Moody"s Considers Municipal Ratings Changes That Could Push Illinois Into Junk Territory

A few weeks ago, we expressed some level of astonishment that the rating agencies, in their infinite wisdom, decided to bestow an investment grade rating upon a new $3 billion bond issuance by the City of Chicago.  Of course, this wouldn"t be such a big deal but for the fact that the state of Illinois is a financial disaster that will undoubtedly be forced into bankruptcy at some point in the future courtesy of a staggering ~$150 billion funding gap on its public pensions, a mountain of debt and $16.4 billion in accrued AP because they can"t even afford to pay their bills on a timely basis.  Here are just a couple of our recent posts on these topics:

• Illinois Pension Funding Ratio Sinks To 37.6% As Unfunded Liabilities Surge To $130 Billion


• Illinois Unpaid Vendor Backlog Hits A New Record At Over $16 Billion


• The State Of Illinois Is "Past The Point Of No Return"

Alas, as Capitol Fax notes this morning, it seems as though Moody"s may finally be waking up to the farce that is their own municipal ratings system and is currently in the process of seeking comments from market participants on proposed changes for states’ general obligation credit ratings, which would include an increased emphasis on debt and pension obligations.  Of course, with their GO rating just one notch above junk, all of those long-only bond funds that have scooped up billions in "juicy" 4% Illinois paper over the past couple of months should probably take notice.

Under the proposed changes, debt and pension obligations will have a 25% weight on state credit ratings, up from 20% currently. The individual state’s economy, another factor in Moody’s ratings, will also have a 25% weight, up from 20%. Governance will fall to 20% from 30% and finances will be maintained at 30%.

 

The debt and pension factor “is critical because debt and pension obligations are the primary long-term liabilities that states have,” Moody’s said in an announcement on the proposed changes Tuesday. “As these liabilities grow, states face rising expenses to pay debt and pension benefits. High fixed debt service and pension costs can crowd out other budgetary priorities and force states to raise taxes in order to meet them. Debt and pensions can curtail a state’s budgetary flexibility and heighten the risk that it will seek to deleverage through a debt restructuring.”

Of course, the proposed changes come just after Fitch put out their 2017 State Pension Update which showed that Illinois’ pension crisis is the worst in the nation with an underfunding of more than $151 billion...or $60 billion more than second worst state: New Jersey.

“Six states have long-term liability burdens that Fitch considers elevated [in excess of 20 percent of personal income],” the report said, “with Illinois carrying the highest liability burden at 28.5 percent of personal income.”

 

Fitch Senior Director Doug Offerman said taxpayers should care because the burden takes up more than 28 percent of all personal income in Illinois, “which is essentially a proxy for the wealth level, the resource base of a given government.”

 

“For the last several years the [pension] increases did grow faster, and I would say do crowd out other spending that might have otherwise taken up organic revenue growth,” [Fitch Ratings Senior Director Karen Krop] said.

Meanwhile, State Senator Dan McConchie (R) noted, as have we on multiple occasions, that people are already fleeing Illinois in droves because of its financial crisis and resulting tax burdens.  “Whether it’s through their property taxes or because of the recent income tax increase, they just can’t afford to [stay here],” McConchie said. “This day of reckoning is fast approaching us. I don’t think we want to wait until the absolute last minute to try and do everything we can to really right the ship.”

Unfortunately, Mr. McConchie, we"re afraid your proverbial ship is taking on so much water at this point that it hasn"t a hope of surviving the crushing weight of your state"s mounting debts...perhaps it"s better at this point to simply seek a life raft and follow your constituents to Texas.

US Household Debt Is Rising 60% Faster Than Wages, And One Rating Agency Is Worried

In a report released today by DBRS titled "Consumer debt and debt burden", the rating agency which is best known for keep Italian debt eligible for ECB monetization at the peak of the European banking crisis, looks at the latest Quarterly Report on Household Debt and Credit issued by the NY Fed (discussed here previously) which showed that consumer debt for the third quarter of 2017 was approximately $12.96 trillion, representing an increase of $116 billion over the second quarter of 2017. The debt level for the first three quarters of 2017 has continued to increase above the previous record debt level which was established in the third quarter of 2008 as shown in Exhibit 1 below.

DBRS also highlights that not only did total debt levels increase, but their composition changed as highlighted in Exhibit 2 below.

The good news: total mortgage debt has decreased since 2008, to $8.743 trillion from $9.29 trillion, but as of the third quarter of 2017, still accounts for 67.5% of overall consumer debt.

The bad news: since 2008, the growth in total debt has been attributable to the auto loan and student loan sectors. Auto loan debt has increased by 50% since 2008, to slightly over $1.2 trillion from approximately $800 billion. The most dramatic growth rate, as Zero Hedge readers know well, has been in student loan debt which has grown by 122% since 2008, to $1.357 trillion from $611 billion.

But a bigger concern flagged by DBRS is that the growth in consumer debt is raising concerns when viewed in the context of the existing wage stagnation hampering the current economic environment. The rating agency cites a paper published in October 2017 by the Harvard Business Review which stated that the inflation-adjusted hourly wage has grown by only 0.2% per year since the mid-1970s and labor’s share of income has decreased to its current level of 57% from 65%.

Meanwhile, in the second quarter of 2017, wages were only 5.7% higher than they were a decade earlier. In comparison, the Federal Reserve Bank of New York/Equifax data shows that consumer debt growth over the same period was 9.3%.

In other words, the purchasing power of US households has been largely a function of rapidly rising debt, which over the past decade has risen 60% faster than wages.

There is another concern: while overall delinquency rates have stabilized in recent years, the one stubborn outlier remains student debt, where 90+ day delinquencies have risen to more than 10%.

This is a problem because as Bloomberg"s Lisa Abramowicz writes, considering that GOP tax overhaul may eliminate tax deductions on interest on student loans, this debt load could become even more onerous.

