Tuesday, 20 December 2011

Markets update - Credit - The European Flutter

"Even as I approach the gambling hall, as soon as I hear, two rooms away, the jingle of money poured out on the table, I almost go into convulsions."
Fyodor Dostoevsky, The Gambler - 1867

As a follow up to our "Generous Gambler" from 1864, our title analogy, this time around has many dimensions.

A flutter is a colloquial term for a bet or a wager in gambling, but, in relation to the European situation, an "Aerolastic" flutter seems more appropriate to the current predicament of the European failing structure.

"An Aerolastic Flutter is a self-feeding and potentially destructive vibration where aerodynamic forces on an object couple with a structure's natural mode of vibration to produce rapid periodic motion. Flutter can occur in any object within a strong fluid flow, under the conditions that a positive feedback occurs between the structure's natural vibration and the aerodynamic forces. That is, the vibrational movement of the object increases an aerodynamic load, which in turn drives the object to move further. If the energy input by the aerodynamic excitation in a cycle is larger than that dissipated by the damping in the system, the amplitude of vibration will increase, resulting in self-exciting oscillation. The amplitude can thus build up and is only limited when the energy dissipated by aerodynamic and mechanical damping matches the energy input, which can result in large amplitude vibration and potentially lead to rapid failure." - source Wikipedia.

And "Flutter" can occur on other structures than aircraft (the 1940 Tacoma bridge failure for example). Indeed, when discussing recently our European Peregrine Soliton, we already touched on nonlinear resonance shift, leading to formations of "rogue" waves and circularity issues.
Therefore, our European flutter could lead to another type of flutter, the "Atrial" type (heart failure)...So, could the European Union face the same outcome as the 1940 Tacoma Narrow Suspension Bridge? But here I go again in my usual rambling habit.

Before we enter in a longer than usual credit conversation, our last for 2011, discussing LTRO, revisiting upcoming goodwill impairments for European banks, IMF, deleveraging and the Eurozone's core issue, courtesy of my global macro friends at Rcube Global Macro Research, namely Unit Labor Cost Divergence, it is time for a quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Better tone in the CDS space with German IFO coming better than expected at 107.2 (106.1 expected), but given the absence of liquidity, it is of no surprise to see somewhat some sort of relief rally on the eagerly extended LTRO by the ECB. Yesterday was roll date for single name CDS rolling to March, whereas credit indices roll every 6 months.

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index still remain elevated as we move towards year end - Source Bloomberg

Most interestingly in the sovereign space is the ongoing divergence between Spanish 5 year Sovereign CDS and Italy - source Bloomberg:
The much expected 3 year LTRO has had a significant impact as well on government bond spreads.

The current European bond picture, a story of ongoing volatility, also displays similar divergence between Italy and Spain - source Bloomberg:
Spain today successfully placed 5.64 billion euros, above the maximum target (4.5 billion euros) at much improved yields of 1.735 for three months compared to 5.11% at the previous auction of November 22nd, at similar demand levels 2.86 times versus 2.85 times last month. 6 months paper was placed at 2.435% down from a previous 5.227%, at a lower bid to cover of 4.06 times compared to 4.92 previously.
Bank of Spain is encouraging Spanish banks to borrow at the ECB and buy Spanish government bonds.

The loosened collateral rules by the ECB is helping the peripheral banking sector in borrowing more at the ECB but the liquidity picture is far from improved - The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

Every cloud has its silver lining?
Truth is the Spanish banking sector is a long way from being out of trouble as indicated by Charles Plenty in Bloomberg on the 19th of December in his article - Spanish Bad Loans Jump to 17-Year High as Lending Falls: Economy

"Spanish banks reported more bad loans and lower lending and deposits in October, hurt by the fallout of the country’s property crash and the European sovereign debt crisis.
The ratio of bad loans as a proportion of total lending climbed to 7.42 percent, the highest level since 1994, from 7.16 percent in September and 5.68 percent a year earlier as the value of borrowings in default rose to 131.9 billion euros($171.9 billion), the Bank of Spain in Madrid said in a statement today. Lending fell 2.5 percent from a year ago, following a record 2.6 percent drop in September, and deposits slid 2.2 percent to their lowest level since 2008.
Rising defaults and declining loans and deposits show how banks are suffering from the fallout of Spain’s property slump and a wider European debt crisis that has shut them out of wholesale debt markets."

