#negativeequity

Let shareholders burn

We buy shares because we expect to gain a return. We all know there are risks attached. As we wrote yesterday on Boeing, it has embarked on reckless buybacks which have compromised the balance sheet. The company has drawn down all of its $13.8bn in credit lines from banks overnight. It is panic stations. It was completely avoidable.

How ironic that companies which are among those that splurged $4.5 trillion on share buybacks just to chase short term management incentives will be the first lining up for taxpayer support to save them from negligent governance.

We say shareholders should suffer the downside of that investment choice. They had the power to remove officers from the companies they entrusted management to. If a company goes belly up, let other players in the market pick up the spoils for fire sale prices.

The Wolf Street correctly noted,

The Trump administration is putting together a rumored $850-billion stimulus package that will include taxpayer funded bailouts of Corporate America, according to leaks cited widely by the media. Trump in the press conference today singled out $50 billion in bailout funds for US airlines alone. A bailout of this type is designed to bail out shareholders and unsecured creditors. That’s all it is. The alternative would be a US chapter 11 bankruptcy procedure which would allow the company to operate, while it is being handed to the creditors, with shareholders getting wiped out.”

All this Trump package will do is encourage the same bad behaviour. We think this is nothing more than trebling down on the problems that hit us in 2008. But hey, it’s an election year!! Reckless.

As usual, the SEC has been asleep at the wheel. Same as in the lead up to 2008. This is what happens when regulators hire clueless lawyers who don’t have a clue about how markets operate. Therefore they miss crucial events.

As for shareholders – you earned it.

The only upside to this market volatility is that no one has talked about climate change for weeks! Probably because when people are about to lose their livelihoods, all of a sudden virtue signaling is worthless. That goes for diversity and inclusion too. Every cloud has a silver lining.

Boeing’s negative equity & prospect of zombie lending

We should have seen this earlier. One sign of trouble in industrial businesses can be seen through the lens of the cash conversion cycle (CCC). A CCC that is positive essentially means that payables are being executed way before receivables are being banked. Rising CCC is never a good thing. Amazon is at the other end of the spectrum with negative CCC which means they receive payment before delivery.

Note Boeing has seen its CCC blow out from around 124 days in Dec-2010 quarter to 344 days in Dec-2019. Effectively Boeing is sucking up a year of net receivables before collecting them. What escaped us is that the company is trading in negative equity at present and it will be a hard balancing act to let such CCC get much larger to a group that is so under the fiscal pump.

We recall the difficulties the supply chain had under the delayed 787 program in the early 2000s. Parts suppliers were bleeding because they’d invested and prepared for an expected ramp-up that ended up arriving 3.5yrs later than anticipated. All that high fixed capital formation and inventory that needed to be paid for by a client that couldn’t take delivery. Boeing tried to muddle through but was ultimately forced to rescue suppliers to keep them alive after some faced the brink. Boeing bought some suppliers in house.

One imagines the 737MAX delays will exacerbate the CCC again although Boeing contends it is in cash conservation mode. Coronavirus can only add to the misery of airlines reluctant to add to fleets where capacity is being slashed aggressively. Just look at the self-isolation bans being put in place in recent days. Who wants to holiday abroad if told they’ll spend two weeks in their hotel room feasting on room service? Airlines get the efficiency of new aircraft helping operating performance but at the same time running any planes at 20% capacity won’t help.

This is only going to get worse. For all of the pain of a much higher unit volume plane yet to be approved for flight, Boeing cash flows are being tortured. It is incredible that the shares had held on so well during the MAX crisis.

It is interesting to note that Boeing is trading in a state of negative equity. Liabilities are greater than assets. Where is the press on reporting this? It is hardly trivial for a business that hasn’t even faced the worst of its struggles.

