They’re Back

This weekend I attended an open house for a new listing in my neighborhood. I have no real intentions on moving, but it is fun to look at the neighbors houses and see what the market is like. I often chat up the agents to get their gauge on the market, but in this case, an aggressive mortgage broker was in attendance who was pitching interest only ARM’s to any buyer who mentioned the price was out of their range.

I thought these loans were dead and gone after the mortgage meltdown. It turns out I was wrong, in fact they are the hottest product going in high priced California neighborhoods. I followed up with the mortgage banker at the bank I work for and asked him about the product. Being from a pretty conservative bank I thought for sure he would chuckle and say he can’t offer something like that. I was wrong again. He quoted a 10/1 Interest Only (I/O) Adjustable Rate Mortgage (ARM) at 80% Loan to Value (LTV) with a rate fixed at 3.75% for the first ten years. After the ten year initial I/O period, the loan reverts to a floating rate with principal amortized over 20 years. Therefore, even if rates stayed the same, the payment will rise considerably after 10 years due to the additional of principal payments.

I got to thinking about it and wondered if I have been doing it all wrong with my conservative 15 year fixed rate mortgage. I decided to compare an I/O and a conventional loan on a hypothetical $800,000 purchase. In the analysis below, the net present values of the two loan programs were derived by discounting at the current risk free rate of return and assuming real property prices continue to grow at the Fed inflation target of 2 percent. From the analysis we can see the I/O loan has a very slight advantage over a ten year period. And, if one is disciplined and each month invests the difference between I/O and conventional loan payments, the I/O advantage becomes quite large.


There is a reason why these loans are considered risky and were largely abandoned for several years after the financial crisis.  It allows borrowers to buy more house than they really should and the savings from the lower monthly payments are likely not going into other investments. By leveraging up and not putting away the savings, there is little equity available down the road should prices drop again or home equity needs to be tapped for unexpected repairs. After ten years the loan payments can easily double or triple; forcing borrowers to default. On the positive side, however, the low payment will likely allow the property to cash flow should it need to be rented out with positive cash flow in the case of a job loss or transfer out of the area.

I am not sure what to think of the return of exotic mortgages, but it makes me think prices are again unaffordable in certain regions and caution should be used. Talk to your lender and get a feel for how often non-standard loans are being used in your area. That being said, as tempting as it is to knock over $2,000 per month off my monthly payment, I think I will stay with my 15 year fixed rate mortgage for now.


James Thorall

Photo credit:

Reading the Junk Bonds

Junk bonds, as the name implies, represent the lesser credit-worthy entities, and thus, carry a higher yield than investment grade bonds. Junk bonds, also due to their lower credit quality, often trade more like equities than treasuries. They tend to lead equities in response to improving or deteriorating financial conditions. For example, junk bonds began trading higher in January of 2009, almost three months before the equity markets made the turn higher. We can confidently say high yield more often than not leads the way for the rest of the market.


In recent weeks we saw a divergence between junk bonds and stocks. From our historical knowledge, when high yield bonds and socks diverge, the bonds typically prove to be correct. The reason for the divergence is primary traced back to the weakness in crude oil prices, which is hurting oil and gas exploration companies. As a result, junk bond rates (which move in the opposite direction as prices) closed at a 6-month high yesterday, as measured by the BofA Merrill Lynch US High Yield Master II Effective Yield. At the same time the S&P 500 is within a few percentage points of its 52-week high. This set of conditions has only been seen on 21 previous days going back to 1997.


As the markers on the chart above indicate, when similar conditions were present in the past, they were not too favorable for equities. Below are the dates of those occasions:

  • June 30, 1998
  • January 10-19, 2000
  • March 16-27, 2000
  • November 17, 2005
  • July 3-9;27, 2007
  • September 24, 2014
  • December 5-9, 2014
  • July 22, 2015

As we see in the charts, when divergence happens, it typically does not bode well for stocks. Following the 1998 and earlier March 2000 and July 2007 events, the S&P 500 was able to hold off weakness for a few weeks before facing a strong sell-off. The other events exhibited weakness almost immediately. And even though the S&P 500 has since recovered following the events in September and December of last year, the index did suffer sharp losses in the subsequent weeks. According to market sources after 1 month, just 3 of the 21 occurrences saw the S&P 500 higher, and a median return of -4.1%. In the longer-term the situation was even worse.