When austerity bites...

Also from the same article:

“What we have been saying for a while, and I think the banks themselves have been in denial on this, is that the asset quality decline has not bottomed out yet because unemployment is still going up,” said Inigo Lecubarri, who helps manage about $300 million at Abaco Financials Fund in London. “A non- performing loans ratio of 7.4 percent is already very bad. Ten percent would be catastrophic and it’s not impossible we could get there.”

In our previous conversation we argued the following:

"In addition to this, the sovereigns 2012 massive funding needs will result in a deadly competition between the protagonists to raise whatever money is available, resulting in much higher funding costs and the collapse of those with weaker balance sheets."

Ignacio Lecubarri seems to agree with us as he indicated in the same Bloomberg article:

"Spanish bank deposits are shrinking at a time when lenders are being forced to compete for funds between themselves and also with the government, Lecubarri said."

It is still the same game of survival of the fittest which leads to touch again goodwill impairments for European banks, a subject we discussed back in November in our post "Goodwill Hunting Redux", CreditSights in a note published on the 18th of December entitled - Season of Impaired Goodwill, seems to be sharing our concerns:

"The UK veto impaired a lot of political goodwill, both within the country's coalition government and with its EU partners. But Crédit Agricole (-16%) took the theme directly into the banking sector, announcing large write-downs of financial goodwill across a range of businesses with its profit warning on Wednesday. Coming on top of a €500 mln negative effect on net income from deleveraging, goodwill impairments totalling €2.5 bln will push the quoted entity Crédit Agricole S.A. into an overall net loss for the full year. The negative impacts of €3 bln compare with €1.6 bln earnings in the first nine months and a former consensus forecast of just over €400 mln for the fourth quarter, implying that the FY11 net loss could be €1 bln or more.

While goodwill is already deducted from Core Tier 1 capital and therefore does not affect ratios, the earnings effect can be highly damaging in the equity market, and there are bound to be more goodwill impairments to come in the near future from other banks, as they adjust projections of their subsidiaries' earning capacity to the current business and regulatory environment. The timing of impairment decisions is the hardest thing to second-guess, though."

Large goodwill impairments can affect a company stock price and spreads, as well as its debt ratings.

In this difficult funding environment, as per our previous conversations, not even our CPDO/EFSF has been successful enough in raising much needed funds. The CPDO/EFSF picture - source Bloomberg:
The potential downgrade of both France and the EFSF, would render it useless or far more dangerous as we indicated in our post "Much ado about nothing and CPDO redux in European Style", namely that:

"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

This would basically mean, that the more downgrades you get, the more leverage you need in order to make up for the increased shortfall in quality collateral...

Natixis bank in their latest 2012 Credit Yearbook indicated that the EFSF could raise 60 billion euros in 2012, taking into account the first Greek plan (compared to the 16 billion euros only raised in 2011...). Clearly not enough firepower to backstop European Sovereign debt for peripheral countries. ESM which should be deployed by 2012, is also depending on the economic situation of the members of the European Union as well as in the faith of investors.

One the most interesting point from Natixis latest Credit Yearbook was their simulation on Eurobonds and the impact they would have on European government yields:
Emphasis ours (click graph to enlarge). Natixis in their exercise take into account GDP growth projections, deficit and debt levels as well as funding needs for 2012, assuming 10 year Eurobond could be issued at z-spread +30bps (assuming quantitative rating of AA+ for the Euro zone as a whole). This would amount to 10.9 billion euros savings in funding, representing 1.4% of total funding needs.

My good credit friend and I discussed the following in relation to the latest IMF involvement or the rescue funds:
"To repeat what we discussed in our last conversation, neither the IMF nor the rescue funds can sort the solvency problem out. France is about to be downgraded, bringing down the EFSF structure. So anyone who thinks that the EFSF and the ESM will run in parallel has it wrong. Of course the ESM will remain, but its firepower will be far less than the Euro 500 billions earmarked, not enough to rescue all the peripheral countries under pressure. Of course, the IMF may help sovereigns funding issues but, it will do in accordance with specific rules: liquidity issues will be faced, solvency one will not. While we do not foresee major problems right now for the core European countries, the environment could change very quickly."

As the Head of the Canadian Central Bank just declared, “developed economies have regularly increased their debt leverage over dozens of years. But this period is now over. If the deleveraging trend is now clear, the speed and size of the process are not. This process could last and be done in an orderly way, or be abrupt and disorderly.”