It"s not all bad news, however: as DBRS concedes, stabilizing delinquency trends imply that a tipping point has not yet been reached. There is also the suggestion that since there have been significant economic booms since the 1970s, during periods of persistent wage stagnation, the tolerance level for gaps in debt and earning power is quite large.

On the other hand, the rating agency also concedes that with consumer debt at all-time highs, and rising, as the debt/wage relationship seems to be entering a previously unobserved phase, "it seems prudent to closely monitor both components."  This is a "red flag" for the economy because as Abramowicz concludes, "should unemployment rates rise at some point, this balance could fall out of whack, exacerbating any economic downturn."

Of course, a variant perception on this threat is that once the economic fundamentals catch up with reality, and the US consumer is tapped out in a rising rate environment and crushed by the weight of $1.4 trillion in student loans, the Fed will promptly halt the current monetary tightening regime, and revert back to preserving the "wealth effect" with more ZIRP, QE and eventually NIRP. One look at the S&P confirms just how "worried" the market is about the current state of the economy...

U.K. Litigation Cases On Defaulted Consumer Debts Soar Beyond 2008 Levels

Last month, S&P warned that UK lenders could incur £30 billion of losses on their consumer lending portfolios consisting of credit cards, personal and auto loans if interest rates and unemployment rose sharply.  Much like in the U.S., S&P warned that "loose monetary policy, cheap central bank term funding schemes and benign economic conditions" had fueled an "unsustainable" yet massive expansion of consumer credit that will inevitably end badly.  Per The Guardian:

The rapid rise in UK consumer debt to £200bn from car finance, personal loans and credit cards is unsustainable at current growth rates and should raise “red flags” for the major lenders, ratings agency Standard & Poor’s has warned.

 

In detailed analysis of the sector, S&P warned that losses from this form of lending suffered by banks and other financial institutions could be “sharp and very sudden” in an economic downturn and may be exacerbated if the Bank of England increased interest rates.

 

It also warned that it could downgrade banks’ credit ratings if the high growth rate persisted or banks took on too much risk in this sector. But it did not fear any system-wide impact from consumer credit.

 

“Loose monetary policy, cheap central bank term funding schemes and benign economic conditions have supported consumer credit supply and demand,” S&P said.

 

Annual growth rates in UK consumer credit of 10% a year have outpaced household income growth, which is closer to 2%, and become a focus for the Bank which is scrutinising lenders’ approach to the sector.

 

“We believe the double-digit annual growth rate in UK consumer credit would be unsustainable if it continued at the same pace,” S&P said.

Now, new data surrounding the growing number of court filings related to the recovery of consumer debts highlights just how serious the personal leverage problem has become in the UK.  As the FT points out this morning, there have been over 900,000 court judgements on consumer debts in just the first 9 months of 2017, up 34% compared to the same period in 2016, compared to only 827,000 at  the height of the great recession in 2008.

Consumers who refuse to repay their debts are increasingly being taken to court, with litigation at levels last seen in the run-up to the 2007-08 financial crisis.

 

New figures show there were 910,345 county court judgments in the nine months to the end of September. This is an increase of 34 per cent per on the same period in 2016, and compares with 827,000 in the whole of 2008, at the onset of the financial crisis.

 

The rise in court judgments is another indication of the high levels of unsecured debt weighing on British consumers, with Bank of England data showing that borrowing through credit cards, overdrafts and car loans has topped £200bn for the first time since the global crisis.

 

Although UK unemployment is at all-time lows, growth in real incomes and the savings rate have both deteriorated in recent months, suggesting household finances are worsening. Many economists are predicting a slowdown in what has been robust consumer spending.

This should come as little surprise to our readers as we pointed out earlier this summer that the U.K. auto market had seemingly taken a page from U.S. subprime lenders by offering a brand new car, with no money down, to anyone who walks into a dealership with a pulse (see: Undercover Investigation Exposes Deteriorating Auto Lending Standards In Europe; No Job, No Problem) . As the Daily Mail pointed out, their undercover reporters visited a total of 22 dealerships and were repeatedly offered cars of various values with no money down and despite reporters admitting that they had no job and no source of income.

Reporters visited 22 dealerships in England and Scotland, saying they were in their early twenties and either unemployed, on low incomes or trying to buy a car despite having poor credit ratings. Half of the dealerships – including ones selling Audis, Mazdas, Suzukis, Fords, Vauxhalls and Seats – told them they could have a brand new car without paying a penny up front.

 

In each case they were offered Personal Contract Purchase (PCP) deals – a type of car loan that now makes up nine out of ten car sales bought on finance in Britain.

 

These deals offer smaller monthly payments than traditional car loans.

 

A reporter who said he was working part-time on the minimum wage was offered a £15,000 Seat Ibiza without a deposit at a Seat dealership in Manchester.  Another reporter suggested that he had bad credit, but he was offered an £8,600 Vauxhall Corsa in Birmingham.

 

Kevin Barker, 71, found himself £3,500 in debt when he suffered a heart attack six months into a PCP deal. He said a ‘pushy’ Toyota salesman ‘pressured’ him into taking out a 36-month agreement in November 2014 and he was not told of the repercussions if he fell ill or lost his job.

Of course, excessively levered household balance sheets work wonders for gaming GDP growth...that is, right up until the point that interest rates start to rise and those households realize their ability to "afford" their spending binge was nothing more than a temporary blip courtesy of accomodative interest rate policies...the reversal of which will now render many of them bankrupt.

China Issues First Dollar Bond Since 2004, Bails Out Corporate Liquidity

Despite downgrades from the rating agencies, China is issuing its first sovereign dollar bond issues in 13 years on an unrated basis (what do the agencies know anyway) and at tight spreads to US Treasuries. The 5 and 10-year issues come just over a month since S&P cut the nation’s rating one level to A+ on 21 September 2017. Moody’s had already cut to single A.