One can say this time is different, because, well, it is. That is not to say, however, that commodity weakness which is driving the high yield weakness is not going to have an impact on the overall economy and equities at some point. I thought this correlation was useful to point out and drive home the reason to be very cautious with your current equity investments. We are facing increasing interest rates and statistically, the divergence between high yield bonds and equities is a sign for caution.  Then again, we are in a distorted world of fed intervention, so what is up is down and what is down is up until the powers that be say otherwise.

How are you reading the current situation?

Thank you and take good care,

James Thorall


What is a central banker to do?

Today weekly jobless claims were the lowest in more than four decades. Even better, weekly jobless claims, taken as a four-week moving average and compared with the monthly employed of America is at the lowest in more than 50 years (see Chart from Bloomberg below). The economy must be booming and interest rates heading back at historical averages, right? Why aren’t the fed funds futures pointing to aggressive rate increases by Janet Yellen in September?


Long-term interest rates, however, are going down. Treasury spreads are flattening—a sign of economic weakness—as indicated by the twos over tens and the five-thirty spreads dropping to the lowest level in months. Perhaps this is simply a function of an anticipation of a fed hike causing the short-end of the curve to rise? Or is it due to decreasing expectation of future inflation causing long-term rates to drop? Treasury Inflation Protected Securities (TIPS) had a poor auction today, with yields dropping to the lowest levels in months.

Today we also saw very poor earnings and guidance from the likes of Caterpillar, who missed on revenues and basically said there is a global recession happening in infrastructure and mining.  Also this week Apple, Yahoo, Microsoft, United Technologies, 3M, IBM, Goldman Sachs, Verizon and Boeing disappointed on weaker demand. Caterpillar reported a 30% drop in Asian Pacific demand and a whopping 50% drop in Latin American orders.


Chinese consumer confidence dropped as did manufacturing PMI, suggesting a softening of foreign demand. Both are at 15 month lows, driving commodity prices ever lower. Industrial metals, precious metals, energy, soft commodities, cattle, and basically every other possible commodity showed weakness this week. The Chinese stock market continues to fall, despite a series of restrictions imposed by the government to stop the fall.

On the labor front, the participation rate continues to drop, which makes the unemployment rate appear lower. The Gross Domestic Product (GDP) is continuing to flatten. Growth in average hourly earnings is beginning to stall out.

labor participation rate

So back to the original question, what is a central banker to do? As Janet Yellen recently stated, any move will be data dependent. Just looking at the unemployment rate, one would say the US is humming along and it’s time to raise, but if one looks at the global economy, one would say it’s time to wait for further confirmation.

What is my prediction?

Janet hikes rates by 25 basis points in December then waits at least one meeting to gauge the market’s reaction before making another move. This will be a slow process. Inflation will remain very low and commodity prices will continue to be depressed. Anyone thinking oil or gold will substantially recover by year end will be disappointed.

In the meantime it appears the S&P might just break out of its very tight trading range. Today was quite weak and damage is being done to the charts. However, as long as the longer-term trend remains intact, don’t sell and hold on. There is, though, good reason to be paying closer attention and to take action should the long-term trend line be violated.

Currently I am a buyer of European equities as I believe the ECB will continue to provide stimulus and they are just beginning their recovery. My trade in that space is the WisdomTree European Hedged Equity Fund NYSE: HEDJ. Domestically I am stalking a purchase of senior bonds in the oil and gas space. Over the next few month I believe crude will remain at depressed levels, sparking some panic selling of “higher quality” junk bonds. Finally, I think lower rated municipal bonds offer some great value. The BB+ range seems to offer the greatest risk/reward ratio. These lower rated General Obligation bonds have similar default profiles to the A rated issues and offer much better returns.

As always, please feel free to email me with specific questions or enter your email address to follow this blog.

Take good care,

James Thorall

Cover photo courtesy of


An ounce of prevention…

Did anyone learning anything from the Great Recession? Today a number of global housing markets are exhibiting trends similar to those the U.S experienced during our real estate bubble. Those countries that learned from our mistakes are less likely to repeat them in the future. So far in Australia, this appears to be the case.

On July 1, 2016 the Australian Prudential Regulation Authority will come into effect and require the country’s four big banks to hold additional equity capital. The new rulings will require approximately an additional 80 basis points of capital to be held against real estate secured assets. In other words, these banks need to increase capital buffers against declines in asset prices from the current 16% of assets to 25% of assets by 2016 and eventually 30%.