Simon Johnson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, had an interesting column in Bloomberg relating to the IMF involvement in the European Sovereign debt crisis on the 19th of December - IMF Bazooka Is Between Meaningless and Dangerous:
"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again.

This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."

Simon Johnson also adding:
"Even if the IMF went all in for troubled Europe -- an idea with little support in emerging markets -- it wouldn’t make much difference. Italy’s outstanding public debt of 1.9 trillion euros is bigger than that of Greece, Ireland, Portugal and Spain combined. The country faces about 200 billion euros in bond maturities in 2012 and an additional 108 billion euros of bills, according to Bloomberg News. The euro area’s 2012 sovereign funding needs are estimated at more than $1 trillion next year alone, and any credible financing plan needs to fully cover 2012 and 2013 at a minimum. It remains unclear who is willing to fund European banks in this stress scenario.

The idea that the IMF could tap emerging markets for additional capital to lend to Europe is met with polite public demurrals. Behind closed doors, it’s not so polite.

The more innovative ideas involving the IMF include some financing provided by the European Central Bank or national central banks within the euro area to the IMF, with the fund then lending this back to Europe.

This would constitute a misguided or even dangerous form of financial innovation. If the precise arrangement involves the IMF taking credit risk, its membership should be worried about losing their capital. The U.S., as the largest single shareholder, would have the most to lose."

Similar to our "Generous Gambler" conclusion ("The greatest trick European politicians ever pulled was to convince the world default risk didn't exist", Martin - Macronomics), Simon Johnson ends his column with the following points which also resonate with our European Flutter analogy, namely failing structures due to inadequate design:

"Eighty years ago, most prominent officials and private financiers were confident that the gold standard should and would remain in place. Starting in 1931, the gold standard failed as a global financing system, with unpleasant consequences for many.

As 2011 draws to a close, the age of the global bailout also seems to be fading. Perhaps the Europeans will find a way to scale up their own rescues using their own money. Perhaps they will manage to protect creditors fully, and convince investors to lend to Italy again. More realistically, the bazooka standard is about to collapse."

Our European structure suffered from poor design such as the 1940 Tacoma Narrow Suspension Bridge. On a final note, the most evident Euro zone structural problem as highlighted by my macro friends from RCube in their recent paper comes from Unit Labor Cost divergence:

"In addition to being a political symbol, the Euro was supposed to offer two irresistible benefits to its members: (1) the Deutsche Mark’s low interest rates for everyone and (2) no more exchange rate volatility within the Eurozone.
Until 2008, the first benefit (lower interest rates) kept its promises. Italy’s yield spread against Germany went from 12% in 1982 to a mere 20bp in 2007. It actually worked so well for some countries that it led to huge housing bubbles, consumer credit bubbles and fiscal largesses, as deficits were easy to finance. Unfortunately, as we can see nowadays, these were all sources of phantom growth, i.e. growth that resulted from stealing from the future and not from increasing productivity. The debt crisis in the Eurozone is a direct result of this unchecked debt bubble.
The Euro’s second “benefit” (no more currency volatility) created another imbalance that will probably be even more painful to resolve than the first one. Since the last competitive devaluations of the early nineties, we have witnessed a huge divergence of Eurozone members’ unit labor costs (especially against Germany), as evidenced by the following chart 1:

1 We use unit labor costs rather than raw labor costs to take into account changes in productivity.

We start the series in 1995, 2 years after Europe’s last major devaluations.

