Accounts Receivable

Just how far behind the curve is the Fed?

As the Fed raised its Fed Funds Rate to 1.5~1.75% overnight, one has to question just how far behind is it? 3M Libor rates have surged from 0.5% in 2016, c.1% at the start of 2017 to 2.27% today, the highest levels since 2008.  Normally Libor minus Overnight Index Swap (OIS) rates don’t diverge so much without causing a credit issue. The gap is effectively the market price over and above the risk free rate. At the time of the GFC, the Libor-OIS spread hit 3.5%, with 1% being the detonator level. While it is currently at 0.54% spread, it has risen consecutively for the last 32 sessions.


As Libor drives corporate credit recycling, with corporate debt piles approaching record highs and average credit ratings the worst they’ve been in over a decade (chart below depicts Top tier as AAA and bottom tier as BBB-) we could see the Libor-OIS spread keep expanding.


What could be causing this? If we think logically the US Treasury has to refinance $1.5 trillion over the next 12 months and $8.4 trillion over the next 4 years. Add to that a Fed looking at quantative tapering and a less eager Japan and China as buyers of US$ federal debt then the corporate will undoubtedly get crowded out. The demands for refinancing are not being met with the supply of funds.


Of note, the St Louis Fed reports the YoY increase in inflation reported by the CPI in the US in Feb 2018 was 2.3%. The 10yr breakeven inflation rate is around 2.08%. CPI ex food items is still at 1.9%. In any event the US remains in a negative real yield environment.


The Fed can bang on all it wants about healthy growth, full employment but the depth of problems stored up is getting worse. $9 trillion in unfunded public pension liabilities, $67 trillion in combined public, private and corporate debt…

…many are recently talking of the huge pent-up profit boost to banks which have had such compressed spreads for so long. Indeed that all makes absolute sense from a theoretical (and to date practical) reasoning but banks like those in Australia up to their gills in mortgage debt, rising spreads have far nastier implications for blowing up balance sheets than boosting P&L accounts.

In a sense it is almost futile to call central banks as being behind the curve. The failure to take the harsh medicine of almost two decades ago is gathering momentum in so far as there is not much can left to kick down the road.

Credit card delinquency in America – nothing to see here?


Waltzing through the treasure trove of data at the St Louis Fed, this chart intrigued. It shows delinquency rates on credit cards among the smaller banks. Presumably the smaller banks have to chase less credit worthy customers because they lack the ultimate battleship marketing cannons of the bigger financial instititutions. We’re back at times worse than the highest levels seen during GFC. Among all banks, we are still away off the $40bn of delinqient credit card debts we’re back at levels higher than those before Lehman’s brought financial markets to a grinding halt.


Add to that the step up in interest rates as well to levels we saw before the whole edifice of cards came crumbling down.


Then why worry when the number of financial institutions looking to tighten standards on consumer lending languishes at close to zero, the types of levels we saw ahead of the market collapse? Nothing to see here?


Meanwhile American household savings languish at 3%. Similar levels as just before GFC  melt down. Not much in the rainy day funds. So when Trump’s new economic policy advisor Larry Kudlow starts telling us to back a strong dollar and weak gold, you know exactly what to do.


Moral hazard was supposed to be contained at the private sector level. Looks as though this time around the government is joining the party.

$8.4 trillion of the $21 trillion in US debt matures in 4 years. What could possibly go wrong?

E0F20948-4A5A-48F1-B8AF-06FA92EBAC7AWith a US Fed openly stating it is looking to prune its bloated balance sheet by around $2 trillion, it seems that $8.4 trillion of that debt held by the public matures within the next 4 years according to the US Treasury. To that end, debt maturing in the next 10 years totals $12.233 trillion. It needs to be ‘rolled over’. The national debt pile has jumped $1 trillion in the last 6 months. After the GFC and an overly accommodative central bank, the Treasury took advantage of this free money. Under President Obama, the debt doubled. That’s right, debt in his 8 years equaled that of the previous 43 administrations combined. Most of it was short term meaning the mop up operation starts earlier.