These new provisions are only an interim measure and further changes may come depending on the rate of deceleration experienced in the Australian housing market. The international Basel Committee on Banking Supervision ( the group who really came up with the plan), will review the effectiveness on risk mitigation and possibly make additional recommendations in the future.

The most positive result of this increased capital requirement is getting in front of the problem before it is too large. In the 2008 U.S. housing collapse capital requirements were much too low and the entire financial system faced insolvency without significant aid from the federal government. By requiring banks to increase tier 1 capital during periods of strong cash flow generation the likelihood of a bailout is greatly reduced and the burden on tax payers equally reduced.

Tax payer funds and private bank liabilities should never meet. Banks should be responsible for their underwriting and investors should be responsible for keeping their investments in check through good board governance and shareholder activism. Investors in hot banks with hot money and gimmicks for securitizing should bear the burden of investment losses.

The entire housing boom and subsequent collapse could have been easily avoided by removing government guaranties, credit enhancements, and the Fannie May’s and Freddie Mac’s of the world. Banks should be responsible for a loan from cradle to grave.


Forget the Grexit, let’s discuss a Gerxit

A case for a Gerxit:

Greece bailout number three is about to become official and in this case, the third time is not a charm. The outline of this plan is just more of the same, though the details still need to be hammered out. German law makers offered some short-term financing to deal with immediate pressing payments to the ECB and IMF, but on the whole, there is nothing new about this bailout. Even the IMF does not think more austerity combined with some can kicking will yield any positive results.

Angela Merkel understands the best thing for Greece is to exit or receive substantial haircuts on their debt combined with less austerity. However, Merkel also knows a Grexit will mean immediate chaos and economic collapse for the Greeks and that debt forgiveness and relaxation on austerity can cause contagion with rest of the PIIGS who may ask for their own restructures. For the present time the best course of action seems to be keeping the Euro Zone together, despite knowing Greece won’t make it in the Euro Zone.

There is an alternative course of action, though. Part of the issue with the EU is the mismatch of economies and their inability to control their own currencies and interest rates as need to match economic conditions. If Greece can increase its monetary base, i.e. printing money, it can help spur exports, tourism and make their debt less burdensome to repay. The problem is, debasing the euro will potentially hurt stronger members such as Germany. In fact, most of the EU members are suffering from high levels of debt and sluggish economies and may benefit from a weaker euro, except Germany.

It really seems Germany is the one who doesn’t fit in the union. If Germany were to exit the EU, there might be more winners than losers. The value of the euro would immediately fall, giving the PIIGS and other countries in Europe’s periphery a much needed boost in competitiveness. Germany’s deutschmark will likely appreciate, but they have lived through a strong currency before, and can use the opportunity to reduce its current account surplus. Moreover, Germany could stop being a creditor to weaker nations and focus on becoming a stronger, less export driven nation.

Take good care,

James Thorall

photo credit
Workout Word Cloud

Workout Tips…but not for the gym

Loan Workouts: Most commercial borrowers, and even some loan officers, rarely expect to have a business face structural difficulties such that the prospect of full contractual repayment becomes a concern. When a borrower does face difficulty, their banking relationship is often transferred to a special banking officer to “workout” the problem loan. At smaller banks, the originating lender or chief credit officer might assume such a role. In either case both borrower and lender need to quickly create a strategy to maximize the chances of a successful outcome. Drawing from personal experience doing loan workouts I put together a few basic points to consider when entering this new territory.

For Lenders

Cash is king. Understand what drives the business’ cash flow. Regardless of what the accrual financial statements say, a business in distress is a cash based business. What is the operating cycle and how long does it take to convert a sale into cash. Is the business seasonal, like an agricultural trucking company or a resort hotel? Ask for a 13-week or seasonal rolling cash flow forecast. This will be your short-term roadmap of how you will get repaid.

Size up the borrower. Meet with the key executives as soon as possible and walk the entire business and ask lots of questions about how the business operates. Don’t be afraid to ask to look inside buildings, open boxes, make sure the equipment runs, and generally size up the inventory to see if it matches what appears on paper. This is a critical time to assess the management to determine their strengths and weaknesses, honesty, and most importantly, character. This meeting will be formative to the future strategy.