Bloomberg reports that China began marketing its first sovereign dollar bonds since 2004 following a week when Chinese leaders in Beijing outlined a greater role for the nation on the world stage. The Ministry of Finance is offering $1 billion of five-year notes at a spread of 30 to 40 basis points over Treasuries, and the same amount of 10-year debt at a premium of 40 to 50 basis points, according to people familiar with the offering, who aren’t authorized to speak publicly…China is offering the bonds unrated, in a break with traditional practice by sovereigns in the region when they sell dollar notes. S&P Global Ratings last month followed Moody’s Investors Service in cutting China’s sovereign rating, citing soaring debt and increased economic and financial risks. The debt sale is one of the most eagerly anticipated in Asia this year…

The sovereign itself has been a rare issuer in foreign currencies and has only ever sold the equivalent of about $11 billion of such notes, according to data compiled by Bloomberg.

The order books exceeds 22 billion dollars, according to Bloomberg.

The lack of a formal rating on the Ministry of Finance of the People’s Republic of China’s dual-tranche U.S. dollar bond offering isn’t impeding the sale as the order books are reported to exceed $22 billion at initial price guidance as the books move to Europe…

 

Key comparable bonds include Japan Bank for International Cooperation’s $1.25 billion 2.875% due July 2027 which was quoted around T +43 basis points, State of Israel’s $1 billion 2.875% due March 2026 which was quoted around T +41 basis points and Germany’s KFW’s $2 billion 2% due May 2025 which was quoted around T +4 basis points…

 

China’s first sovereign dollar bond offering since 2004 is being lead managed by Bank of China, Bank of Communications, Agricultural Bank of China, China Construction Bank, CICC, Citigroup, Deutsche Bank, HSBC, ICBC and Standard Chartered Bank

The scarcity of similar Chinese bonds was a factor having a positive impact on spreads as one analyst told Bloomberg.

“We believe that pricing will ultimately settle on the tight end of initial price guidance,” said Todd Schubert, head of fixed-income research at Bank of Singapore Ltd., citing strong demand for emerging market bonds, and the scarcity value of a Chinese sovereign bond.

 

The announced guidance “is in line with our expectation,” he said. BNP Paribas SA said this week the five-year and 10-year bonds may price at 30 basis points and 40 basis points respectively over Treasuries. The 10-year note is set to price at a spread lower than South Korea’s bond of the same tenor. South Korea, rated two levels higher than China, sold a 10-year bond at a spread of 55 basis points in January, and it was about 74 basis points on Thursday.

Cynicism regarding the modus operandi of the Chinese authorities might have played a role too – this from Reuters.

The MoF has previously manipulated offshore bond sales by force-feeding them to compliant Chinese banks. This simulates demand without market substance. This time around, however, the securities may attract more foreign interest: as the mainland economy has recovered, foreign anxiety has genuinely eased.

Reuters emphasises the favourable (but incorrect in our opinion) repricing of Chinese risk and China’s motivation for the dollar bond issue.

Beijing’s dollar bonds show how Chinese risk has been repriced. The country is selling $2 billion of five-and 10-year sovereign dollar bonds, the first such issue since 2004. Despite recent downgrades by global rating agencies, these are likely to yield just 30 to 50 basis points above U.S. Treasury bonds. Local banks can guarantee demand if needed, but there is also a genuine reassessment of China risk underway. China does not need the money, but the borrowing serves multiple purposes. It helps stabilize cross-border capital flows, refills hard-currency reserves, and makes it easier for companies to refinance in dollars, since there will now be benchmark issues to price against. It is also a rebuke to the credit rating agencies, showing China can brush aside their warnings.

Indeed, the anticipation that China’s sovereign issue would “price tight” helped push spreads on state-owned corporate debt lower.

Despite investors falling over themselves to get hold of these Chinese sovereigns, we have sympathy for Reuters’ warning about dollar lending to China’s over-leveraged corporate sector.

Even so, this is an unrated issue by a country infamous for credit-fueled growth, weak rule of law, and selective respect for international norms.

It’s one thing to lend money to the Chinese government, but this will serve as a benchmark for pricing debt sales by other Chinese borrowers, some of them far more opaque.

Too late.

If the Treasury General Account on the Fed’s balance sheet is replenished to late 2016 levels and the Fed begins to taper, bank reserves will be extinguished and dollar liquidity is going to tighten significantly in the coming months - as we explained here.

With about $10 trillion of offshore dollar debt – with maybe a $1-2 trillion belonging to China -  this will make it more difficult for EM banks to roll dollar funding. China’s dollar borrowing by its corporate sector has been on a tear - with Bloomberg reporting record dollar-bond issuance of $144 billion by Chinese companies so far in 2017.

Finally, Bloomberg provided feedback on the Chinese sovereign bonds from analysts and investors.

AllianceBernstein (Brad Gibson) - If you look at CDS, the market has already priced in that China is a stronger credit than Korea. I suspect China could issue a $2 billion bond at any given spread to U.S. Treasuries. There will be strong Asian support for this bond as it is the first China sovereign dollar issue since 2004. Ultimately, China’s ability to service a $2 billion bond is unquestionable.

 

ANZ (Owen Gallimore) - We see the technical driven fair value as T5+20 (2.2% yield) and T10+25 (2.7%), a relatively flat 15bp Z-spread curve, with our expectation of non-Chinese demand for this ‘collector’s item’ in primary and onshore ‘policy’ demand in secondary. These levels would be moderately tighter than the similarly-rated Chile and Israel but more befitting China’s status in the world and proven policy firepower

 

Bank of Singapore (Todd Schubert) - The announced IPT is in line with our expectation. Given the still strong bid for Emerging Market bonds, the scarcity value of a Chinese sovereign bond and the favorable capital treatment from the HKMA, we believe that pricing will ultimately settle on the tight end of initial price guidance.

 

Columbia Threadneedle (Clifford Lau) - A lot of expectations and enthusiasm are built into this offering, so there’s been tightening of spreads going into the deal. We have taken some positions in the quasi-sovereign area, and would certainly consider participating in the new USD bonds offering, partly because it’s a rare and small deal.