Just like we wrote two years ago about GE, Boeing went straight down the line of monster share buybacks. $43bn to be exact since 2013. Over half of the buyback has been conducted at share prices above the current level. The goodwill and intangibles on Boeing’s balance sheet total $11.398bn. Equity at minus $8.3bn. So negative $20bn.

bA

We did the following infographic some 3 years ago but the trend has deteriorated further. As we can see AAA-rated (top) stocks in the US have dwindled while BBB+ and below has surged. It is estimated that over 50% of US corporates have a rating below BBB. That is the result of artificially low-interest rates which have lured companies to borrow big and splurge on buybacks. Our biggest worry is if the market starts to reprice corporate debt accordingly, such as what happened to Ford when it was dropped to junk.

IMG_0523.PNG

So the question remains how does Boeing manage to get out of this pickle? Even if MAX gets certified, airline cash flow is being crippled. How big will discounts need to be in order for airlines to take on new planes? At the moment one imagines many airlines are deferring deliveries (787, 777 etc) until they get a clearer picture.

Boeing has delivered 30 aircraft in the first two months of 2020. At the same time last year, Boeing had delivered 95 planes. A lot of MAX impact but we imagine March will be even worse.

Airbus delivered 86 aircraft so far in 2020. At the same time last year, Airbus delivered 88 planes.

Think of the major gateway that is Hong Kong International Airport. It’s passenger flow for February 2020 – minus 68%! 6 months of this type of crippling volume would be catastrophic for airlines. 9-11 was a watershed moment for the aviation industry where the confidence to get back on a plane turned quickly after the terror attacks. Now we have a situation where passengers would be more than willing to fly again but governments simply aren’t letting them. The problem is whether they will be in the same financial position to fly if the virus isn’t contained rapidly

One sweet spot for Boeing is that it is a major defence contractor which means that government bailouts are a given. Sadly, shareholders shouldn’t think this current share price collapse has finished. Boeing feels a lot like mimicking GE when it sunk to $6 from over $30.

It is probably worth referencing AerCap Holdings which owns International Lease Finance Corporation (ILFC) one of the big two commercial aircraft leasing companies. Its share price has cratered from a high of $64.79 to $24.50. Moody’s affirmed the “Baa3” ILFC this month.


AerCap

The company has 3.1x leverage. $36bn of property (mostly planes) on its books. The shares are trading at 0.35x tangible book value presumably because the market is forecasting the value of the tin is going to fall through the floor if leased planes return from airlines that have been forced to cut costs or go bankrupt.

The only crux is the future appetite of investors to support AerCap in the debt markets. It has $17.5bn in unsecured notes and $9.8bn in secured debt with a further $2.3bn in subordinated, mostly via a 2079 maturity bond issue. The maturity profile is still comfortably beyond 2028. No problems just yet but times are only just starting to get challenging.

Of note, AerCap is paying $1.295bn in interest charges on $29.5bn of debt. Leasing rents from its airline customers total $4.281bn. It all comes down to the assumption that its multiple airline customers can keep honouring those payments or whether the leasing companies are forced to renegotiate their deals in order to keep the customer alive. The last thing a leasing company needs is a flood of aircraft to return because customers go belly up. Fingers crossed there is no zombie lending to avoid having to mark-to-market the value of the fleet (assets) which would flip the ratings and refinancing prospects considerably. The balance sheet would be slammed.

With so many financial excesses built into the global economy, a prolonged spell of coronavirus containment will come at the expense of a crippling economic armageddon which will undo so much of the disastrous can-kicking we’ve become accustomed to. You can’t quarantine the world for 6 months and expect a tiny ripple.

CLies IT

It is not the disease we need to worry about per se. It is government and central bank incompetence over the last 20 years which has created a situation where we are out of ammunition to rescue the situation because expediency is so much easier for voters – comforting lies are easier to take than inconvenient truths.

Be sure to reference our thoughts on

Aussie banks,

Aussie government debt,

central banks and the

pension crisis ahead.

ScoMo does Westpac a favour via first home buyer scheme

What a joke our government is. Whack Westpac over the head again because it has been a “very naughty boy” by banning it from the government’s first home buyer deposit scheme. While it might look good in front of voters to bash a bank, what they don’t realize is Westpac actually wins.