Size up the collateral and unencumbered assets. Immediately engage appraisers to value the fixed assets and conduct environmental reviews if the operations or the walk thru warrant further investigation. Obtain detailed accounts receivable aging reports with contact information for each account. Audit the accounts and inventory to determine collateral sufficiency. Find out if there is more collateral that you may be able to get during negotiations.

Prepare a liquidation analysis. If all collateral were to be liquidated, how much cash would it bring? Identify all possible sources of repayment, including those unrelated to the primary business. Use this analysis as a guidepost for progress and decision making.

Evaluate the downside risks. Do the borrowers have any legitimate issues with the Bank? Should you prepare pre-negation agreements? Preform a careful and thorough document review to look for any deficiencies, such as unperfected liens or missing guaranties. Retain qualified counsel to review all documentation and be on retainer for future documentation preparation, consultation and litigation needs. Make demand and limit access to credit facilities or other bank products with credit exposure such as treasury management, international trade products or derivatives.

Understand the borrower’s business inside and out. Read all the original credit and underwriting files. Determine what has changed or if there were issues overlooked at origination. Do the problems stem from market forces (low milk prices coupled with high feed costs) or are they a result of operational errors (overcapacity, careless administration) and keep an eye out for fraud or money laundering.

Finally, once you have a handle on the situation and critical issues have been resolved, meet again with the borrowers and their trusted advisors to set expectations that you expect to be repaid in full and to hear their plan to do so. Be inquisitive, upfront and set hard deadlines. Failure by borrowers to follow through with agreed upon deadlines and objectives is a sign to change course.

For Borrowers

Come to the table. Chances are borrowers have never been in this situation, so understand the rules of engagement and do not act out with hostility or silence. Your relationship with the Bank has changed and how you present yourself is going to play a significant role in developing character and the chances of a successful workout. The lender is in control now and likely has very robust and comprehensive default remedies. The bank is your new best friend and they want to get to know you better than ever.

Be an open book. The bank is going to ask lots of information that you have never provided before. Be prepared with cash flow projections and annual operating budgets. Be ready to have auditors spending a week counting inventory and checking your books and records. Can you produce monthly financial and collateral statements? Any delay in producing documents, especially financial records, will be viewed with suspicion or as incompetence, either of which will greatly diminish your credibility and ability to negotiate.

Do not be afraid to ask for help. Sometimes hiring a consultant approved by the lender will help you identify the operational issues causing the business to underperform or can aid in proactively presenting a workout plan to the lender. This demonstrates a commitment to fix problems and shows strong character. Also, if you are struggling, ask for help early, long before you are introduced to a workout officer at the bank. Your chances of survival will be much greater.

Be willing to compromise. The bank will only be willing to give if they get something in return. Most often borrowers need more time to turn the business around. If so, are you willing to provide additional collateral, shorten loan tenor, inject additional capital or sell equity to raise liquidity? At the same time, carefully review the loan documents and find deficiencies that you can use against the bank to negotiate time or even additional funds.

Every workout is different. Sometimes the problems are just too great to overcome and the asset values or cash flow just do not warrant a turnaround. If this is the case, you can decrease potential deficiencies by being proactive and self-liquidating. An orderly sale of assets will garner significantly higher prices than a bank auction or a foreclosed property. If you have any personal assets, the bank will likely pursue the deficiency through legal action. Bankruptcy is expensive, and many times, preferred by the bank since it is orderly and forces action. However, you are responsible for all expenses incurred by the bank, including legal fees, consultant fees, inspections, and repossession and auctioneering fees. Obstruction and delays will only cost you money.

I am happy to discuss more specific strategy or field any questions you may have regarding debt collection.


No More Stripping in Bankruptcy Court

Today I wish to talk about a recent Supreme Court decision long sought by secured lenders. When the real estate bubble burst in 2008 most lenders were hurt badly, but none more than those lenders who provided loans to individual and businesses with subordinate liens on real property. During the boom one of the most prevalent ways to buy real estate with no money down was through the 80/20 loan structure on residences. This allowed for an attractive conventional first mortgage combined with a second mortgage for the remaining 20% of the purchase price. In small business lending the soup de jour was the SBA 504 loan program.  Simply put, a bank financed the first 50% of the purchase price while a Certified Development Company backed by the Small Business Administration financed 40% and the borrower put up just 10% of the purchase price.