 

Pimco (Luke Spajic) - Coming straight after the 19th Party Congress, the timing of issuance was spot on. The upbeat tone of the congress will be mirrored in the demand for bonds. Though the deal size is relatively modest, the symbolic nature of this issuance will give state owned enterprises, and banks, a marker for valuation. Over time, we would like to see a full sovereign curve be established with longer maturities. Demand will outstrip supply by significant multiple, so pricing is going to be at the tighter end. No surprise there.

 

JPMorgan Private Bank (Anne Zhang) The 10 year is in line with the comps released. In context, 5 year appears generous, however, I’d expect final pricing to be tighter from IPT. The market has built up the hype in the last week with very high expectation of very tight spread.

 

Nomura (Nicholas Yap) - Given the relatively small deal size (just USD2bn in total) and the fact that it will likely be well anchored by domestic financial institutions, China essentially possesses the ability to print the new bonds wherever it wants, and estimating fair value (FV) is arguably more of an academic exercise, one that we will nevertheless attempt to undertake! Comparing with suitable Asian and global sovereign peers, Nomura estimates fair value for the new China 5Y/10Y at around 25bp/35bp over Treasuries

The State Of Illinois Is "Past The Point Of No Return"

Everyone knows Illinois’ financial condition is poor. Conventional thinking seems to be that a bond default, should that happen, would be many years in the future. Pardon me, but wasn’t that the thinking right up to Puerto Rico’s, “We can’t pay” announcement?

To answer the question of just how badly off is Illinois, I assembled a list of key creditworthiness indicators and applied them to New York, a highly rated state, and Illinois.

Commentary and Benchmark Private Bond Ratings

The State of New York is managing its financial resources and obligations in a better-than-average manner. Particularly, the State’s employee pensions are reported to be 90% funded, but the general fund deficit must be contained and then eliminated. Unfunded OPEB costs are too high and can be renegotiated. Funded and pro forma unfunded long-term contractual obligations equaled 23% of general fund revenue in FY ended June 30, 2017, and exceeds the 15% threshold for a Benchmark AA or AA+ credit rating.

*Both NYS income tax and sales tax bonds are payable from annual general fund appropriation. For additional information, click here.

Commentary and Benchmark Private Bond Ratings

The State of Illinois, in my opinion, is past the point of no return. It does not have the ability to raise taxes or cut spending to the degree necessary to reduce the annual cost of bond and retiree benefits from 33% to a sustainable level. The amount of debt issued by Illinois requires a moderate 8% of general fund revenues to pay P&I.

The insolvency is not the result of too much bonded debt, but rather the government promising retirement and other post-employment benefits that aren’t affordable.

Bear in mind that direct debt of the State is exempt from any form of bankruptcy. Most believe that the State’s pension benefit obligations are on parity with states’ general obligation bonds and bankruptcy-exempt as well.

Let’s assume the State did find itself in a “no money to pay everyone” position and chose bond default as the relief value over failing to appropriate sufficient funds for pension funding and OEB costs.

Since neither GO bond holders nor pension fund creditors are subject to any bankruptcy court, who would win? Together they would be by far the State’s largest long-term contractual obligors. I think the State’s GOB investors would come out ahead because the State would not be able to borrow in its own name until it makes good on past due GO P&I.

Retired public employees might understand that it is better to negotiate a fair agreement than to demand one the employer can’t afford. This is the only scenario, however unlikely, where Illinois stands a change of pulling itself out of its deep financial hole.

Benchmark and rating agency ratings

Hartford Bankruptcy Looms As CT Gov Admits "We Spent Money On Wrong Things"

Connecticut Governor Daniel Malloy is among the country’s least popular governors after forcing through two tax hikes that sent individuals and corporations fleeing from the state. Luckily for the state and its people, Malloy apparently has no interest in sticking around to take the heat when it comes time for the next hike: He has announced that he will not seek a third term.

Connecticut has gone without a budget for two months, and is facing devastating cutbacks in municipal services if one isn"t passed soon. But Malloy took time off this week from grappling with legislators to speak with a reporter from Reuters, he offers little insight into what lead to the state’s precarious fiscal situation. Instead, he blames it on overspending on prisons.

"The state invested in the wrong things for a period of time. It allowed its higher educational institutions to suffer while it sought to placate communities with respect to other forms of local reimbursement," Malloy told Reuters during an interview in his office on Thursday.

"We built too many prisons, which we"re still paying off even while we"re closing them," he said. The Democrat took office in 2011 and is not seeking a third term.”

Prisons are only a small part of the state"s problem. Choked by outmigration and a debt-service burden that’s the highest in the nation compared with revenues, Connecticut’s fiscal situation is deteriorating rapidly. And after two months without a budget, Reuters reports that, unless lawmakers act soon, the government of one of the wealthiest states in the country will begin cutbacks in education spending and municipal aid as Malloy tries to close an expected $3.5 billion budget shortfall over the coming two years.

Connecticut is one of a handful of US states on the verge of a Greece-style debt-crisis, as it struggles to service some $23 billion in municipal debt, all while lawmakers keep one eye on the state’s unfunded pension liabilities, which have climbed to a terrifying $50 billion, thanks to the generous retirement packages enjoyed by Connecticut state employees.

Back in May, all three of the main rating agencies downgraded the credit rating on the state’s general-obligation bonds, sending the state’s credit risk soaring. Meanwhile, municipal debt for the city of Hartford, Connecticut’s once-proud capital, has been downgraded to junk status. Health-insurance giant Aetna, which was founded in Hartford nearly 200 years ago, recently dealt the city a major blow when it announced plans to relocate its headquarters to New York City, though most of the company’s 6,000 employees will remain in the state.

About a year earlier, General Electric, which had been headquartered in Fairfield, CT for decades, announced it would re-locate to Boston, where it would face a lower tax bill AND access to top-flight talent, who typically prefer to work and live in trendy urban hubs.