While there is little doubt this $8.4 trillion will be recycled, the question is at what price. With rising rates and a Fed back-pedaling one would expect the interest bill can only lift. At the moment the US federal government pays around $457 billion p.a. in interest alone. Average interest rates rose for the first time since 2006. Were average rates to climb back to 2007 levels then the interest bill alone would surpass $1 trillion.


This global aversion to tightening belts continues. Many US corporations have taken the same approach to their balance sheets as the government as pointed out in the previous example on GE. Lever up and be damned with the credit rating as the spreads have been almost irrelevant to higher rated paper. It has been a financially credible decision to lower WACC and increase ROE provided one didn’t lose control and overdose on free money. However the relatively short duration on corporate debt is facing a similar refinancing cliff as the US government.

All this cumulative debt needing refinancing while credit ratings are on average the worst they’ve ever been in a rising interest rate environment coupled with a bubble in bonds while a growing number of these levered consumer and industrial stocks have negative equity. What could possibly go wrong?

Do we see the Fed reverse its decision and embark on more QE? Indeed to do such a thing would tank the dollar and send the yen back towards the 70s to the US$. Interesting times ahead. Throw on the $7 trillion shortfall in state public pension liabilities and watch the fire from the other side of the river. Finally some university think tank has come out saying that wiping out the $1.5 trillion in student debt would be ‘stimulatory’ to the economy adding 1.5 million jobs. What a world we live in when we get to walk away from responsibility and accountability.

GE’s Goodwill is Electric

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It seems that GE’s woes are going from bad to worse. While the shares have been slayed as earnings have been restated and restructuring is underway pundits are wondering whether the horror is properly priced in. GE, in the days of CEO Jack Welch was a killer. A $500bn wrecking ball which claimed it had to be a Top 3 in everything it did or it wasn’t worth it. GE is now worth $122bn, the stock halving since the start of 2017. Goodwill on the balance sheet has exploded from $68bn to $83bn while shareholders equity has slid from $76bn to $64bn. So subtracting the Goodwill from shareholders equity gives us minus $18.7bn.

Goodwill refers to the amount paid, when acquiring a company, that is in excess of fair value of the firm’s net assets. Let’s say the fair value of Company A’s net assets are $8bn, and Company B purchases Company A for an amount which corresponds to $11bn. After the transaction, Company B will be left with $3bn worth of Goodwill on its balance sheet. The intangible value expressed by goodwill is what Company B believes will exist in the combined company down the line in things such as brand name. However Goodwill has the potential to inflate the perceived level of Shareholder’s Equity in a company. Let’s say Company B has $20B worth of assets, $19B worth of liabilities, and $1B worth of shareholder’s equity. As this $3bn goodwill amount is a non-cash asset, and furthermore unlikely to ever be converted into anything of value to the corporation, then the argument could be made that Company B actually has negative $2B worth of equity. In GE’s case, it has almost $19bn in negative equity.

Interesting to note that Parker Hannifin was also in negative equity at its FY2017 close. When looking at many Japanese industrials like Komatsu or Amada they are comfortably in positive equity. So when the stock market eventually lunches itself, the American industrials do not appear to have the same meat in the balance sheet as the Japanese. Which sort of tells us that GE, as much as investors seem to be wanting to catch that falling knife, may be well advised to wait much longer. The word “too big to fail” somehow resonates much less these days.

As we wrote several weeks ago, the ratings agencies have made it clear that the average quality of US corporate debt has deteriorated severely over the last decade. Much of it was thanks to leveraging up at such chronically low interest rates.  One could argue it was rational however it seems it became addictive, driving merciless M&A deals which loaded all this goodwill on the balance sheet in the quest to drive ROE. The corporate bond spreads between AA and BBB- is currently a paltry 75bps (0.75%). Please refer to page 21.