In a rising real estate market these types of structures were typically not an issue for junior lenders as price appreciation generally provided enough meat on the bone to remain fully or partially secured in a default situation.  If a debtor filed Chapter 7 Bankruptcy the courts held (at least for the past 20 years) that if the value of the real estate securing a loan is less than the amount owed, the secured creditor was only “allowed” a secured claim equal to the collateral value. The unsecured portion (underwater portion) of the loan can then be stripped down and discharged.. For example, a lender holds a $600,000 loan secured by a first deed of trust on a home worth $400,000. In a Chapter 7 case the lender’s secured claim can potentially be stripped down to $400,000 (the amount equal to the home’s value) with the debtor asking the court to essentially void the lien on the remaining $200,000.1ba9c3e9df5b32c70e9f8fcf783c1501

This scenario is obviously very advantageous to a debtor if they remain in their home, especially if the home value increases over time. Certainly the lender’s preference is to keep the full lien in force for as long as the debtor owns the property. Should prices rise, or the first mortgage is paid down, there is a chance for a higher recovery down the road when the home is sold.

In the aftermath of the real estate crash the stripping down principal pursuant to Section 506(d) of the Bankruptcy code was at times used to completely extinguish liens of junior creditors when a loan was wholly underwater. The SBA 504 and 7(a) piggyback loan structures were severely impacted (due to their junior positions) by such treatment from 2009 to 2011. The practice became so prevalent there  were professional “lien strippers” who specialized in helping motel and other property owners file bankruptcy to remove SBA and other junior liens. In the preceding years, some of those properties doubled in price, giving the property owners a windfall while tax payers often took a hit.

Last month lenders received some much desired relief from lien “strip downs” and “strip offs” when the U.S. Supreme Court heard Bank of America, N.A., v. David B. Caulkett, et al. In this case, Chapter 7 debtors filed motions to strip off junior mortgage liens that were wholly underwater, arguing if the collateral properties were sold at the present value, the junior lenders would receive nothing and thus should be voided.  The Court refused to do so, and confirmed that junior mortgage liens are valid “secured claims” under Section 506(d) and may not be voided, regardless of whether those liens are partially or wholly underwater.

Do you think this is a fair application of the law? Should lenders’ secured claims be extinguished due to a temporary impairment in collateral value? Is there a moral hazard in allowing lien stripping? Could this ruling actually help borrowers as lenders are more willing to stretch LTV limits, knowing their liens will stand in the face of bankruptcy?

Photo credit:

Don’t Let Your Town Become Greece

A few weeks ago I posted about the importance of managing cash flow and how deficit spending can quickly turn into insolvency. It is as simple as paying current expenses with a credit card and then using long-term debt (home equity loans) to pay off the credit cards, only to run up the cards again as spending is not contained. The game can only go on for so long before liquidity runs dry and current obligations cannot be paid.

There are two simple solutions to this problem; either make more money or spend less money. Obviously both are easier said than done. The usual result is to pretend the structural deficit doesn’t exist, or is temporary, and continue spending as normal while liabilities accumulate. This principal applies to individuals, municipalities and states alike. In municipal finance the term used for refunding short-term liabilities with long-term is “scoop and toss.” The term alone should give you a good visual of why this is bad.

Chicago Public Schools “CPS” is a wonderful example of this phenomenon. The district has been running a deficit of $500 million or more per year since fiscal 2011, building one-time revenue such as federal stimulus funding into its spending base and failing to count pension liabilities. The retirement system was, in as recently as 2001, 100% funded, but now has barely half the assets it needs to pay promised benefits. As a result of this deficit spending, borrowing has ramped up, so much so that debt service will soar from an estimated $119 million in fiscal 2014 to $305 million in 2016 and $420 million in 2020. The district’s bonds are rated junk and recently had to enter into a forbearance agreement with creditors. A copy of a May 2015 report by Ernst and Young outlining the fiscal issues at CPS is available here.

The Mercatus Center at George Mason University publishes a ranking of states by fiscal condition. No surprise Illinois holds the bottom rung followed by New Jersey, Massachusetts, Connecticut and New York. California and Kentucky come in at 44 and 45 respectively. For these bottom states, even though they may be able to raise taxes and eventually be able to meet their obligations, their revenue systems, budgets and liquidity are structured such that any financial downturn results in near crisis.