"While Germany was going through painful social reforms, labor costs increased faster than productivity for many Euro members on a relative basis (average increase vs. Germany: 38% between 1995 and 2012).
The divergence ended during the 2008 financial crisis, as some countries (most notably Ireland) started to converge back towards Germany’s unit labor costs. However, we can see that we are still very far away from levels that could restore Eurozone members’ relative labor competitiveness against Germany.
Interestingly, we can notice that the five countries whose unit labor costs grew the most are the PIIGS. This is probably not a coincidence. Low labor competitiveness hurts the economy, thus lowering tax revenues, while public spending is used to hide the underlying decline of the economy. This leads to a degradation of the fiscal situation.
In a nutshell, labor forces in many Eurozone countries are now getting paid in a currency that is vastly overvalued compared to their productivity (this can also be seen in the degradation of the trade balance of many European countries including France).
To restore to competitiveness of PIIGS (and to a lesser extent France and Belgium), labor costs will therefore have to decrease significantly. There are many ways this could happen. We can think of at least four:
1) Very high unemployment rates combined with a dismantlement of welfare states (due to the debt crisis), would force people to discount the value of their labor.
2) As some economists proposed in the case of Greece during last summer, it could also be enforced through internal devaluations. These would obviously be much more difficult to accept than current austerity plans (which concern mostly public finances). Italy’s welfare minister bursted into tears after she announced an end to pension indexing. What would she do if she had to announce an across-the-board reduction in wages by 5% every year for the next 5 years?
3) Rather than living through a decade of austerity, some countries might end up preferring to leave the Euro. The pain would be very intense in the short-term, as inevitable devaluations would destroy the purchasing power of workers and savers, but it would eventually restore the competitiveness of their labor force.
4) The ECB could crash the Euro. Monetizing huge amounts of sovereign debt would contribute to this (in addition to solving the liquidity situation of PIIGS). However, Germany and other countries that are already competitive will oppose this. Additionally, it would not solve the structural problem of unit labor cost divergence, which would inevitably lead to new crises further down the road.
It is difficult to predict what path (or combination of paths) will be chosen by politicians. The one thing we strongly believe is that, whatever the path, real aggregate demand is going to crash a lot further in large parts of the Eurozone. Growth expectations remain way too optimistic.
This is why we consider that Europe’s P/Es of 8 are not cheap by any standards, and that the Euro is poised to fall against other currencies."
Reproduced courtesy of RCube Global Macro Research.

“I don't attempt to be a poker player before this crowd”
Dwight D. Eisenhower

Stay tuned in 2012! In the meantime we wish you all a Merry Christmas and a Happy New Year!

Sunday, 11 December 2011

Markets update - Credit - The Generous Gambler

If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

While we already referred to Baudelaire's "Generous Gambler" in our post "Complacency" in conjunction with Verbal Kint's adapted quote from the Usual Suspects, the latest European summit and ECB statements inspired us, this time around, to refer to this great text from Charles Baudelaire.

But before we delve ourselves in another long credit conversation, it is time for a usual quick credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Sovereign CDS 5 year index (15 European countries sovereign CDS) led the widening on the back of the European summit, reaching around 366 bps, a weekly advance of more than 40 bps (the most since July according to Bloomberg), with Italy breaking ranks yet again, rising 20 bps to 545 bps, with ECB buying 10 year bonds at 6.54% yield.

The interesting point is that the SOVx Western Europe index on the 5 year is again wider than its Central Europe and Middle East counterpart, namely SOVx CE as per the below graph - source Bloomberg:

Itraxx Financial Senior 5 year index (linked to senior debt of 25 banks and insurers) and Itraxx Financial Subordinate 5 year index remains stubbornly elevated - Source Bloomberg:

The current European bond picture, a story of poor liquidity and volatility - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS on ongoing European issues - source Bloomberg:

Our flight to quality indicator, the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is breaking up again - source Bloomberg:

The liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
The new reserve period for deposits at the ECB will start on the 14th of December and last 35 days.
The ECB awarded a significant extension of its liquidity facilities for Eurozone Banks from 13 months to 3 years, so that they could somewhat provide credit to the real economy. The European credit crunch has already started given the European Banking Association planned 9% Core Tier 1 by June 2012, means deleveraging on a massive scale. The EBA is also indicated banks need to raise 114.7 billion euros in new capital when it was only 9 billion needed following the July European banks "stress" test...
Broader collateral has been allowed for Asset Backed Securities, a looser rule, from AAA paper, now single A paper allowed.
25 bps rate cute given deteriorating growth prospects.

Our CPDO/EFSF yield on the rise again, courtesy of Standard and Poor's negative watch on the fund, following the agency's decision to put all 15 European countries (of our SOVX CDS 5 year index) on review for downgrade - source Bloomberg:
European Council President Herman Van Rompuy announced on Friday the EFSF would be rapidly deployed.
Fact: The EFSF has only raised 16 billion euros from four bonds this year and looking at the amount that needs to be raised in 2012, the prospect of raising more money is looking slimmer by the day.
We already discussed the flawed EFSF in our conversation "EFSF - If you are in trouble - double". Recent developments relating to the European summit were interesting, namely because the latest proposal seems to have the "transitional" EFSF rescue fund and the "permanent" rescue fund the European Stability Mechanism (ESM due to start in July 2012) running alongside each other.
In our previous October conversation this is what my good credit friend had to say about the proposed combine structure as a reminder:

"Main talks were about E.U. combining the EFSF and the ESM by mid-2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there are a number of issues about such a conclusion….
The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds…. But there is a bias; it is double counting the money.
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue."