After meeting with Millstein & Co, the same firm that tried to help Puerto Rico reorganize its massive debt burden, State Comptroller Denise Nappier proposed a new tax-secured revenue bond program, which she says will lower borrowing costs and boost reserves. The bonds would be issued in lieu of general-obligation bonds, according to Reuters.

But that"s a long-term solution. Right now, the state still desperately needs a budget, or its municipalities will be faced with devastating cuts.

“…until lawmakers craft a budget, the state"s fiscal uncertainty is causing havoc among municipalities. Some are considering whether to delay the start of school or dip into reserves.

 And for Hartford, the longer the state goes without a budget, the closer the city comes  to a possible bankruptcy filing, said Hartford Mayor Luke Bronin, a 38-year-old former U.S.  Treasury official.

"The lack of a state budget... makes a liquidity challenge come that much faster," he said.”

By some measures, Connecticut has the worst debt problem in the country.

“It has the most net tax-supported state debt per capita in the nation at $6,505, versus a median of $1,006, according to Moody"s Investors Service.

It has the highest debt service costs as a portion of state revenues, as well as debt relative to gross domestic product, Moody"s said.”

During fiscal 2017, CT spent $2.85 billion servicing debt – the most in seven years.

“The $2.85 billion of principal and interest the state paid on its bonds in fiscal 2017 was the highest in six years, according to preliminary unaudited information from State Treasurer Denise Nappier"s office that has not yet been published.”

A crisis at the state level promises to ripple across the state, destabilizing municipalities that have taken state aid for granted for too long.

“Further, the state"s budget crunch is threatening its cities including the state capital of Hartford, which is considering bankruptcy due, in part, to its dependence on state aid.

Connecticut has borrowed for decades to fund school construction, whereas nearly all other states typically borrow at the local level for those projects.

Lack of county governments means some other local costs are picked up by the state, including for all of its detention facilities.”

As with many of its troubled peers, Connecticut’s financial struggles began with the crisis.

“Connecticut has piled on debt to bolster its public pensions, selling $2.3 billion of bonds in April 2008.

And again in December 2009, the state sold $916 million of economic recovery notes to close a budget deficit after depleting its rainy day fund during the Great Recession.”

Beyond that, its decline has been hastened by a combination of forces. A deteriorating local economy, coupled with a plunge in hedge fund profits, have strained the state’s already narrow tax base. Meanwhile, high taxes have inspired wealthy hedge fund types to move to states that are more tax-friendly, like Florida.

Despite its desperate financial situation, the state still leads the country in one important metric...

…college basketball championships.
 

Will Trump Use Obama's "Secret Debt Ceiling Plan" To Avoid A U.S. Treasury Default?

After voting to repeal and replace Obamacare 60 times under the Obama administration, Senate Republicans, now that it counts, are locked in a heated civil war over how or if they should even modify the controversial legislation.  As proven time and again, despite sharing a common party, conservative and moderate republicans have very little else in common.

So, while many may think that a repeat of the 16-day government shutdown in 2013 is unlikely while a single a party controls all three branches of government in Washington D.C., we suspect it may not be quite as simple as that.  Without a budget in place that truly balances, conservative republicans will most likely be unwilling to approve debt ceiling increases no matter who is sitting in the White House.

While republicans have attempted to get ahead of the game by passing a debt ceiling increase well in advance of a breach, efforts so far have failed.  And while it may seem far away, the U.S. government will reach its statutory limit on borrowing some time in October.  So how will Mnuchin handle the Treasury Department if Republicans fail to act and Democrats refuse to play ball?  Turns out Obama had a plan for that.  Per Bloomberg:

When the nation almost breached its debt ceiling six years ago, the Federal Reserve and Treasury drew up contingency plans that were kept secret until January, when transcripts of an Aug. 1, 2011 conference call at the central bank were released after a customary five-year lag.

Under the contingency plan, holders of U.S. debt and recipients of social security, veterans benefits and other entitlements would be paid first. Everyone else, such as government contractors and federal employees, would be at risk of payment delays or partial payments.

Though the scenario nominally protects holders of U.S. debt by prioritizing the payments they are due, it raises fears that the value of their underlying assets could suddenly decline if the U.S. government’s reputation for creditworthiness is damaged.

“I’m assuming that prioritization is the fallback,” said Lou Crandall, chief economist at Wrightson ICAP LLC. The acknowledgment in the Fed transcripts of the existence of a backup plan to pay interest first makes it more plausible, he said, calling it a “truly terrible idea.”

Under the prioritization plan described in the 2011 transcripts, Treasury would make all semi-annual coupon payments on debts in part by using monies built up by deferring other obligations. The government would auction new debt at regularly scheduled times only to fund old debts that matured.

Meanwhile, even though the plan would still make all interest payments on U.S. debt when due, it"s unclear whether Obama"s prioritization plan would merit further downgrades from the ratings agencies.

Prioritizing U.S. debt is a contentious issue, with no consensus over whether it constitutes a default. Former Treasury Secretary Jacob Lew called it “default by another name” while in office. Fitch Ratings disagrees, but says it would trigger a review of whether the U.S. still warrants a AAA rating.

Moody’s Investor Service, which considers it likely that the government would use the plan if the Treasury exhausts extraordinary measures to stay under the ceiling and Congress doesn’t act, seems comfortable with it. The agency says that the economic disruption that could erupt would expedite a political compromise to end the impasse.

Of course, in the long run these shutdowns are just a waste of time as politicians ultimately cave to pressure from a base of constituents who have been whipped into a state of mass hysteria by a barrage of news flow on the damning impacts of a government shutdown.

There is little support for prioritizing debt payments in Congress, with Oklahoma Republican Tom Cole, a member of the House Budget Committee, calling it a “harebrained scheme that is apt to backfire.”

“Proposing to pay interest to the Chinese first, while stiffing American businesses and households that are owed payments by Treasury, hardly seems like a winning political strategy,” Wrightson’s Crandall said. “We’re not sure how the market would respond to that kind of payments twilight zone.”