Westpac should count it’s blessings. Honestly. Piling first home buyers in at the top of the property bubble is hardly the best scheme for prudent risk management. Given the banks haven’t been granted the ability to properly risk adjust for these buyers, it works in Westpac’s favour to be booted from this ridiculous plan.

Here is the deal. Although ‘owning’ one’s own home has always been part of the Game of Life in Australia, at what point will our law makers look to failure in policy as a reason kids can’t join the property ladder instead of trying to grant their wish and saddle them with negative equity right around the corner? Perhaps address productivity, tax reform and unnecessary red tape as opposed to bash a bank, tighten the regulatory noose and eject them from the sandpit by subsidizing a future car wreck.

In reality the scope of business Westpac may have made from this scheme is likely to be so small it would be a rounding error to the group. Yet more virtue signaling from our political class. Utter. Waste. Of. Time.

STAY IN YOUR LANE!!!

Since when did the Australian Prudential Regulatory Authority (APRA) become an axe on climate change? Next thing we will see is 16yo Greta Thunberg, of school climate strike fame, adorning APRA releases and annual reports. APRA should stay in its lane as the only disaster on the horizon will be self inflicted.

In the AFR today, it was reported that the financial services sector regulator said, “there is no excuse for inaction on climate change, warning there is a high degree of certainty that financial risks will materialize as a result of a warming climate.”

APRA noted that only 1 in 5 companies are meeting voluntary climate risk disclosure targets which are set out by the Task Force in Climate-related Financial Disclosures, a private sector body chaired by none other than global warming alarmist Michael Bloomberg.

What in the world is APRA doing trying to implement guidelines put forward by a body backed by an agenda? Has APRA considered the wealth of literature debunking global warming? The plethora of scandals that have befallen the UNIPCC, NOAA and even our own Bureau of Meteorology! Has it considered the dozens of dud predictions made by the IPCC? The UN climate science body has publicly climbed down from so many alarmist claims, citing no evidence or extremely low confidence. Can APRA put hrs numbers on what global warming might do?

To be honest, APRA should stay in its lane. It follows on from the lunacy spread by the Reserve Bank of Australia (RBA) on the same topic. The only “high degree of financial risk” will come from their own terrible stewardship of the financial sector.

As CM wrote late last year Australian banks are in a terrible position financially. CM believes there is a high risk that some of Australia’s major banks will end up all or part nationalized when the property market bursts. To quote some excerpts:

In the late 1980s at the peak of the property bubble, the Imperial Palace in Tokyo was worth the equivalent to the entire state of California. Greater Tokyo was worth more than the whole United States. The Japanese used to joke that they had bought up so much of Hawaii that it had effectively become the 48th prefecture of Japan. Japanese nationwide property prices quadrupled in the space of a decade. At the height of the frenzy, Japanese real estate related lending comprised around 41.2% (A$2.5 trillion) of all loans outstanding. N.B. Australian bank mortgage loan books have swelled to 63% (A$1.7 trillion) of total loans

From the peak in 1991/2 property prices over the next two decades fell 75-80%. Banks were decimated.

In the following two decades, 181 Japanese banks, trust banks and credit unions went bust and the rest were either injected with public funds, forced into mergers or nationalized. The unravelling of asset prices was swift and sudden but the process to deal with it took decades because banks were reluctant to repossess properties for fear of having to mark the other properties (assets) on their balance sheets to current market values. Paying mere fractions of the loan were enough to justify not calling the debt bad. If banks were forced to reflect the truth of their financial health rather than use accounting trickery to keep the loans valued at the inflated levels the loans were made against they would quickly become insolvent. By the end of the crisis, disposal of non-performing loans (NPLs) among all financial institutions exceeded 90 trillion yen (A$1.1 trillion), or 17% of Japanese GDP at the time.