The point is, take an active role in not only your personal finances, but those of your cities, counties and states. Don’t accept accounting gimmicks and off balance sheet liabilities such as unfunded pension obligations. How realistic is it for you, as an individual, to write yourself IOU’s instead of actually contributing to an IRA or 401k? Will you, as an individual, justify your deficit spending by telling yourself that you will simply demand a raise from your boss next quarter, so all is fine? Also, and I hope this is not a surprise, but tax payers and their representatives don’t always agree on raising taxes to fund poor fiscal stewardship–that raise likely will not happen.

You hopefully wouldn’t put yourself in such financial harm, so why do you let your elected officials do it to our cities, schools, counties and states? Demand a fix before the place you call home becomes the next Greece.

Take good care,

James Thorall

A man watches a board showing the graphs of stock prices at a brokerage office in Beijing, China, July 6, 2015. Chinese stocks rose on Monday after Beijing unleashed an unprecedented series of support measures over the weekend to stave off the prospect of a full-blown crash that was threatening to destabilise the world's second-biggest economy.  REUTERS/Kim Kyung-Hoon

Global Reflation Going Flat

The headlines continue to be dominated by the ongoing showdown between Greece and its creditors and the Chinese stock market crash. Here in the states we are closely watching every little data point, discussing, arguing and betting on exactly when Janet Yellen and the Fed will raise interest rates for the first time in nearly a decade.

Meanwhile, crude oil prices are tumbling again after a short rebound from their most recent plunge. Copper, Iron, and precious metal prices are continuing to make lower lows. Interest rates are coming back down and the equity markets are feeling a bit shaky.  Recent U.S. economic data showed a slowdown in job growth, a sharp drop in the labor force participation rate, and flat wage growth. Nothing in the economic data nor the following charts suggests to me the global economy is on the mend or that the U.S. should be considering a rate hike anytime soon.

First off, crude oil prices are not suggesting any rising demand to balance the rising supply. Much of the drop can be explained by geopolitics and continued increases in production, but the recent decline is noteworthy in a macro sense  (see the third chart–global crude production).


Long-term WTI Crude Oil

Shorter time frame for WTI Crude

Shorter time frame for WTI Crude

Global Crude Production

Global Crude Production

Copper and Iron Ore prices are collapsing and making new lows for the year. Again, too much supply and not enough expected growth to support prices. In other words, deflationary.


Copper Futures


62 Percent Iron Ore

The U.S. dollar is consolidating after a relentless rally built on expectation of future rate hikes combined with interest rate reductions and currency devaluations by central banks abroad. The strong dollar is also putting pressure on commodities and U.S. exports.


U.S. Dollar Futures

Interest rates are failing to breakout of their downward trend. Five year treasury futures are rallying as traders discount a September rate hike and investors seek shelter from potential volatility caused by Greece and deflationary pressures.


Ten year U.S. Treasury Yields

Finally, equity markets are either consolidating for the next move higher once it becomes clear low rates are here to stay (i.e. more stimulus and liquidity) or a rotation out of equities and into treasuries and income producing assets is in process. High yield bonds are starting to break down, despite lower treasury yields, and money is flowing into utilities and reits, which is not a vote of confidence. Market leader Apple is showing some toppyness and uncertainty, but has yet to actually confirm a break down. My guess is as Greece falls deeper into crisis once further restructuring proposals fail next Sunday and the equity markets will enter a brief correction as a result. It is really too early to tell at this point, but I would stay nimble and buy puts or short the Nasdaq E-mini futures for protection.


Long-term S&P 500


Long-term Apple Chart


Short-term Apple (a close below the lower trend-line on decent volume is a clue the broader market is in trouble)



Gobal Debt: A Week in Review

With so many economic and debt related events happening in the world, I thought I would give a quick breakdown of the main headlines. From these headlines it is clear there continues to be global economic risks fueled by easy access to credit, central bankers, and questionable fiscal policies.


First and foremost is Greece. After falling into arrears with the IMF, the country now joins the ranks of Somalia, Sudan, Zimbabwe and a few other select countries who have defaulted on IMF payments.   Greece’s Prime Minister, Alexis Tsipras, is putting Europe’s latest bail-out offer to a public vote, in a referendum scheduled for today. As a result, a nasty chain of events followed. Euro-zone leaders refused to extend the current bail-out program and the European Central Bank announced that it will stop all emergency funding that has been used to keep the Greek banking system running. Capital controls–last resort efforts to prevent matters from spiraling out of control–were implemented to prevent a bank run.

