Weekly T Report: What a Week! LIBOR, JPM, Spain, China, Earnings, Ireland

LIBOR

LIBOR remains an issue for the banks involved. Many of the headlines are confusing, and some are just plain wrong. This issue isn’t going away any time soon, so understanding the potential impacts will be key as reactions to headlines will create opportunities.

• Only banks that were part of the LIBOR panel can get in serious trouble. In the U.S. the only banks that contributed were JPM, Citi, and BAC. GS, MS, WFC, JEF, etc., did NOT contribute to LIBOR so should not have any serious litigation risk. If you want exposure to banks but are extremely concerned about the LIBOR issue, there are choices.
• Pre Financial Crisis LIBOR has the problem that this is when many of the most damning and blatant e-mails from Barclay’s occurred. It is clear they were attempting to manipulate LIBOR. From the FSA report, it looks like other banks may have been involved. In the end, the markets were so calm that the manipulation had minimal, if any effect. This period will likely bring fines, possible sanctions, and firings, but will not turn into a big litigation risk for the banks.
• During the Financial Crisis, different and potentially serious issues arose. It looks like Barclay’s spent a period of time complaining and warning that other banks were submitting LIBOR that was too low. Then it appears that they may have started submitting low LIBOR quotes as well. The market, so far has focused on whether Barclay’s started submitting LIBOR that was too low. While bad, the bigger issue, is whether other banks were submitting LIBOR quotes that were too low for even longer. This may be difficult to prove, but if there are serious litigation risks, they are going to come from manipulation during this period, because the range of quotes is so large it was possible to move LIBOR by a meaningful amount (even a single dealer could have moved it by 3-5 bps).
• LIBOR affects many loans, interest rate derivatives, and Eurodollar future contracts. Any contract that referenced LIBOR was at risk of being impacted if LIBOR was in fact manipulated. If LIBOR was manipulated on a “setting” date for any particular contract, then either the party paying or receiving LIBOR would have lost (the other would have benefitted). So if LIBOR was off by 10 bps or more for an extended period, as some suggest it could have been during the Financial Crisis, then the litigation risk grows.
• Some banks may have submitted low LIBOR quotes even though they were receivers of LIBOR. On the surface this seems counterintuitive since it would reduce their income, but at the time, the “signaling” risk was a bigger concern than forgone income. There was real fear that high LIBOR submissions would attract bear raids, crippling the bank with the high submission. It is also possible that a panel member who didn’t ever lie, was hurt by submissions which could result in one panel member suing another.
  
• Can anyone with a LIBOR contract that was impacted sue the lying bank(s)? This is the big question. If you were receiving LIBOR and LIBOR was set artificially low because of fraud by one or more banks, what can you do? It seems that there would be a case to sue the lying bank(s) even if you did not have a contract on with them. That would be the worst case, as the lying bank(s) would face all the losses their actions caused. Far less extreme, would be if all a “LIBOR Loser” could do was sue their counterparty under the basis that LIBOR had been miscalculated and they owed payment retroactively. This would be a pain as each receiver would have to sue their payer, who may or may not have been a LIBOR bank. This could result in payments throughout the entire system and would be unclear if there would be any big net losers. This method has some appeal because all it would do is try and enforce payments that would have been made if LIBOR had been set correctly. Liar banks would love this outcome; whereas some could be devastated if anyone negatively impacted could sue the LIBOR bank.
  
• Regulators, a blind eye, tacit complicity, or outright encouragement. Okay, I left out “diligent efforts to enforce rules, stymied at every opportunity”, but that doesn’t really seem to be the case. The regulators in general wanted to ease bank funding. They wanted to see LIBOR going down. Low LIBOR would have been a sign that the Fed and BoE had been successful in calming the markets. They were taking action after action to help reduce pressure on bank funding, so while they wouldn’t want to see LIBOR come down based on lies, they may chosen not to dig deep and decided it was just a function of their policies and programs working so well. It seems unlikely that the regulators will avoid any fallout. That may also impact what litigation occurs as the Fed is explicitly immune from lawsuits.
  

There will remain headline risk for the banks involved. In some cases it may already be overdone. The deeper I dig into Barclay’s, it looks like in the pre-crisis period they shamelessly tried to manipulate LIBOR on days it suited them. They have paid the fine for this, but since their manipulations seemed to fail, there may not be much further cost. During the crisis it really is looking like they may have been more honest than others and that they may have even tried to act as whistleblowers. Some banks may not have been impacted enough yet. In any case, following the headlines, understanding what they mean, and reacting properly should create some nice opportunities in the banking space, both for the LIBOR banks and those not involved.

JPM made $1.09 per share

I really am not sure that I saw that headline. I saw $4.4 billion loss in the CIO office over and over, but the reality is the firm made $1.09 in Q2 (not including DVA and had a small adjustment to Q1).

Has the dirty rotting stinking whale carcass finally been dragged from the shore? The taint is still there, but JPM should now be able to move beyond this. JPM should be on track to restart their share buyback program in Q4. Q3 should be another good quarter as they kept most of the CIO’s available for sale bond portfolio and can harvest that as they need. Also, I am convinced that the residual whale positions that were transferred to the investment bank, were done at prices and with enough “liquidity” reserves that they should provide some nice profits for the bank as they continue the unwind.

The bigger question is what does JPM look like next year? I think they have to be examining a way to split up the bank. Not only is the regulatory scrutiny making it hard to make money, but it makes it hard to retain talent. JPM has many extremely capable traders/risk managers who are not able to use their skills in an environment where risk taking is not tolerated. The best and brightest will leave as more of their cheap 2008 and 2009 stock vests. It would be a complete waste to lose all these good people, so expect employee retention to be another impetus to find away to split into a regulated and non-regulated entity. The funny part is that most of the people who went ballistic over the whale trade would probably prefer to invest in the higher risk entity in the end.

With LIBOR a remaining cloud over the bank, I’m not sure the stock can get back to its May 10^th pre-whale announcement close of 40.74, but the May 11^th close of 36.96 still seems achievable, and they have had a dividend “ex-date” since then.

3 Days Without Writing About Spain

Europe was finally a little off the radar screen. The Spanish Financial Sector Bailout memorandum of understanding was leaked. It was okay. It wasn’t great and is still lacking some details, but I gave it an initial grade of C+/B- and that seems to be higher than the market was expecting. We need details and if rumors of cheap 10 year loans turn out to be true, the program could get upgraded further.

The Spanish bond market didn’t do too much. The 5 year bond ended the week at 5.76%, an improvement from last Friday’s close of 6.09% but the volatility remains high, with the 5 year peaking at 6.34% on Monday. The 5.76% close is still well above the most recent tight of 5.29% on July 3^rd (is it just me, or does that seem so long ago?).

So Spanish and Italian yields haven’t responded wildly to any details, but they seem to have stabilized, and the market seems able to ignore them for now as it puts some faith that the EU will ultimately continue to take incremental steps to mitigate the problem, for at least a period of time.

One very encouraging sign was that the broader credit markets in Europe also were able to segregate themselves from the Spanish and Italian bond market. The equity markets have often been able to ignore what is going on in sovereign debt markets (usually with much regret), but until recently, the broader credit market moved very much in line with sovereign debt.

This week, MAIN (the European Investment Grade CDS index), only moved 1 basis point wider on Monday, when Spain was being taken to the woodshed. Even during the rest of the week, MAIN remained in a pretty tight range (172.5, 168.5, 167.5, 168.5, and 166.25 were the closing prices).

If it was only equities that managed to ignore the ongoing problems in Spain and Italy I would be less sanguine, but MAIN’s price action was encouraging, and in the U.S. we saw similar stability all week in IG. It traded in a very tight range, and was actually a bit weak on Friday, but the stability was evident even when stocks were struggling. The credit markets feel healthy.

The Opportunity In High Yield

Credit markets as a whole felt healthy, and high yield was no exception. HYG ended the week unchanged and traded in a very narrow range. That is probably about as well as it can do at this stage. As we have been writing for awhile, the big “go go” names that form the core of the indices (and the ETF’s that match the indices) have little upside left. Too many long duration bonds trade at low yields so cannot get much more price appreciation and actually have a lot of rate risk. Too many other bonds are trading to short dated calls so the convexity is awful as it limits the upside.

Careful selection of individual credits and even individual bonds will be the deciding factor in generating real upside from high yield. Sticking with the most liquid names will likely increase volatility since fast money is overweight these bonds and fast money tends to all sell at the same time. At the same time, returns are lower because the liquid bonds trade at a noticeable premium.

Shifting to less liquid bonds is one way to improve return potential without sacrificing credit quality.

Another way, that hedge funds in particular need to look at, is the high yield CDS market and high beta names in particular. As I wrote yesterday, there is opportunity here as it looks cheap, but there is reason to believe that the “technicals” are changing, making this area of high yield risk even more attractive.

China

Did China land? For the first time, the data out of China seemed to be stabilizing, or at least not going down as fast as prior weeks. There is hope of stimulus. I think this is likely to occur. Talking to various officials, I got a sense that they have a pragmatic view of what can be done and what needs to be done. I don’t think we have the final answer on how bad the Chinese economy can deteriorate, but it looks like we are going to get a period of relief from the daily evidence of further deterioration.

Ireland and Portugal

Still a little off the radar screen, but further evidence that they are turning the corner. The 5 year bond yield is down to just over 5% and I read that their banks are actually seeing deposit growth. Is this the poster child that not every country that hits the bailout stage deteriorates into Greece?

Even Portugal is below 10% in five years. The Portuguese 5 year bond was over 14% in May and is now 9.5%. In price terms it moved from 68 to 82 in less than 2 months.

Returns like that are hard to ignore. It is easy to argue that the returns are artificial as the markets are thin and it is completely dependent on government and central bank support, but if markets are going to remain thin and government and central bank support is going to continue, it can help sway more investors over from the fear to greed stage in the peripheral debt arena.

Earnings

So far earnings have had a far greater impact on specific names rather than the market as a whole. Or at least it seems that way to me. There was so much macro data this week that much of the micro data was overlooked.

Clear signs that earnings momentum has slowed or is even reversing, but the market seems to have anticipated that, and so far, the comments about the future aren’t universally disastrous. I still have found little evidence that CEO’s are any better are predicting the global economy 3 months from now, but somehow we take comfort in their views.

Without so much attention on the whale trade, the market may have picked up on indications that both JPM and WFC are seeing improvements in their credit portfolios. I’m certainly not ready to declare an end to the bear market in housing, but more and more evidence points to a stabilization in that market, and more investors are poking around looking for cheap housing related investments, where mere stability can provide high returns.