With the US Fed curtailing its balance sheet and $9 trillion of short term national debt funding needing recycling in the near term, that corporate bond interest rate differential is unlikely to stay so tight. This could turn pear shaped very quickly.

Should we trust ratings agencies on US state credit?


The Financial Crisis Inquiry Commission concluded in 2011 that “the global financial crisis could not have happened without the ‘Big Three’ agencies – Moody’s, Standard & Poor’s and Fitch which allowed the ongoing trading of bad debt which they gave their highest ratings to despite over three trillion dollars of mortgage loans to homebuyers with bad credit and undocumented incomes.” The table above tabulates the deterioration in US corporate credit ratings since 2006. The ratings agencies have applied their trade far more diligently.

As written earlier in the week, US state public pensions are running into horrific headwinds. Unfunded pension liabilities are running at over double the level of 2008. With asset bubbles in stocks, bonds and property it is hard to see how plugging the gap (running at over 2x (California is 6x) the total tax take of individual states) in the event of a market correction is remotely realistic. However taking a look at the progression of US states’ credit ratings one would think that there is nothing to worry about. Even during GFC, very few states took a hit. See below.


Looking at the trends of many states since 2000, many have run surpluses so the credit ratings do not appear extreme. It is interesting to flip through the charts of each state and see the trajectory of revenue collection. A mixed bag is putting it lightly. Whether the rebuild after Hurricane Katrina in 2005, since 2008 revenue collection in Louisiana has drifted.


Looking through S&P’s own research at the end of last year it included an obvious reference.

U.S. state and local governments can use pension obligation bonds (POBs) to address the unfunded portion of their pension liabilities. In certain cases, POBs can be an affordable tool to lower unfunded pension liabilities. But along with the issuance of POBs comes risk. The circumstances that surround an issuance of POBs, as well as the new debt itself, could have implications for the issuer’s creditworthiness. S&P Global Ratings views POB issuance in environments of fiscal distress or as a mechanism for short-term budget relief as a negative credit factor.”

Perhaps the agencies have learnt a painful lesson and trying to stay as close to being behind the curve as possible. It doesn’t seem like public pensions are being factored at levels other than their actuarial values. Marked-to-market values would undoubtedly impact these credit ratings.

As mentioned in the previous piece on public pensions, a state like Alaska has public pension unfunded liabilities equal to $145,000 per household, treble the 2008 figure. It is 3.5x annual tax collections. The state’s per capita operating budget of $13,728 per person is way above the national average of $6,826 per person. Alaska relies on oil taxes to finance most of its operating budget, so a sudden drop in oil prices caused tax revenues to sharply decline. The EIA’s outlook doesn’t look promising in restoring those fortunes in any scenario. So S&P may have cut Alaska two places from AAA in 2015 to AA in 2017.


While pension liabilities aren’t all due at once, the last 8 years have shown how quickly they can fester. It wasn’t so long ago that several Rhode Island public pension funds reluctantly agreed to a 40% haircut, later retirement ages and higher contributions with a larger component shifted from defined benefits to defined contributions raising the risk of market forces exerting negative outcomes on the pension fund.

In 2017, despite a ‘robust’ economy, 22 states faced revenue shortfalls. More states faced mid-year revenue shortfalls in the last fiscal year than in any year since 2010, according to the National Association of State Budget Officers.


Pew Charitable Trust (PCT) notes in FY2015 federal dollars as a share of state revenue increased in a majority of states (29). Health care grants have been the main driver of this. FY2015 was the 3rd highest percentage of federal grants to states since 1961.


By state we can see which states got the heftiest federal grants. Most states with higher federal shares expanded their Medicaid programs under Obamacare (ACA) and got their first full year of grants under the expanded program in FY2015.