In 2018, Australia’s GDP is likely to be around A$1.75 trillion. Our total lending by the banks is approximately $2.64 trillion which is 150% of GDP. At the height of the Japanese bubble, total bank lending as a whole only reached 106%. Mortgages alone in Australia are near as makes no difference 100% of GDP...

…In Westpac’s full-year 2018 balance sheet, the company claims around A$710 billion in assets as “loans”. Of that amount, according to the latest APRA data, A$411 billion of lending is ‘real estate’ related. Total equity for the bank is A$64.6 billion. So equity as a percentage of property loans is just shy of 16%. If Australia had a nationwide property collapse (we have not had one for three decades) then it is possible that the banks would face significant headwinds.

What that basically says is if Westpac suffered a 16% decline in the value of its entire property loan book then it would at least on paper appear in negative equity, or liabilities would be larger than assets. Recall in 2009 that BoA had over 16% of its residential loan portfolio which went bad.

We ought to be extremely worried if our financial regulators are devoting any time to this utter nonsense. It is highly doubtful that APRA could gain any meaningful insights on climate change even if there was 100% compliance with Bloomberg’s diocese. Utterly embarrassing.

Complacency kills – the ticking time bomb for Aussie banks

クリックすると新しいウィンドウで開きます

In the late 1980s at the peak of the property bubble, the Imperial Palace in Tokyo was worth the equivalent to the entire state of California. Greater Tokyo was worth more than the whole United States. The Japanese used to joke that they had bought up so much of Hawaii that it had effectively become the 48th prefecture of Japan. Japanese nationwide property prices quadrupled in the space of a decade. At the height of the frenzy, Japanese real estate related lending comprised around 41.2% (A$2.5 trillion) of all loans outstanding. N.B. Australian bank mortgage loan books have swelled to 63% (A$1.7 trillion) of total loans.

REpx.png

Sensing the bubble was getting out of control, the Bank of Japan went into a tightening rate cycle (from 2.5% to 6%) to contain it. Unfortunately it led to an implosion in asset markets, most notably housing. From the peak in 1991/2 prices over the next two decades fell 75-80%. Banks were decimated.

In the following two decades, 181 Japanese banks, trust banks and credit unions went bust and the rest were either injected with public funds, forced into mergers or nationalized. The unravelling of asset prices was swift and sudden but the process to deal with it took decades because banks were reluctant to repossess properties for fear of having to mark the other properties (assets) on their balance sheets to current market values. Paying mere fractions of the loan were enough to justify not calling the debt bad. If banks were forced to reflect the truth of their financial health rather than use accounting trickery to keep the loans valued at the inflated levels the loans were made against they would quickly become insolvent. By the end of the crisis, disposal of non-performing loans (NPLs) among all financial institutions exceeded 90 trillion yen (A$1.1 trillion), or 17% of Japanese GDP at the time.

The lessons are no less disturbing for Australia. Don’t be surprised to hear the authorities and local banks champion stress tests as validity that we are safe from any conceivable external shock. The November 2018 Reserve Bank of Australia minutes revealed that the next rate move is likely up but the board is happy to sit on its hands because housing is slowing even at 1.5% cash rates.

With US rates heading higher, our banks are already facing higher funding costs because of our reliance on overseas wholesale markets to fund mortgage lending. Japanese banks have 90%+ funding from domestic deposits. Australia is around 60-70%. Our banks need to go shopping in global markets to get access to capital. Conditions for that can change on a dime. External shocks can see funding costs hit nose bleed levels which are passed onto consumers. When you see the press get into a frenzy over banks passing on more than the rate rises doled out by the RBA, they aren’t just being greedy – a large part is absorbing these higher wholesale funding costs.

What about America? Who could forget former Goldman Sachs CEO and US Treasury Secretary Hank Paulson tell us how robust US financial institutions were right before plugging $700 billion to rescue the crumbling system? US banks such as Wells Fargo, Citi and Bank of America (BoA) have been reducing mortgage exposure relative to total loans outstanding. Yet each received $10s of billions in TARP (bail out funds) courtesy of the US taxpayer.