And, in the end, the result is always the same:

The Other Shoe Drops: Prime Auto Loans Losses Surge As Recoveries Tumble

When we looked at subprime auto delinquencies most recently, we found some troubling trends: first, in February, we showed that 61+ day delinquencies in General Motors" subprime securitization book would support a rather bleak thesis for future auto sales, and specifically the demand side of the equation, with January 2017 delinquency rates soaring to the highest levels since late 2009/early 2010. 

Ironically, this hasn"t stopped lenders from providing financing, and according to Morgan Stanley since 2010, the share of Subprime Auto ABS origination that has come from deep subprime deals has increased from 5.1% to 32.5%, suggesting that yield-starved buyside will put "other people"s money" into anything as long as it provides a slightly higher yield.

Meanwhile, the subprime shock has already impacted the broader market, observed with the latest monthly auto sales data which declined four month in a row heading into May. An even bleaker picture of the subprime market emerged a month later when looking at the latest securitization analysis from Morgan Stanley which revealed that 60+ day delinquencies at 266 subprime auto ABS deals were surging - despite low unemployment, high consumer confidence and debt-to-income ratios at 30-year lows - back to "great recession" levels. Meanwhile, loss severities were also shooting higher just as used car prices were sliding.

 

In part, this tied in with the overnight look at the "flood of off-lease vehicles", according to which by the end of 2019, an estimated 12 million low-mileage vehicles are coming off leases inked during a 2014-2016 spurt in new auto sales, which is set to put even more pressure on used (and new) car prices for the foreseeable future.

As Reuters noted, a computer search for available used vehicles within 150 miles of Reel revealed an eye-popping figure: 668 Escapes. That"s enough to put more than 40 percent of the inhabitants of this small northeastern Ohio town, population 1,600, into the popular crossover. A search for the Chevrolet Equinox, a comparable crossover, showed 461 available.

"The automakers have flooded the market," said Reel, owner of Reel’s Auto in Orwell, Ohio, about 40 miles east of Cleveland.

The above trends validate a recent bearish Morgan Stanley analysis, which forecast that the plunge in used car prices is just getting started, and in a bear case, the bank sees used car prices dropping by up to 50% over the next 5 years.

 

* * *

However, in an even more troubling development for US consumers, it now appears that the other shoe for the US auto market has finally also dropped, and according to analyses by both Morgan Stanley and S&P, losses on prime auto loans are also surging.

In the latest note by Morgan Stanley"s Jeen Ng, the analyst reports that "fundamental performance deterioration has not been confined to Subprime. Both 60+ day delinquencies and default rates in Prime ABS pools have nearly doubled from their post-crisis lows."

A slightly better picture - at least according to MS data - emerges in terms of loss severities. Still, while subprime losses are far worse, the deterioration among prime loans is unmistakable: compared to peak levels, 60+ day delinquencies in Prime auto loan pools are roughly 65% of the way back, whereas Subprime pools are close to 95% of their peak levels. On the default rate side, the deterioration is somewhat more subdued, with Subprime over 80% of the way back to prior peaks while Prime has yet to reach the 45% mark.

One troubling observation, as confirmed in the recent Fed Senior Loan Officers Survey is that credit standards have continued to ease: as in Subprime, some of the ongoing Prime deterioration can be attributed to a relaxing of credit standards.

Aggregate credit scores have decreased by about 5 points, which while easier is not even half as much as the 10+ point deterioration in Subprime. The same is true for longer origination terms. Most Prime issuers have extended loan terms by 3-4 months over the past 5 years. In Subprime, extension in most cases has been longer than 10 months. These easier standards can help explain both why delinquencies and defaults are higher, according to Ng. Also, keep in mind, there is a limit as to how far Prime issuers can expand their credit box in the form of lower credit scores before the deals become Subprime.

Some more observations from Morgan Stanley, which finds a particular deterioration in recent loan issuance at Huyndai and Mercedes:

As auto lenders expand their credit box to weaker credit borrowers, we should expect to see poorer credit performance among more recent deals relative to the more seasoned ones.

Across the OEM originators above, we see a very consistent shift in lending standards over time - marginally longer loan terms, higher credit scores and lower used car composition. Overall, the longer loan terms and higher credit scores have offsetting effects on fundamental performance. If we look at the 60+ delinquencies and 3-month CDR curves by vintage, we don"t necessarily observe performance  deterioration over time, and for some issuers we even see relative outperformance among recent deals. However, we do see higher severities among recent vintages, which we can at least partly attribute to the decline in used car values.

HART (Hyundai) and MBART (Mercedes Benz) serve as exceptions to the above, with a higher % of used vehicles and FICO migration of less than +10 points over the last 7 years. They are also the two shelves which show the most pronounced performance shift. TAOT (Toyota) also extended their credit score by less than 10 points, but their change in origination loan terms has been minimal and they have a lower  composition of used vehicles over time.

Additionally, in terms of loss severities, the bank finds that all originator types appear to be trending higher in similar fashion, with non-bank originators printing the lowest recovery values. OEM originators overtook bank originators to see the highest recovery values last year.

* * *

In a separate, and even more downbeat report, S&P Global Ratings analyst Ann Matin noted that losses in bonds tied to "prime auto loans have surged surged in recent months from a year ago, hurt by falling recoveries" and notes that prime net losses rose to 0.73% in February from 0.57% in same month last year. According to S&P, bonds from some issuers that have become a larger share of the index, including Mechanics Bank’s California Republic and TCF Financial Corp., and both are contributing to those higher losses.  Additionally, the rating agency referred to the abovementioned loan losses at Huyndai, stating that “we’ve increased our expected cumulative net loss levels for certain issuers, including Hyundai’s most recent transaction, HART 2017-A."

Margin also wrote that prime asset-backed deals issued in 2015 seem to be performing worse, comparatively, than those sold between 2010 and 2014, and the deterioration in loans made to strong credit borrowers has forced S&P to revise its net loss expectations for various bonds.

* * *

To summarize: subprime loan losses have been surging alongside loss severities (with the buyside happy to soak up any and all issuance, regardless of underlying fundamentals), as recoveries slide, and in recent months this deterioration has finally shifted over to prime loans. Meanwhile, used car prices are tumbling, while new car sales have declined for 4 consecutive months as auto loan demand among tapped out consumers has tumbled. Meanwhile, millions of used cars are about to hit the market as they come off lease, which in turn will further pressure used car prices and new car sales.

So what happens next?  Here, we"ll repeat what we concluded last night:

Unstable used car prices will almost certainly reduce OEM reliance on leases as the implied 3-year depreciation (or residual values, if you prefer) will make them all but completely uneconomical: remember, Americans only care about that monthly payment.  Meanwhile, the relative value between used and new cars will tilt heavily in favor of the used market.  Thankfully Americans will still be able to buy that Mercedes they require to get back and forth from their minimum wage jobs, while maintaining a monthly payment of $500 or less, but it will just have to have 30,000 miles on it.

Of course, the OEMs of the world won"t admit that their game is over until it"s way too late.  So, they"ll keep right on producing new cars to cover a 17-18mm SAAR environment up until the point they face an outright revolt from their dealer networks.  At that point, however, dealer inventories will be so high that Detroit will be forced to shutdown for months on end while new car prices are slashed to reduce the massive inventory glut.  Tanking new car prices will put even more pressure on used car prices which will mark the beginning of the death spiral that will result in a new round of inevitable auto bankruptcies, catalyzing the next economic contraction... assuming one hadn"t started already.

Biggest EU Banks Embark On The Mother Of All Debt Binges

Submitted by Don Quijones via WolfStreet.com,

Spain’s three biggest banks, Banco Santander, BBVA and Caixa Bank, have got off to a flying start this year having issued €8.6 billion in new debt, seven times the amount they sold during the same period of last year. The last time they rolled out so much debt so quickly was in 2007, the year that Spain’s spectacular real estate bubble reached its climactic peak.

Santander accounts for well over half of the new debt issued, with €5.12 billion of senior bonds, subordinate bonds, and a newfangled class of bail-in-able debt with the name of “senior non-preferred bonds” (A.K.A. senior junior, senior subordinated or Tier 3) that we covered in some detail just before Christmas.

Investors beware...

This newfangled class of bail-in-able debt was cooked up last year by French-based financial engineers in order to help France’s four global systemically important banks (BNP Paribas, Crédit Agricole, Groupe BPCE and Société Générale) out of a serious quandary: how to satisfy pending European and global regulations demanding much larger capital and debt buffers without having to pay investors costly returns on the billions of euros of funds they lend them to do so.

That’s what makes senior non-preferred debt so ingenious: it pretends to be simultaneously one thing (senior), in order to keep the yield (and the cost for the bank) down, and another (junior) in order to qualify as bail-in-able. What it amounts to is a perfect scam for big banks to bamboozle bondholders – usually institutional investors like our beaten-down pension funds – into buying something with other people’s money that doesn’t yield nearly enough to compensate them for the risks they’re taking.

Put simply, if a bank is resolved, holders of these instruments could lose much or all of their money, similar to stock holders. According to Olivier Irisson, executive chief financial officer at Groupe BPCE, France’s second largest bank, it’s a “very good compromise for investors and banks.”

Judging by how they’re selling, yield-starved investors seem to agree. After the new bonds were rubber stamped by the Banque de France in mid-December, investors gobbled up €1.5 billion of Credit Agricole’s senior non-preferred 10-year bonds despite only receiving about 45 basis points more than they would get on traditional senior debt and about 65 basis points less than on subordinated.

Voracious Appetite

Société Générale quickly followed CA’s lead, issuing €3.5 billion of 5-year dollar-denominated notes. Investors lapped it up. During the same week BNP Paribas sold €1 billion of bail-in-able debt, a mere drop in the ocean compared to the €30 billion of senior non-preferred debt it hopes to raise by 2019. BPCE issued its first non-preferred deal in the second week of the year, a €1 billion six-year trade that attracted $2.4 billion of orders. It then launched an even riskier samurai (yen denominated) non-preferred trade, and most investors were not put off by the A- rating.

“2017 will be the year of senior non-preferred,” said Vincent Hoarau, head of financial institutions syndicate at Crédit Agricole. Europe’s biggest banks certainly have a voracious appetite for new funds. The European Banking Authority recently estimated a €310 billion gap in all the region’s banks meeting their total loss absorbing capital requirements before the 2019 deadline. And much of that gap is expected to be filled by senior non-preferred bonds.

The European Commission has already endorsed the financial instrument, rating agencies have also lent their approval and the ECB can’t wait to come up with “a common framework at Union level“. However, the legislation permitting its issuance is currently only in place in France and is not expected to be passed elsewhere in Europe before the second half of 2017, at the earliest.

But certain banks have already jumped the gun, including Holland’s ING and Spain’s Santander, both of which have begun issuing senior non-preferred bonds despite the fact their issuance has not been officially sanctioned by each bank’s respective national regulator. Even more ominous, Italy’s fragile superbank, Unicredit, has also expressed an interest, though it will probably have to wait for Italy’s banking crisis, of which it has a major part, to blow over (assuming it can) before joining the party.

A Staggering Volume of Debt

Even by today’s inflated standards, the volume of debt the G-SIBs hope to issue in the next two years is staggering. Santander alone intends to issue between €43 billion and €57 billion, in order to meet the capital requirements that are scheduled to come into effect for the world’s 30 biggest banks on Jan 1, 2019. That’s between 60% and 75% of Santander’s entire market cap. And if everything goes according to plan, most of that debt — between €28 billion and €35.5 billion worth — will be issued in the form of senior non-preferred bonds.

For the moment there’s little concern over investor appetite, says Demetrio Salorio, global head of debt capital markets at Société Générale Corporate & Investment Banking. “The investor base is keen,” he says. “They are far more at ease with the instrument than they were 18 months ago.” Spreads could even tighten, he reckons.

