios 12 What if Belgium is included as well? 13 What if total bank recap needs were 150 bn instead? 14 What if the IMF covered the bank recap for the periphery? 15 What if a 20% guarantee worked? 16 What if 2014 had to be covered as well? 17 Larger bank recap. 2014 coverage needed for Sp/BeVIt 18 20% EFSF guarantee. IMF help. thru 2013 only Comment EFSF plus original EFSM Greece disbursements have not impacted the EFSF: Greece was funded through other bilateral and IMFprograms whose unspent balances are assumed to expire Through the end of 2013 The July 2011 109 billion package wont be needed if Greece defaults. but monies will still be needed to recapitalize banks. insurance companies. pensions. etc. Also includes next 8 billion disbursement After incorporating pier and future disbursements As of right now, we are assuming a total new recap effort of 75 bn. after some massive window-dressing by the EBA (see EMU on page 1). The 100 bn number mentioned in the press might include monies already pledged to Ireland. Greece and Portugal. so we reduced the figure to 76 bn. In our model. France and Germany assumed to recap their own banks. further reducing the drawdovm needed from the EFSF to 44 bn After incorporating prior and future disbursements and bank recap We do not think a 20% guarantee would be sufficient Total debt that periphery countnes could issue with EFSF guarantees Coy. 988 1.1 Through 2013. including 7-bills 750 1.4 Through 2013. excluding T-bills 1.2 Relative to line 11 1.2 Relative to line 11 1.6 Relative to line 11 1.9 Relative to line 11 0.9 Relative to line 11 0.8 2.4 Relative to line 11 EFSF = European financial stability facility; EFSM = European financial stabilization mechanism; EBA = European Banking Authority EMU = European monetary union (the common name); ECB = European central bank; CBO = Congressional budget office; CDS = Credit default swaps; ESMA = European Securities and Markets Authority London Telegraph article: http://www.telegraph.co.uk/news/uknews/8837768/Britons-are-lazy-and-addicted-to-benefits-China-claims.html Xinhua article: http://news.xinhuanet.com/english2010/indepth/2011-08/06/c 131032986.htm The material contained herein is intended as a general market commentary. 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