By 2009 the Global Financial Crisis (GFC) had turned over 16% of Bank of America’s residential mortgage portfolio into either NPLs, mortgage payments over 90-day in arrears or impaired (largely from the shonky lending practices of Countrywide (which BoA bought in 2008). Countrywide’s $2.5bn acquisition price turned out to cost BoA shareholders a further $50bn by the end of the clean-up. Who is counting?

Oh no, but Australia is different. Residential property prices in Australia have had a far steadier rise over a longer period – a 5-fold jump over 25 years – meaning our local banks should be less vulnerable to external shocks. There is an element of truth to that, although it breeds complacency.

Property loans in Australia as at September 2018 total A$1.653 trillion. 82% of those loans are made by the Big 4 banks. Interest only loans are around $500 billion of that. As a percentage of total loans outstanding in Australia, mortgages make up 65%. The next is daylight, followed by Norway at around 40%. US banks have cut overall property exposures and Japanese banks are now in the early teens. Post GFC, US banks have ratcheted back mortgage exposure. They have diversified their earnings through investment banking and other areas. You can see this below.

REEx

The advent of interest only loans has helped pushed property prices higher. NAB notes in its latest filing that 29% of its mortgage loan book is in interest-only form. The RBA expects $120 billion of interest only loans resetting to principal & interest (P&I) each year to 2020 which will hike monthly mortgage repayments to jump 30-40%. If investors were up to the gills in interest only mortgage repayments, adding one third to the bill will not be helpful. This is before we have even faced a bump in wholesale finance rates due to market instability. Look at the way that GE – once the world’s largest company in 2000 – is being trashed by the credit markets as they seek to reprice the risk attached to the $111bn in debt after a credit downgrade. This is a canary in the coalmine issue.

We also need to consider what constitutes a bubble in property. Sensibly, affordability makes the strongest argument. At the height of the bubble, the average central Tokyo property value was around 18.2x income. Broadening this out to greater Tokyo metropolitan area this was around 15x. This figure today is around 5x. Making arguments that ever higher levels of migration will keep property buoyant is not a sound argument as affordability affects them too.

Back in 2007, Sydney house prices were 8x income. In 2017 Demographia stated average housing (excluding apartment) prices are in the 13-14x range. The Australian Bureau of Statistics notes that 80% of people live in houses and 20% on apartments. Only Hong Kong at 19x beats Sydney for dizzy property prices.

In 2018, Australia’s GDP is likely to be around A$1.75 trillion. Our total lending by the banks is approximately $2.64 trillion which is 150% of GDP. At the height of the Japanese bubble, total bank lending as a whole only reached 106%. Mortgages alone in Australia are near as makes no difference 100% of GDP.

Balance sheets are but snapshots in time. If we look at our current bank exposure to mortgages, it is easy for analysts to paint rosy pictures. Banks’ shareholder equity has quadrupled in the past 16 years. Prosperity and record bank profits should give us comfort. Or should it? We need to understand that the underlying tenets of the Australian economy are completely different to that of a decade ago.

At the time of Global Financial Crisis (GFC) Australia’s economy was lucky to get away broadly unscathed. We carried no national government debt and were able to use a $50 billion surplus to prime the economy through that period of turmoil. Many countries were not so lucky. Our fiscal stewardship leading up to the crisis allowed economic growth to remain in positive territory soon after. Now we have $600 billion debt and charging the national credit card with all of the promises so aggressively that we should expect $1 trillion of debt in the not too distant future.

Australian banks are highly leveraged to the mortgage market. It should come as no surprise. In Westpac’s full year 2018 balance sheet, the company claims around A$710 billion in assets as “loans”. Of that amount, according to the latest APRA data, A$411 billion of lending is ‘real estate’ related. Total equity for the bank is A$64.6 billion. So equity as a percentage of property loans is just shy of 16%. If Australia had a nationwide property collapse (we have not had one for three decades) then it is possible that the banks would face significant headwinds.

