ECB’s reversal, covenant lite vulnerability, and delinquent mortgages

ECB stimulus

The biggest development today was the ECB’s announcement that it is reversing its stance on stimulus and offering new bank loans:

The European Central Bank signaled a major policy reversal Thursday, flagging plans for fresh measures to stimulate the eurozone’s faltering economy less than three months after phasing out a €2.6 trillion ($2.9 trillion) bond-buying program, making it the first rich-country central bank to ease policy in response to a global slowdown.

The ECB said it would hold interest rates at their current levels at least through the end of this year—months longer than previously signaled—and unveiled a fresh batch of cheap long-term loans for banks.

The series of policy moves represent a more aggressive response to the economic slowdown than investors had expected.

Draghi is outlining the new measures as I write this.

There have been rumors that the ECB would reverse course. And I wrote about this last month.

In the markets, people are already saying the ECB will be forced to reignite QE by March. That’s the word on the street. And it has people buying long-dated periphery government bonds. Two days ago, the Italians auctioned 8 billion euros of 30-year bonds at 3.85%. And there was record demand – 41 billion euros of orders.

Except for Greece, that’s the highest sovereign yield you can get in the eurozone – and the longest duration and most risk too. Clearly, someone thinks the ECB will have Italy’s back. But, will it? I have my doubts.

This is stimulus, yes. But, this isn’t QE. So I think we should continue to have doubts about QE, in particular because the ECB is coming up to near the 25% ownership threshold for the government bonds in Italy. And they don’t want to go over that level.

Even so, what people were saying, as Martin Wolf put it Tuesday, “The ECB must reconsider its plan to tighten“. And they have done. Not only have they reconsidered their plans, they reversed course. So, this is an even more aggressive move than the Fed’s move to standing pat. And it needs to be, frankly. On both growth and inflation, the eurozone is undershooting. And, given the fiscal constraints of the stability and growth pact, the ECB is the only game in town. Will this be enough though. I doubt it.

Leveraged Loans

In terms of downside scenarios, leveraged loans and high yield are being touted as a potential locus of contagion – not just in Europe, but in the US in particular.

First, there is the potential fallen angel problem. I spoke to the excellent David Rosenberg of Gluskin Sheff about this yesterday. He noted that half of US corporate debt is now rated BBB, just a nose ahead of junk. And while those bonds often trade as if they were junk, David told me they likely have spoken to the ratings agencies to assure them that they could cut capex and share repurchases enough to maintain their BBB status. So, as the earnings recession proceeds, it either leads to a capex recession in a best case scenario or these guys fall into the junk bond pool. And that would precipitate forced selling by pension funds and mutual funds that have asset quality requirements preventing them from holding fallen bonds.

But then, there is also a problem regarding the covenant light nature of these bonds. Here’s the lead, via the FT’s Sam Fleming:

The Financial Stability Board, a top global rulemaker, has launched an examination of parts of the $1.4tn leveraged loan market, as officials intensify scrutiny into potential financial stability risks surrounding corporate debt.

According to Dion Rabouin of Axios, in 2019 so far, nearly all leveraged loans originated in Europe have been covenant-lite and 85% of US loans in 2018 were cov-lite. His money quote:

“As a borrower, it’s a great time. We don’t need covenants on anything anymore. We want to buy a building, build a building, we can borrow as much as we want at the terms we want. It’s great. The last thing I want is to be the guy who provides that funding on the other side,” said JPMorgan Global Alternatives Managing Partner Anton Pil. “This will end poorly. It’s just a question of when.“

So, when this cycle turns down, you have a huge slug of debt, both in high yield and leveraged loans, where you have the potential for serious contagion to occur. We’re talking $3 trillion or more, bigger than the subprime sector in 2007-08.

US housing vulnerability

Generally speaking, I am thinking about the releveraging of the corporate sector as the problem for the US in terms of a downturn. But Politico is talking about housing as a big source of vulnerability too. They key in on New York City.

“When you look at the New York metro area, we are moving from an extended period of stagnation to one of outright softening,” said Joseph Brusuelas, chief economist at RSM, U.S.

The Manhattan declines are directly linked to the late-2017 tax law that capped the mortgage interest deduction and indirectly to the capping of the state and local tax deduction, Brusuelas said. “People joke that they should have called the tax bill the ‘Everybody Moves to Austin Act.’ This wasn’t virtuous tax policy. It was punitive tax policy.”

Under the new law, individuals can no longer deduct more than $10,000 in state and local taxes from their federal returns. The law also slashed the mortgage interest deduction from $1 million to $750,000.

Politico also talks about more general worries regarding declining housing starts and existing home sales. And on that same note, I have been talking to a housing analyst named Keith Jurow. And his thesis is that “bubble era mortgages are a disaster waiting to happen“. He says that delinquencies on the non-Agency mortgages from that era have skyrocketed.

 Nationwide, almost one-third of these delinquent owners had not paid the mortgage for at least five years.  In the worst four states, more than half of them were long-term deadbeats.  Notice also that four of the other states were those you would not expect to have this rampant delinquency — North Dakota, Massachusetts, Vermont, and Maryland.

I am not sure how much concern we should have about the household sector here. But, I did want to flag these two stories as potential causes for concern regarding household sector deleveraging in a downturn.

Brief synopsis

I continue to see Europe as the weak link. And it’s encouraging that policymakers there understand the gravity of the situation. The ECB is now more aggressive than the Fed in reversing course. But it has almost no ammunition left as it is already using negative base rates. I don’t think the stimulus will be nearly enough.

In the US, by contrast, the numbers look much better. Jobless claims continue to be higher than year ago levels however, as data released today showed an average 226,250 initial claims versus 224,750 a year ago. This isn’t alarming, per se. I would need to see the differential rise to 30,000 after several weeks of poor comparisons to be truly alarmed about a recession. But, in conjunction with other poor data, it paints a picture of a US doing less well in 2019 than 2018. Whether we are bottoming in the US is another story.