Germany still remains against combining both structures.
On the latest headlines relating to the ESM, here is what my good credit friend had to say:

"The ESM is to be implemented as soon as July 2012, and the EFSF running in parallel for 1 year (please note that the combined firepower of the ESM/EFSF 500 billion euros only that might be revised in March 2012. Which means it will not be over 500 billion euros!"

We also had the agreement from European politicians to lend 200 billion euros to the International Monetary Fund via national central banks to be used for loans to troubled states and limiting so-called private-sector involvement (PSI) to the terms accepted in IMF bailouts was part of the package. The PSI was a major blunder which led to the questioning of "risk-free" status which we discussed in "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory".

As a reminder, this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August -Sovereign Subjects had to say about the PSI:
"'Private sector involvement' in the restructuring of Greek debt was in our view a major policy error, which has changed in a quasi-irreversible way the perception of sovereign debt in advanced economies as risk-free and therefore as safe haven assets. This has broadened the channels of contagion across Europe.
Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.

Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences.

Pandora’s Box has been opened. Only fiscal integration accompanied by centralised financing of governments can bring about full stabilisation of the market in Europe, in our view. The alternative could eventually be a resumption of the run on governments and a wave of public and private defaults.
The ECB can provide protection against a run, temporarily. While the ECB has the capacity to act as a lender of last resort, doing so exacerbates political tensions and is not a lasting solution, we think."

In relation to the IMF bilateral loans agreement, my good credit friend added:
"Provision of additional resources to the IMF of up to 200 billion, in the form of bilateral loans, to ensure the IMF has adequate resources to deal with crisis. Very interesting indeed! If the EU has 200 billion euros to spend, why not using them to increase the size of the ESM? Why do they need the IMF?"

As we pointed it out in our credit conversation "The European issue of circularity", "Nothing is more frequently overlooked than the obvious" (Thomas Temple Hoyne). The latest European agreements do not resolve the European issues!

As a follow up on our "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October when discussing circularity issues:

"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

A Tale of Two Central Banks - according to Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”.

My good credit friend and I came to the following conclusion:

"We remain fundamentally negative on European markets for 2 reasons: a) the negative impact on the European economies from austerity measures which will be implemented by the governments, and b) the financial institutions’ deleveraging which will drastically reduce the funds available to the various agents of European economies. In addition to this, the sovereigns 2012 massive funding needs will result in a deadly competition between the protagonists to raise whatever money is available, resulting in much higher funding costs and the collapse of those with weaker balance sheets."

In relation to the deflation story playing out in Europe, here is an update on 30 year Swiss bond yields compared to Japan 30 years yield - source Bloomberg:

On a final note, I give you Bloomberg Chart of the day, showing bank US treasury holdings surging in echo of Japan:
"The CHART OF THE DAY shows bank ownership of U.S. Treasury and agency debt climbed to a record $1.71 trillion in the two weeks through Nov. 23, the latest period for which Federal Reserve data are available. It also tracks deposits at banks rising to the most ever. The lower panel charts an index of Treasuries maturing in 10 years and more.
Investors are snapping up Treasuries after Europe’s debt crisis slows global growth, helping send benchmark U.S. 10-year yields to a record low of 1.67 percent on Sept. 23. The trend echoes developments in Japan, where demand from lenders helped keep rates on 10-year government bonds, so called JGBs, at 2 percent or less since 1999."
Treasure treasuries?

"The greatest trick European politicians ever pulled was to convince the world default risk didn't exist"
Martin - Macronomics.

Stay tuned!

Sunday, 4 December 2011

Markets update - Credit - A Tale of Two Central Banks

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only."
A Tale of Two Cities (1859), historical novel by Charles Dickens, opening paragraph of the novel.

“The European Central Bank has a different task from that of the US Fed or the Bank of England”
Chancellor Angela Merkel.