What that basically says is if Westpac suffered a 16% decline in the value of its entire property loan book then it would at least on paper appear in negative equity, or liabilities would be larger than assets. Recall in 2009 that BoA had over 16% of its residential loan portfolio which went bad. It can happen. CommBank is at a similar level. ANZ and NAB are in the 20% range before such a hypothetical situation would be triggered. See the chart below. Note how the US banks stung by the GFC have bolstered balance sheets

RESHREL.png

Of course the scenario of a housing collapse would imply that a growing number of borrowers would have to find themselves under mortgage stress and default on payments. It also depends on the portfolio of the properties and when those loans were written. If the majority of loans were made 10 years ago at 40% lower theoretical prices than today then there is lower risk to solvency for the bank if it foreclosed and dumped the property.

Although if we look at the growth in loans since 2009, the Australian banks have been making hay while the sun shines. As it stands, the likes of Westpac and CommBank each have extended mortgage loans to Aussies to nearly as much as BoA has to Americans. That said the American banks, so stung by the GFC, have become far more prudent in managing their affairs.

REGrowth.png

It goes without saying that keeping one’s job is helpful in paying the mortgage. If you were a two income family and one of you lost your job, it is likely that dining out, taking fancy overseas holidays, buying new cars (which have been awful this year) and so on will go on the backburner. Should those actions swell to a wider number of mortgage holders, the economic slowdown will exacerbate in a downward spiral. Even your local coffee store may be forced to close because $4 is just cash you and others might not be able to spend. Boarded up High Streets were everywhere in America and Europe post GFC.

UnempvHPI.png

The following chart shows the negative correlation between housing prices and unemployment rates. US unemployment doubled to 10% when Lehman collapsed. Housing prices took heavy hits as defaults jumped. It is not rocket science.

AusUnempHPI.png

On the other hand, Australia’s unemployment curve remained below 6% for around two decades. Even with GFC, jobless numbers never got out of hand. Our housing prices only suffered a mild dip.

We can argue that a sub-prime style mortgage crisis is highly unlikely. But it does not rule the risk out completely. To have that, mortgage holders would need to be in arrears on monthly payments, their houses would need to be in negative equity and banks would be required to take asset devaluations.

An ME Bank survey in Australia found only 46% of households were able to save each month. Just 32 per cent could raise $3000 in an emergency and 50 per cent aren’t confident of meeting their obligations if unemployed for three months.

According to Digital Finance Analytics, “there are around 650,000 households in Australia experiencing some form of mortgage stress. If rates were to rise 150 basis points the number of Australians in mortgage stress would rise to approximately 930,000 and if rates rose 300 basis points the number would rise to 1.1 million – or more than a third of all mortgages. A 300 basis point rise would take the cash rate to 4.5 per cent, still lower than the 4.75 per cent for most of 2011.”

Do you know how many homes NAB has under repossession on its books at the latest filing? Around 277. Yes, Two hundred and seventy seven. Out of 100,000s. Recall BoA had 16% of its loan portfolio go bang in 2008?

If we think about it logically, examining the ratio of total assets to shareholder equity (i.e. leverage), the Aussie banks maintain higher levels than the US banks listed below did in 2008. Were total asset values to suddenly drop 7% or more ceteris paribus, Aussie banks would slide into a negative equity position and require injection.

TASE.png

Human nature is conditioned to panic when crisis hits. Sadly many of our middle management class have never experienced recession. They are in for a rude shock. As for depositors note that you should be focused on the return “of” your money, not the return “on” it.

As Mark Twain once said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!

 

 

Nothing to see here

ntsh.png

Aussie bank mortgage lending continues to reach ever dizzier heights. What is probably lost on many is that Westpac & CommBank have outstanding mortgage loans extended to as many Aussies as the colossal Bank of America (BoA) is lending to Americans.

