Tuesday, November 23, 2010

Spanish Banks' Dependence on Wholesale Financing

This chart from a September 30, 2010 Economist article (“Two Cheers, Three Tiers”) sums up the significant risk building up in Spain’s banking system.

As suggested in the chart, Spanish banks’ loans as a percent of deposits have leapt to approximately 130% over the last decade. This 30% gap has been filled by wholesale financing, which tends to be much less sticky than retail deposits (think Lehman or Bear Stearns, which faced a massive run when their access to the capital markets dried up essentially over night). While the larger and healthier Spanish banks have been able to access wholesale financing (albeit at higher rates), the vast majority of the country’s financial institutions have been shut out of this market. As such, the country is in the midst of a severe deposit war, with the Economist suggesting that “banks are trying to claw share from the beleaguered cajas by offering rates as high as 4%. Higher funding costs are squeezing net interest margins, which fell by 6.4% in the first half of the year for the banks and by nearly a quarter for cajas.”

While drawing too many parallels to Ireland may be a bit premature, its important to note that Ireland’s bailout was precipitated by the rapid loss of retail deposits from the nation‘s largest banks. As an example, Allied Irish lost €13 billion ($21 billion) of deposits since the beginning of the year. Investors fearing contagion to Spain should monitor carefully the deposit levels in the country’s banking system.

As if the deposit war isn’t concerning enough, the Economist concludes the article by commenting “that banks still have €323 billion of exposure to property developers, which for some is close to four times their core capital.”

Saturday, November 20, 2010

Japan's Demographic Timebomb

Here is a great picture from a recent Economist article (“Into the Unknown”) showing the rapid shift in Japan’s population from 1950 to 2055. From 1955 to 2005, the steadily increasing population of working age people (reflected in the pyramid shape of the left most schematic) and rising productivity of its workforce propelled Japan to become the world’s second largest economy. However, over the next forty years, the working age population is forecasted to shrink so quickly that by 2050 it will be smaller than it was in 1950 (dropping from a high point of 87mm in 1995 to less than 50 million by 2050; see second chart). Similarly, over this timeframe, Japan’s population, currently 127 million people, is expected to fall by 38 million or nearly 30%! By 2050, four out of ten Japanese will be over 65.

As the population ages, the nation’s pension system is becoming increasingly strained. When public pensions were introduced in the 1960s, there were 11 workers for every pensioner. Now there are a mere 2.6, compared with an OECD average of four.

Finally, Japan’s rapidly aging population has resulted in a substantial reduction in the nation’s savings rate. Once above 20% of disposable income, the ratio has dropped to about 2%, and the Economist posits that it could go negative over the next few years. Given that 95% of the government’s debts are financed by domestic savings (primarily banks, pension schemes, and insurance companies), Japan could be forced to seek external financing to sustain its huge public sector debt. Rates would undoubtedly rise under this scenario given that Japan currently borrows at a paltry 10-year rate of 1% from its risk-averse populace.

Given all these facts, its not terribly difficult to sympathize with the bearish thesis surrounding Japanese government bonds.

Thursday, November 11, 2010

Sovereign CDS Spreads Widening in Europe

European sovereign 5-year CDS spreads are blowing out this morning, with Spain at 285bps (+58.5bps), Portugal at 495bps (+78bps), and Ireland 605bps (+65bps). As of now, concerns seem contained to the Euro zone, but I think it is only a matter of time before we start seeing the residual effects spill over into the United States. US treasuries in the belly of the curve (2-5 years) remain well bid, as investors try and front run the Fed’s $600 billion quantitative easing program, but the yields on the long-end of the curve (particularly 30-year treasuries, where the Fed will only do marginal buying) have blown out over the last few days. Yesterday’s weak $16 billion auction of 30-year treasuries could serve as the canary in the coal mine for investors who have been piling into fixed income over the last 18 months.




Here are a few recent articles from the WSJ that address mounting concerns in the Euro zone.

Spain’s Bank Mergers Suddenly Drying Up
QE2 Off its Course: Yields Are Going Up
Ireland’s Next Blow Could be Home Loans

Tuesday, November 9, 2010

Systemic Risks Posed by ETFs

Here is a great report published by Harold Bradley and Robert Litan of the Kauffman Foundation warning about the potential dangers caused by the explosion of ETFs. The authors conclude that the growth in ETFs and ETF derivatives poses more of a systemic danger to the financial system than the advent of high frequency trading. At 84 pages, the report is highly detailed and fairly technical, but definitely worth a read for those interested in learning more about the subject. While I am by no means an expert into the inner workings of the financial markets (at least as it pertains to high speed algorithmic trading), all I could think about as I was reading this report was that we could be facing another October 1987 type-meltdown should regulators continue to ignore the rapid growth in the ETF market.

ETFs have proliferated around the globe at an astounding pace, from roughly ninety at the beginning of this decade to about 450 at the end of 2005 and more than 2,300 today, with another 1,000 or so in the regulatory pipeline (see chart 4).

But there can be too much of a good thing if taken to extremes,and this is now happening with ETFs. From an asset base of about $75 billion a decade ago, ETF assets now approach $1.2 trillion, with trading reaching an astounding $18.2 trillion last year. ETFs have been morphing in new and unexpected ways. Simply put, we will argue here that ETFs and the derivatives built around them have become the proverbial tail that wags the market.

As more ETFs are created, the risk grows that in the event of a future market meltdown triggered by any number of possible causes the rush to unwind the ETFs will aggravate any sell-off. Indeed, some creators of ETFs may not be able to honor their obligations. If those institutions or holders of ETFs are deemed sufficiently important or interdependent with other financial actors, the U.S. government could be forced again to make the agonizing decision whether to come to the rescue, as it did with AIG and a number of other large enterprises during the financial crisis of 2008.