This week analogy with Charles Dickens' masterpiece, relates to the different stance currently being taken in Europe in relation to what the ECB's role should be in the ongoing Europe sovereign debt crisis. Given recent macroeconomic set of data, for both the US and Europe, indeed we can say we have a Tale of Two Central banks.
European PMI pointing towards recession:

But I wander again...

Last week, no sooner we had posted a credit update relating to the deterioration of liquidity in the financial system on the 30th of November, that we encountered the mighty coordinated intervention of 5 central banks to unfreeze somewhat a financial system, which is in dire need of dollar support. Well, we already knew from one of our very first credit discussion that liquidity issues always trigger a financial crisis: "It's the liquidity stupid...and why it matters again..." which was in August. We discussed at the time:
"Why liquidity matters again? Because bank funding is a key source for bank earnings, ability to lend, therefore a drag on the economic recovery if it doesn't happen smoothly."

We also noted the following:

"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians."

But before we engage in another long credit conversation, revisiting the recent central bank intervention and discussing as well yet another tender, this time around by Lloyds in the UK and the implications, it is time for a quick credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
The Itraxx SOVx Western Europe index (15 European Western Europe Sovereign CDS) fell towards 328 bps, following the relief rally triggered by the joint intervention of the central banks.
The Itraxx Financial Senior 5 year index (CDS linked to senior bonds of 25 European banks and insurers) dropped as well below 300 bps to around 285 bps (weekly drop of 72 bps).

My good credit friend commented on the recent price action:

"While the equity market wants to believe in Santa Claus, the credit market does not. I know that credit market participants are often perceived as “negative”. No one seems to remember how positive they have been from 2004 until 2007. Nevertheless, the point is that credit market is the key to the future as the equity market will not perform over time if credit growth does not resume."

The current European bond picture, an impressive relief rally - source Bloomberg:

A significant tightening move as well between the spread of German 10 year government bonds and French 10 year government - source Bloomberg:

German 10 year government yield falling in lockstep with German 5 year sovereign CDS, following the intervention of the central banks - source Bloomberg:

Even our CPDO/EFSF benefited from the fall in European bond yields and fell in conjunction with French OAT 10 year government yields - source Bloomberg:

The somewhat "improved" liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

In relation to the acute liquidity issues we have been following, The Economist in their latest publication commented about the intervention of the central banks to ensure a flow of dollars into the system:
"While America has largely escaped spillover from Europe's banking squeeze so far, the shortage of dollars in Europe remains a problem. To relieve that pressure, the Fed lends dollars to the European Central Bank via a "swap" line, which the ECB then lends to its banks, for up to three months. Demand, so far, has been low, because of the stigma for any bank that uses the system, and the cost: 100 basis points more than a benchmark overnight rate.
On November 30th the Fed, ECB and other central banks sought to rectify this by lowering the spread to 50 basis points. Stock markets soared but the euphoria may not last: illiquidity is a symptom of Europe's crisis, not the cause. As long as sovereigns are at risk of insolvency, their banks are, too. If the euro collapses, the resulting chaos will not spare America's economy, despite the health of its banks".

We have discussed at length the issues relating to the oncoming wall of issuance for 2012 for both banks and sovereigns and the issue of circularity, leading to high correlation between both Sovereign credit risk and European banks credit risk.

My good credit friend commented:
"Pro-cyclical austerity budgets will affect a wide range of sectors, and when added to the European banks deleveraging, will have far reaching consequences all over the Globe. Non-financial corporations will not be immune from the slowdown and we should see credit metrics deteriorate further.
The market may breathe better, but health is far from being back. Psychology is key for a recovery, but how will investors react when they will realize that the road to recovery may take years. While US equities are priced for perfection, the risk is for more disappointment."

It brings us back to our "Tale of Two Central Banks" and the European political situation. Germany favors legally binding rules with a possibility to settle cases of fiscal mis-behaving before the European Court of Justice, at the same time President Sarkozy in his latest speech, is ready to crater to German demands of surrendering economic and fiscal sovereignty in exchange for more ECB involvement in helping out on the ongoing European debt crisis. Mario Draghi has also reacted positively to the ongoing French and German conversations: Europe needs a "fundamental restatement of [its] fiscal rules, together with the mutual commitments that euro area governments have made", before the ECB steps in.