At this very moment the polls for the referendum are putting a ‘No’ vote in the lead. The citizens are effectively telling Tsipras to reject the current bail-out offer, potentially forcing the country into crippling long-term capital controls and a possible exit from the Euro. This really comes as no surprise given the Prime Minister’s campaign promises to the radical-left Syriza party to vote against austerity.

Even if there is a yes vote, the current bail-out package only covers the 12 billion euros needed to meet short-term obligations. The IMF estimates another bail-out package of 52 billion euros would be needed to fund obligations through 2018. Still, near immeasurable damage to the economy has been done through years of political incompetence and brinkmanship that even a yes vote does not guarantee a successful long-term outcome.

A Greece exit, or Grexit, will have only a minor impact on the Euro Zone due to its relatively small economy, though the precedent is set for other countries such as Sgreecechartspain to follow suit. Angela Merkel and other leaders will have a hard time negotiating any further with the Greeks after a no vote, particularly after forcing countries such as Portugal, Span and Ireland to suffer through austerity. A no vote doesn’t automatically mean an exit, but I think the odds will be pretty high. Don’t discount the political will of the EU and the pressure by German tax payers to find a resolution that maximizes payment of their loans. I am especially interested to see how Spanish and Italian leaders react should Europe come back with a new offer.


Just as Greece is to Europe, Puerto Rico is to the United States. This past week Puerto Rico’s government said, after a decade of recession, it will likely default on its debt payments in the near future. Such a default will have a major impact on the U.S. municipal bond market and may require a bail-out from the U.S. Treasury or new legislation to allow political subdivisions of the island to file for bankruptcy under Ch. 9 of the US bankruptcy code.

Puerto Rico, a U.S. commonwealth with a population of just 3.6 million, is allowed to issue municipal bonds that are free from state, local and federal tax for U.S. tax payers.  Being the only triple tax exempt bond available has made them very attractive investments, particularly as investors reach for yield, and allowed the commonwealth to accumulate more than $73 billion worth of debt, or a debt to GDP ratio of 70. The average state has a debt to GDP ratio of 15. Beyond municipal bonds, the island owes some $37 billion in pension obligations to workers and retirees.

Years of artificially high minimum wages (the commonwealth is required to abide by the U.S. federal minimum wage laws, the equivalent US minimum wage would be $19), PRicoDebtoutdated and restrictive trade laws imposed by the U.S. and mismanagement of its finances and tax laws have contributed to the high employment and rapidly depleting labor force. Puerto Rico’s poverty rate is 41 percent (nearly double that of the poorest state, Mississippi) and about 60 percent of the population are enrolled in Medicaid. To pay for the debt public services taxes are rapidly increasing which is driving a new underground economy fueled by the desire to avoid the taxes. Austerity is crushing the working class and those with skills and education are fleeing.

This is a lesson to both bond investors and elected officials to pay attention to fiscal policy and liquidity. Issuing long-term debt to cover current operations is a recipe for disaster. A Puerto Rico default followed by energy infrastructure bonds or even a Chicago default could shock the municipal markets causing forced selling when investors seek redemptions at bond fund in a market that is traditionally not very liquid. In other words, it might be time to trim those high yield municipal bond ETF’s.



Adding to the rapidly decelerating economic growth and bursting real estate bubble, China margindebtnow has one more bubble bursting: its stock market. Three weeks ago the Shanghai composite was breaking all records with its relentless rally fueled by margin debt and a belief Chinese officials will continue to roll out expansionary programs, interest rate reductions, and even quantitative easing to keep adding liquidity to the system and prevent a recession.

In an extraordinary weekend of policy moves, China’s regulators and central bank announced a temporary halt on all IPO’s and a commitment by brokers and fund managers to buy massive amounts of stock supported by the country’s state backed margin finance company and liquidity from the central bank.WeekInChinaStocks

The Chinese economy also has one of the largest shadow banking segments. Many new retail investors are borrowing money from private lenders to purchase stock that is then used as collateral to obtain margin loans to buy leveraged stock funds. We all know Ponzi schemes are destined to fail with the last investors, usually the least informed and/or least capable to sustain losses, left holding the bag when it all collapses.