PCT also wrote “At the close of fiscal year 2017, total balances in states’ general fund budgets—including rainy day funds—could run government operations for a median of 29.3 days, still less than the median of 41.3 days in fiscal 2007…North Dakota recorded the largest drop in the number of days’ worth of expenses held in reserves after drawing down almost its entire savings to cover a budget gap caused by low oil prices. It held just 5.4 days’ worth of expenditures in its rainy day fund at the end of fiscal 2017 compared with 69.4 days in the preceding year… 11 states anticipate withdrawing from rainy day funds under budget plans enacted for fiscal 2018


Looking at the revenue trends of certain states, the level of collection has been either flat or on the wane since 2010 for around 26 states. As an aside, 23 of them voted for Trump in the 2016 presidential election. The three that didn’t were Maine, NJ and Illinois.

Optically US states seem to be able to justify the credit ratings above. Debt levels aren’t high for most. Average state debt is around 4% of annual income. Deficits do not seem out of control. However marking-to-market the extent of public pension unfunded liabilities makes current debt levels look mere rounding errors.

Considering stock, bond and property bubbles are cruising at unsustainably high levels, any market routs will only make the current state of unfunded liabilities blow out to even worse levels. The knock on effects for pensioners such as those taking a 40% haircut in Rhode Island at this stage in the cycle can only feasibly brace themselves for further declines. This is a ticking time bomb. More states will need to address the public pension crisis.

A national government shelling out c.$500bn in interest payments on its own debt in a rising rate environment coupled with a central bank paring back its balance sheet limits the options on the table. Moral hazard is back on the table folks. Is it any wonder that Blackstone has increased its short positions to $22 billion?


The $6.7 trillion US public pension black hole


Zerohedge published this report today on the $1.2 trillion public pension black hole in America. Time to update the latest stats of a report CM wrote in August 2016 on the very same topic. Here is betting things have only got worse.  Taking California Public Employees Retirement Scheme (CalPERS). In 2014 market pension debt per household was $77,000. In 2016 it hit $122,000. In 2008 it was only $36,000. US Pension Tracker reports that the 2016 marked-to-market figure of the total US public pension deficit is $6.734 trillion vs actuarial basis of $1.467 trillion.

Kobe ‘Steal’ – will the market referee wave a red card at what looks a lot like insider trading?


If the referee caught Kobe Steel’s (5406) rugby team up to such foul play it is likely that players would be red carded. While unconfirmed speculation at the moment, it would appear that since September 21st Kobe Steel shares came under heavy selling pressure in what a seasoned market punter might suspect looks like insider trading via aggressive short selling. 7 straight negative candle sticks. Kobe Steel spilled the ball on its data manipulation on October 8th.

This would not be the first time that a broker conspired with a fund to short sell a stock ahead of a negative release on insider information where several weeks later news broke and sent the shares collapsing. This is the current action of Kobe Steel shares.


So excluding borrowing costs or any leverage, if one had managed to short sell Kobe Steel at 1350 (on Sep 21) and brought back at today’s prices a quick fire 53% return would be gained.

The important question is whether the regulator will investigate any potential foul play when looking at the video replay. I will be asking this question directly to the Financial Services Agency (FSA) as I have been invited the regulator to give a speech on ways to improve Japanese corporate governance in a few weeks time.

This won’t be just a beat up of Japan’s corporate governance as foreign corporates have made countless scandals post the introduction of Sarbanes Oxley in 2002.  However it will aim to be a realistic overview of tolerating what seems to be endless preventable insider trading scams with paltry penalties of $500 and a slap on the wrists with a feather duster.

Until serious punishments for flagrant market manipulation are thrust front and centre in front of bewildered and annoyed (foreign) investors, the cynicism will remain that Japan is not a safe place to invest. Remember insider trading is effectively fraud. Perhaps your pension fund owns Kobe Steel in a global portfolio meaning that some shady investor has stolen your retirement to feather his or her nest.

Perhaps I should thank Kobe Steel for getting dirty in the ruck area to help the final presentation draft.