Shareholder equity as a % of real estate loans looks like this. Note how post GFC  the US banks have shored up the balance sheet to avoid a repeat of the disastrous contagion when Lehmans collapsed. Note Citi, BoA and Wells Fargo each took $20-45 billion in TARP to prevent a collapse.

ntsh2.png

Westpac & CommBank have shareholder equity vs R/E loans of 16%. That means if the aggregate loan value get smacked  by 16% or more via defaults or a sharp slowdown then these banks would be in negative equity. Extreme?

In 2009 the Global Financial Crisis (GFC) had turned over 16% of BoA’s residential mortgage portfolio into either NPLs, mortgage payments over 90-day in arrears or impaired (largely from the shonky lending practices of Countrywide (which BoA bought in 2008). Countrywide’s $2.5bn acquisition price turned out to cost BoA shareholders a further $50bn by the end of the clean-up. Who is counting?

In 2018, Australia’s GDP is likely to be around A$1.75 trillion. Our total lending by the banks is approximately $2.64 trillion which is 150% of GDP. At the height of the Japanese bubble, total bank lending as a whole only reached 106%. Mortgages alone in Australia are near as makes no difference 100% of GDP.

Japan ended up wiping out Y90 trillion ($A1.1 trillion) or 17% of its GDP at the time. The only thing that springs to mind with the Aussie banks is complacency and the RBA minutes today only reinforced that view. At least 3 years behind the curve. Yes of course people will lob stress tests as a reason not to worry (we were told in 2007 that everything would be fine until the whole edifice collapsed) but CM doesn’t buy it for a second.

Aussie banks are still beholden to global wholesale markets. In a world where rates are rising overseas and companies like GE are facing a massive wall of higher funding costs due to credit downgrades, risk is about to be priced properly. The Aussie dollar is likely to be hit too.

A recent ME Bank survey in Australia found only 46 per cent of households were able to save each month. Just 32 per cent could raise $3000 in an emergency and 50 per cent aren’t confident of meeting their obligations if unemployed for three months.

The Weekend AFR reported that according to Digital Finance Analytics, “there are around 650,000 households in Australia experiencing some form of mortgage stress. If rates were to rise 150 basis points the number of Australians in mortgage stress would rise to approximately 930,000 and if rates rose 300 basis points the number would rise to 1.1 million – or more than a third of all mortgages. A 300 basis point rise would take the cash rate to 4.5 per cent, still lower than the 4.75 per cent for most of 2011.”

Do you know how many homes NAB has under repossession on its books at the latest filing? Around 300.

Why didn’t GE use the $45bn in buybacks to take care of the $31bn negative equity?

56EF2287-AD02-4349-BA83-0B9765777731

After GE’s monster $22bn goodwill impairment charge, the company remains in negative equity to the tune of $31.3bn. $79.2bn in goodwill remains on the balance sheet with $31.5bn in shareholders equity and $16.4bn in non-controlling interests. To think GE spent $45bn on buy backs over 2015 & 2016. Imagine if the company had used those funds to shore up the balance sheet and go back to positive equity?

While the kitchen sinking of GE Power should be deemed a positive (although somewhat expected) it is interesting to see the reaction to the shares (-9%) which flirted with April 2009 lows. Cutting the 1 cent dividend from 12 cents in the grand scheme of things was optics.

Although the goodwill charge is a non cash item on the balance sheet, she is clearly not in a position to deal with the rest of the goodwill just yet.

The brand new CEO has done the right thing to restructure the former largest company in the world but he has drawn attention to the most gangrenous wound that needs to be cauterized.

It is still a rough ride from here for an industrial stock at the top of the megacycle to have such a dreadful balance sheet.

232DC573-388B-42C8-9CBD-E9EC8265C423

 

 

$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.

5B897135-CCA3-45AC-A616-E153427CA752.jpeg

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

Net Equity.png

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.

%d bloggers like this: