Japanese Collapse: The Pending Sovereign Ruin

As we have been saying for some time, Japan is well past the point of no return. The country faces financial collapse brought on by two decades of unbelievable profligacy. With 10 year JGB rates at 1.5% or so vs 3.5% for the rest of the G-7, Japan's cost of financing is unbelievably cheap despite having debt to GDP of nearly 200% (vs. just over 100% for Greece and about 80% for the US, both of whom are wildly over indebted). Japan has managed to pull this off for a variety of reasons including a) they've run a large trade surplus; b) they've been dealing with price deflation that has allowed even very low nominal interest rates to still be positive real interest rates; and c) 95% of Japan's sovereign debt is financed internally.

Japan's population began shrinking a few years ago and the demographics are such that new retirees are outnumbering new workforce entrants, leading to a dis-savings trend (you save during your working years and spend during your retirement years), meaning that the ability to internally fund Japan's debt is evaporating (simply rolling the existing debt will be increasingly difficult, much less continuing to run deficits, which Japan's is >10% of GDP). Replacing that internal funding with external funding is a non-starter because if Japan's cost of funding were to exceed 3%, nearly 100% of Japanese federal tax receipts would be consumed by interest expense. So going to the external market and competing at G-7 type interest rates would quickly lead to total collapse.

As such, Japan's central bank (the BOJ) will almost certainly have to monetize the debt, leading ultimately to a hyper-inflationary depression. Japan knows this. It has burned through six ministers of finance in the past 18 months (akin to Secretary of the Treasury), the fifth of which committed suicide rather than resigning. On top of that Japan's currency has stayed remarkably strong, staggering its export oriented economy.

We predict much higher rates (ultimately greater than 10%) and a much weaker Yen (surpassing 150 to the dollar and possibly 200). This will devastate Japanese savings, force austerity and likely make Japan default or rework its sovereign debt. Assuming this happens, hopefully it happens soon enough that the US has enough time to reflect on Mad Scientist Bernanke's experiment as conducted by Japan and we choose to retrench and not pursue these horrible, suicidal crippling policies of deficits and inflation.

The piper will ask to be paid someday. Be ready.

Anyway, enjoy the slide deck.

Japan - Past the Point of No Return - Katsenelson

HT: TD

Harrisburg. Pennsylvania Makes Official Its March Toward Default

As we discussed last week, Pennsylvania's state capitol city - Harrisburg - is insolvent. This week, Harrisburg makes it official by passing a budget that excludes paying their financing obligations. Chapter 9 feels right around the corner...

Reuters provides the story. Article included below [emphasis and comments added]:

PHILADELPHIA, Feb 14 (Reuters) - Harrisburg, Pennsylvania, moved a step closer to defaulting on a bond payment when its city council passed a 2010 budget that does not include $68 million in debt repayments on an incinerator.

Without the debt provision in the $65 million budget, the state capital may miss a March 1 payment of $2.072 million, a rarity for a municipal bond issuer. [TILB: a "rarity" indeed, although we suspect that like homeowner mortgage default, this will become less rare over the next few years]

Joyce Davis, a spokeswoman for Mayor Linda Thompson, confirmed the council's decision -- taken at a special session on Saturday -- and said the mayor is not commenting for now on the implications of exclusion of the debt payments from the budget.

The council also defeated a plan to sell city assets to help pay down the debt which is guaranteed by the city on behalf of the Harrisburg Authority, a separate municipal entity that owns the incinerator. Council members also rejected Thompson's plan to raise property taxes and water rates.

The $2.072 million payment is the latest installment on a $300 million bond owed on the construction of the incinerator. An additional $637,000 is due on April 1.

City Controller Dan Miller said last year's payments on the incinerator were made from a debt service reserve fund that is now depleted.

Debt payments on the incinerator total $68 million in 2010, or more than the city's general fund budget of about $60 million, Miller said.

Miller said on Feb. 9 he would "not be surprised" if Harrisburg fails to meet the March 1 payment.

Asked whether the city may file Chapter 9 bankruptcy as a way to get its debts under control, Miller said that was a "possibility."

The tax-exempt municipal bond market, which states, cities and municipalities use to raise the funds to build roads, schools and hospitals, is viewed as very safe with a far lower default rate than the corporate bond market.

Just 54 municipal bond issuers rated by Moody's Investors Service defaulted on their debt between 1970 and 2009, the agency said on Thursday. The average five-year historical cumulative default rate for investment-grade municipal debt was 0.03 percent in the period, compared with 0.97 percent for corporate issuers.

The recession has raised concerns of an increase in defaults as states, cities and towns struggle to balance budgets as required by law in all states except Vermont.

So far, however, those fears have not been realized and ratings agencies have played down the likelihood of a spike in defaults.

Fitch Ratings in January cautioned cities against using the threat of bankruptcy as a weapon to win concessions from labor unions. Even talk of bankruptcy can become self-fulfilling and undermines investor confidence in the market, it said.

The Final Countdown: Greek Sovereign Default

The aptly named band Europe brought us the epic music video and song "The Final Countdown" about 20 years too early (I mean, who cares about the countdown to the end of communism - let's talk about the PIIGS sovereign default).

As I read all these articles about Greece's impending doom, it's hard not to hear in the back of my head the implied complaint, "why won't they just lend us the money for free? This doesn't make any sense. Just lend us the money for free!"

[emphasis added and comments in brackets]

Europe Weighs Possibility of Debt Default in Greece
New York Times
By STEPHEN CASTLE and MATTHEW SALTMARSH

European leaders are quietly considering whether to come to the aid of their troubled neighbor Greece amid fears that the nation might default on its debts and unleash another round of financial crisis.

Only a month after Dubai was rescued by its neighboring emirate Abu Dhabi, Germany, France and other European powers are discussing whether Greece might need a bailout too.

After a decade of debt-fueled profligacy, Greece is confronting what amounts to a run on the bank. And, despite repeated assurances from Athens, the nation’s strained finances have put already jittery financial markets on edge. On Thursday, the worries stretched all the way to Wall Street, where the stock market sank 1.1 percent.

Some economists worry that Greece’s troubles could have deep and lasting repercussions for Europe. The crisis poses complex challenges for the euro, which Greece adopted in 2001. The currency sank to a six-month low against the dollar and yen on Thursday.[ironically, TILB thinks letting Greece go could be an incredibly strong event for the euro]

“Greece failing is not an option, and lots of people think that we will have to intervene at some stage,” said one European finance official, who was not permitted to speak publicly on the matter. “It doesn’t have to happen, and we hope it won’t, but it would be better than seeing a default.”

...

But doubts have intensified over the credibility of the drastic austerity measures put forward to try to get Greece’s budget under control, in spite of concerted efforts by the Greek government to calm the markets.

Investors worry that the crisis in Greece could touch off a domino effect across Southern Europe. Many are fleeing bond markets in Portugal, Spain and Italy out of concern the troubles might spread. [TILB - Collectively known as the PIIGS when Ireland is included]

The market’s judgment has been swift and brutal. On Thursday, the difference between the interest rates on Greek and German bonds — a measure of the risk investors perceive in the Greek debt — rose to nearly four full percentage points, its highest level since the euro was adopted.

Officials in Athens, Frankfurt and Brussels remained adamant that Greece was not at risk of being forced to abandon the euro. [TILB - of course not. Could you imagine if they said, "hey, we're thinking of going back to the Drachma so that we can print our way out of this debacle?" That would be amazing.]

As a condition of any aid package, the Greek government led by Mr. Papandreou would be asked to provide a more detailed program to bring the country’s deficit — currently equal to 12.7 percent of gross domestic product — under control. European Union rules call for a maximum of 3 percent. Officials insist that any bailout must not put into doubt the credibility of the euro.

Another condition of any aid would be further guarantees over the reliability of Greece’s economic data. Last year the newly elected government in Athens announced a sharp upward revision of its deficit figures, which have since been exposed as seriously flawed.

Next week, the European Commission is expected to propose greater powers for the European statistical agency, Eurostat, to audit the accounts of national governments. [TILB - watch Czech president Vaclav Klaus give this interview where he presciently assesses the fact that the EU and the Euro are forfeitures of sovereignity and freedom, then watch the slow leech of powers from the states to the centralized United States of Europe]

The latest moves reflect a continuing skepticism among euro-zone members over the practicality of the plans put forward so far by the Greek government. Athens wants to reduce the deficit to 3 percent of G.D.P. by 2012, an objective described as unrealistic by one European diplomat, also speaking on condition of anonymity. These plans are also to be assessed by the commission next week.

Greece’s budget deficit is four times the E.U. limit, while the country’s debt amounts to 113 percent of G.D.P. But officials insist that, because Greece is not one of the euro zone’s larger economies, the problems created by its grim public finances can be absorbed. The Greek economy represents about 2.5 percent of the euro area’s G.D.P. [TILB - Japan is over 200% sovereign debt to GDP and the US is a bit over 80%. Carmen Reinhardt and Kenneth Rogoff show that 90% is the threshold past which few survive, as well as 60% externally financed debt to GDP - this latter point has been Japan's saving grace, though that is likely over]

...

For Greece’s neighbors, there is the possibility of a domino effect, with investors subsequently moving on to test the resilience of another heavily indebted member of the euro area — possibly Italy, whose debt is also 113 percent of its gross domestic product.

...

One option, deemed unlikely, would be issuing a sovereign bond for the entire 16-nation euro area. That would probably require complex legal changes among members. [TILB - see prior Vaclav Klaus reference]

...

On Monday, Greece paid a hefty 6.22 percent rate to borrow money in the bond market, underscoring investors’ concern. [TILB - and it's much more expensive for them already, just five days later. If memory serves us well, they have a number of huge maturities in April/May that will be challenging to finance affordably without German backstop...]

In an interview this week, the Greek finance minister, George Papaconstantinou, acknowledged that the high rates were punitive but asked that investors keep faith. Greece needs to raise at least 53 billion euros this year, much of it this spring.

People think this is news?

As we've been saying for a year, just wait until Japan blows. It's situation is nearly twice as bad as Greece's. Despite having 40% of the U.S.'s GDP, it has as much debt. If its blended cost of funding goes up from 1.5% to a bit over 3%, 100% of its tax revenue will be absorbed by interest expense. We're talking about the second largest economy in the world and it literally has no other options than massively debasing its currency or defualting on its debt (or, more likely, both). That's what they get for following Bernanke's wicked advice.

The sooner Japan blows, the better for the U.S. - I suspect our only hope of not suffering the same fate is to witness Japan's meltdown after having followed a similar prescription.

And as to Europe, just wait until Greece's implosion lights up Italy, which is a very large economy. That is the real worry the EU is facing: do we let Italy go?

Which brings us full circle, to The Final Countdown...

Commerical Mortgage Defaults Continue To Skyrocket

The pile-up that is the CRE lending market is just beginning to reveal itself.

Unlike resi-mortgages, which hopefully are approaching Camp O'Donnell on the final legs of their death march toward consumer capitulation, commercial mortgages have just recently left Bataan. [sorry, insensitive reference - apologies in advance]

TILB recently came across a great graph that showed 60+ day delinquencies* for loans in CMBS by aggregate annual collateral vintage beginning in 2003 (this includes the vast majority of outstanding loans underlying CMBS). The X-axis shows the number of months since issuance and the Y-axis shows percentage of loans from that vintage that were 60+ days delinquent. See below for the graph.

Historically a graph like this would start out low and flat, trending up ever so slightly. Beginning in month 60 (year five), we'd see a spike up and then back down after the first set of maturities passed (forming a hump). The same would occur around month 84 (year seven) and so on. If well underwritten, each vintage should behave about the same. Certainly no vintage would show a meaningful spike beginning in month 16 (for 2007 vintage), 28 (for 2006) or 40 (2005). But that is precisely what the graph shows. And these upticks are not the beginning of humps; they are the beginning of rockets that have basically gone vertical.

As fascinating as those 2005-2007 vintages are (and they are indicating an astoundingly bad future), we find 2004 to be the most informative because that vintage has just hit its first round of maturities (5 year balloons). Perhaps it represents the proverbial canary?

Let us dig.

For 2004-vintage loans included in CMBS, 24% of those maturing in 2009 are 60+ days delinquent versus less than 2% for those maturing later. Read that again: 24% of all 2004 CRE mortgages packaged in CMBS that are maturing in 2009 are already 60+ delinquent. That's not 24% of all 2004 loans that already have matured in 2009, it's 24% of loans that already have or will mature in 2009 are 60+. 24% through May!?!?

By the end of 2009, this may very well be 40%+ as the five year loans underwritten in the second half of 2004 (and thus ballooning in 2H09) were written just as asset values seemed to take off and lending standards loosened. In fact, according to NCREIF's website, cap rates were still 7%+ for most of 2004, basically in the middle innings of the fateful cap rate plunge to nearly 5%.

In 2004, a few conservative folks thought CRE was getting a bit frothy, though for the most part underwriting standards were still reasonable (at least compared to the 2005 - 1H2008 period). Basically we are saying that the 2004 vintage is failing despite not being astoundingly "toxic". Underwriting standards and the valuations used to support them became progressively more "flexible" every year thereafter.

CMBS Delinquency Graph - May 2009

If the commercial mortgage delinquencies experienced so far in 2009 worry you, just wait until next year (2010) when the aggressively underwritten 2005 vintage has maturities, then 2011 when the 2004 seven year maturities and the egregious 2006 five year wave hits!

Every time you think the last car has hit the pile-up, just think about the ensuing year.

2012 is unfathomably bad: seven year maturities from 2005 originations and five year from 2007; two truly toxic vintages have big resets together.

TILB's personal view is that the way banks and insurance companies try to "solve" this nightmare is by extending maturities in exchange for some amount of new equity injection, tighter covenants and a new rate. This will not be practical in many situations, but it will occasionally be accomplished. This is not an act of charity; it will be their attempt at postponing the recognition of and provision for bad loans. Securitizations will probably be more aggressive in dealing with problem loans now which will keep pressure on CRE prices, preventing recovery.