All of which is testament to just how desperately starved of yield institutional investors have become in the NIRP environment as they’re trying to get their hands on financial instruments that offer virtually no security in exchange for the slimmest of additional returns.

But the investor pain, when it’s time for it, should relieve taxpayers and the public. When the bank collapses and is being resolved or recapitalized, these bondholders are supposed to get bailed in and lose some or all of their investment. This would protect taxpayers at least to some extent from getting shanghaied into doing that job. And if institutional investors who take that risk don’t get paid enough for taking that risk, so be it. It’s just pension funds and retirement nest eggs under their management that will take the hit.

Unless, of course, the government, under political pressure, decides to bail out those bondholders anyway with taxpayer money, as they’re doing in Italy’s banking crisis at the moment, on the pretext that these bondholders were naive retail investors who were missold a similar version of bail-in-able junior bonds. And so it would be back to square one.

In Italy, the insider blame game has begun. Read…  Italy’s Banking Crisis Is Even Worse Than We Thought

Fitch Warns Trump Administration Could Lead To Global Economic Disaster

Twice in one week.

Just days after ECB president Mario Draghi (and other Europeans) suggested that Trump"s proposed deregulation has "sown the seeds of the next financial crisis", when he told the European Parliament that "the last thing we need at this point in time is the relaxation of regulation. The idea of repeating the conditions that were in place before the crisis is something that is very worrisome", clearly ignoring that one of the biggest timebombs facing the world is his own balance sheet... 

... moments ago Trump was also preemptively cast as the scapegoat for the next global economic crash by none other than rating agency Fitch.

In a self-explanatory report titled "The Trump Administration Poses Risks to Global Sovereigns", Fitch is sounding the alarm on the potentially negative consequences of Trump"s economic policies, even though none have been officially disclosed yet.

In the report Fitch warns that "the Trump Administration represents a risk to international economic conditions and global sovereign credit fundamentals" and cautions that because "US policy predictability has diminished, with established international communication channels and relationship norms being set aside", this raises the "prospect of sudden, unanticipated changes in US policies with potential global implications."

Before it unleashes its criticism, Fitch concedes that elements of President Trump"s economic agenda "would be positive for growth, including the long-overdue boost to US infrastructure investment, the focus on reducing the regulatory burden and the possibility of tax cuts and reforms, assuming cuts don"t lead to proportionate increases in the government deficit and debt. One interpretation of current events is that, after an early flurry of disruptive change to establish a fundamental reorientation of policy direction and intent, the Administration will settle in, embracing a consistent business- and trade-friendly framework that leverages these aspects of its economic programme, with favourable international spill-overs."

However, it then quickly shifts to laying out the negatives, which it believes are more likely to prevail:

The primary risks to sovereign credits include the possibility of disruptive changes to trade relations, diminished international capital flows, limits on migration that affect remittances and confrontational exchanges between policymakers that contribute to heightened or prolonged currency and other financial market volatility. The materialisation of these risks would provide an unfavourable backdrop for economic growth, putting pressure on public finances that may have rating implications for some sovereigns. Increases in the cost or reductions in the availability of external financing, particularly if accompanied by currency depreciation, could also affect ratings.

It then explains that base case is not favorable, noting that in Fitch"s view, "the present balance of risks points toward a less benign global outcome."

The Administration has abandoned the Trans-Pacific Partnership, confirmed a pending renegotiation of the North American Free Trade Agreement, rebuked US companies that invest abroad, while threatening financial penalties for companies that do so, and accused a number of countries of manipulating exchange rates to the US"s disadvantage. The full impact of these initiatives will not be known for some time, and will depend on iterative exchanges among multiple parties and unforeseen additional developments. In short, a lot can change, but the aggressive tone of some Administration rhetoric does not portend an easy period of negotiation ahead, nor does it suggest there is much scope for compromise.

The rating agency warns that sovereigns most at risk from adverse changes to their credit fundamentals "are those with close economic and financial ties with the US that come under scrutiny due to either existing financial imbalances or perceptions of unfair frameworks or practices that govern their bilateral relations"As a result, nations that could suffer include Canada, China, Germany, Japan and Mexico, which have been identified explicitly by the Administration as having trade arrangements or exchange rate policies that warrant attention, "but the list is unlikely to end there." Here Fitch takes a stab at Mexico saying that "our revision of the Outlook on Mexico"s "BBB+" sovereign rating to Negative in December partly reflected increased economic uncertainty and asset price volatility following the US election."

Fitch also cautions that as a result of proposed protectionist policies, "the integrative aspects of global supply chains, particularly in manufactured goods, means actions taken by the US that limit trade flows with one country will have cascading effects on others. Regional value chains are especially well developed in East Asia, focused on China, and Central Europe, focused on Germany. "

Curiously, Fitch also takes a detour into Trump"s most controversial policy to date, his immigration executive order, and says that tighter immigration controls and possible deportations "could have meaningful effects on remittance flows, as the US has the world"s largest immigrant population." Here Mexico would be most in danger as "Mexico share the world"s top migration corridor and have the largest bilateral remittance flows." Relative to GDP, remittances are even larger for Honduras, El Salvador, Guatemala and Nicaragua, all of which receive most inflows from the US.

Finally, Fitch warns about the risk to retaliatory measures in the form of offshore direct investment in the US, and says that "countries hosting US direct investment at least part of which has financed export industries focused back on the US, are at risk of being singled out for punitive trade measures."

The list of these countries is potentially long, since US-based entities account for nearly one-quarter of the stock of global foreign direct investment. Countries with the highest stock of US investment in manufacturing are Canada, the UK, Netherlands, Mexico, Germany, China and Brazil.

In short, one wrong policy by the Trump administration, and the carefully constructed house of cards, built over decades of globalization, is in danger of collapse, resulting potentially in a global economic crisis.

And so, after two official warnings by some of the most established institutions, Trump has been officially put on notice that should anything bad happen to the world economy, it will be his fault, as all those who lit the burning fire, quietly wash their hands.