In any case, as banks and insurers extend, it will have a suffocating effect on new lending as these loans will continue to eat balance sheet capacity for lending institutions (and new securitization will remain dormant). This lack of fresh lending capacity will obliterate CRE valuations for obvious reasons.

Watch what happens in two or three years when these postponed problem loans come due at the same time that two major maturity waves from problem vintages hit: a shitstorm of Texas sized proportions.

We look forward to watching Geithner and Bernanke somehow argue that Wells Fargo/Wachovia, Bank of America and the regional banks, which have just begun digesting these trends, are well capitalized. The ultimate losses lenders absorb will be astounding.

As a self aggrandizing aside, here's a brief reminder from TILB's annual Prediction and Surprises we wrote in late December and posted this past January (#3 and #6 in particular):

3) Housing prices cross the -30% peak to trough level (Case Shiller 20-city index). Commercial real estate becomes the watchword as housing price declines begin to slow toward the end of 2009.

6) The credit crisis is not arrested. After having rolled through housing, it begins its attack on commercial and corporate in force. The default rate for HY approaches double digits but bank debt only makes it to mid single digits (5-7%), so far. As I predicted a few years ago, the default wave continues to roll through credit sub-classes. While it was initially in subprime, which had the nearest resets and the lowest quality borrowers and collateral, we see it move into Option ARMs as people begin to reach 115% of their initial balance due to minimum payments and some 3/1 and 4/1 ARMs from the more toxic vintages of 06 and 05 hit resets. New CRE (commercial real estate) financing is unavailable at attractive interest rates and cap rates climb near double digits. That said, the CRE default wave only begins to pick up modest steam in 09 as the 5/25 balloons from 2004 and early 2005 approach or cross through their reset periods. Covenant-lite LBO debt performs horribly, but due to a lack of covenants, the defaults are really a 2010 and beyond phenomenon. Because each of these huge credit asset sub-classes really have staggered aggregate maturities, the credit crisis has trouble getting past us (subprime 2007-08, option ARM 2008-09, jumbo prime 2009-10, CRE 2009-14, full covenant bank debt 2009-10, HY 2009-11, muni 2010-11, cov-lite bank debt 2010-12). All flavors of credit are obviously correlated as the companies and institutions that provide the loans are the same for all kinds of credit and this continues to drive availability of credit down and the price of and standards for credit up. This adjustment hurts many people.

As the creator of the above graph noted, the only green shoot we are seeing is the vertical green line on the 2004 vintage mortgages.

* 60+ days delinquency generally indicates serious delinquency (whereas 30+ includes folks that may simply have foot faulted).

Re-default Rate For Modified Resi Mortgages

JP Morgan put together a helpful overview of re-default (or "recidivism" as many insiders prefer to call it) rates by modification type. Not surprisingly, given the way most Americans manage their finances (month to month), the most effective form of modification is to reduce monthly payments. Loan forgiveness (basically reducing the outstanding balance on the mortgage) is the second most effective method.

In every scenario, a huge portion of modified mortgages re-default, generally within the first six months of the mod.

One of the points not mentioned, but which I think is worth noting, is that loan mods really only began in earnest last summer and, as such, the dataset is still very young. Certain kinds of loan mods (like loan forgiveness) are even newer efforts, at least in scale. So all of the recidivism rates are likely to keep rising simply as a result of time passing allowing for more re-defaults.

This is based on data that JP Morgan pulled together from the Loan Performance database on the Loan Performance database.

Here's what the JP Morgan analyst said about the analysis:

Moving on to the subject of re-default, we note that the overall re-default rate stands at 40%. Breaking that number out by modification methods, we observe that capitalization has the highest re-default rate of 54%, and rate reduction the lowest of 24%. Also, the more severe the starting delinquency status before modification, the higher the re-default rate (Table 7). Despite rate reductions seemingly being more effective than principal forgiveness in terms of re-defaults, we note that lowering the balance of a mortgage through a modification by 20% or more results in a re-default rate of 32%, compared to 43% when the balance is increased (mainly due to capitalization)—i.e., balance modifications impact redefault rates.

There also seems to be a strong correlation between monthly payment amounts and re-defaults (Table 6), reaching from 26% of modified borrowers re-defaulting when their payment drops by 30% or more, to 59% redefaulting when the payment increases. Given the mechanics of capitalization (delinquent amount is added to the loan balance and the loan is re-amortized resulting in higher payments) and the high re-default rates with an increase in monthly payment, it is obvious that the payment increase is the main driver for high re-default rates when capitalization is applied. Therefore the combination of capitalization and rate reduction, which results in an unchanged or decreased monthly payment 94% of the time and a re-default rate of 41%, is much more effective than just capitalization with a 54% redefault rate. Additionally, 66% of re-defaults happen within six months after modification. We think a 40% re-default rate for modified loans is reasonable going forward.

Re Default Rate

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