We are all awaiting to see the outcome of the paramount meeting of the 9th of December. The most recent interesting proposal in relation to resolving the ongoing European debt crisis has been made by German Finance minister Wolfgang Schauble and the possibility of setting up "redemption funds", in effect pooling sovereign debts exceeding 60% of national GDPs, which would be supported by specific tax provisions and would remain in place for 20 years until all excess debt is finally reimbursed. This proposal was first made by the German Council of Economic Experts.

Credit Agricole Cheuvreux Nicolas Doisy, in his latest Microscope issue published on the 2nd of December entitled - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience had to say the following in relation to the ECB much needed support:

"Only the ECB has pockets deep enough to ring fence Eurozone sovereigns from market attacks, since Germany is still firmly opposing (i) Eurobonds now and (ii) making the ECB a lender of last resort. Thus, one of the few options for the Eurozone to survive its near-death experience is a QE-Z, i.e. a larger use of the Eurosystem's balance sheet.
Given the risk of governments free-riding such help, Germany is sensibly pushing for a strong safeguard in the form of very strict fiscal discipline through a rapid and limited change to the Treaty. This would limit such a QE-Z to legacy debts on top of the safeguards introduced on 21 July, whereby the EFSF is to conduct government bond purchases at the ECB's initiative and carry the risk.
This would give the ECB full control over its nonconventional
policy within its current mandate, i.e. provide liquidity at longer maturities (2-3 years)and fine-tune it with government bond purchases. This would also maintain sufficient leverage for an efficient use of the carrot & stick approach retained so far to force fiscal and structural reforms. A political accord on tight fiscal discipline at the European Council of 9 December should suffice."

There was as well an interesting rumor about the ECB channeling funds via the IMF which is worth commenting as related by Bloomberg James Neuger on the 2nd of December - Euro Central Banks Seen Providing Up to $270 Billion Through IMF:
"A European proposal to channel central bank loans through the International Monetary Fund may deliver as much as 200 billion euros ($270 billion) to fight the debt crisis, two people familiar with the negotiations said.
At a Nov. 29 meeting attended by European Central Bank President Mario Draghi, euro-area finance ministers gave the go-ahead for work on the plan, said the people, who declined to be named because the talks are at an early stage."

Credit Agricole Cheuvreux Nicolas Doisy commented on the above in his latest article previously mentioned:
"At the same time, informative (and very likely organised) "leaks" let it be known that something involving the ECB to a larger extent was being considered. One such leak was made public by Reuters which quoted un-named Eurozone officials about a "do-able idea": the ECB would lend to the IMF, "to provide the fund with sufficient resources for bailing out even the biggest euro zone sovereigns". Although neither endorsed nor denied by anyone, this "leak" was surely meant to acknowledge the receipt of the markets' demand for larger ECB involvement.
Indeed, it could not be about the IMF, since it would be strange to see the fund put in the very political position of a Eurozone Treasury just when the role of the EFSF was being discussed. The message was rather about securing the ECB’s independence."

We would have to agree with the above analysis. Like any good cognitive behavioral therapist, we tend to watch the process of how and why the message is delivered, rather than focus solely on the content of the message.

Truth is the German's fearful position relating to the ECB is consequent to the rise in ELA (Emergency Liquidity Assistance) in peripheral countries.

And, as Nicolas Doisy interestingly points out:

"The Eurozone's national central banks could go "rogue" and threaten to disorderly run their own quantitative easing."

He also added:

"One major risk arising from a free use of ELA by NCBs (National Central Banks) is a string of disorderly national quantitative easing on the back of free-riding by national governments. Ireland is a living illustration of such a strategy: up until October 2010, the Irish central bank has used ELA generously to keep its banks afloat. It has thus accumulated large amounts of bad assets in return for the commensurate amounts of cash to banks."

As we indicated in August in our post "It's the liquidity stupid...and why it matters again..."

"Conclusion for the banks in the peripheral countries:
The ECB is currently the ONLY SOURCE of wholesale funding for these smaller banks and have therefore prevented aggressive deleveraging to happen and liquidations."

In terms of liquidity issues, there is always what you see, and what you don't see and as Credit-Agricole Cheuvreux Nicolas Doisy puts it nicely in his latest report:

"Indeed, NCBs hold a wild card, as they can provide large Emergency Liquidity Assistance (ELA) at their own initiative and without the ECB's prior consent to their domestic banks. As the name indicates, such ELA is meant to be provided to illiquid but solvent credit institutions shut out of capital markets by exceptional events. Strangely, the NCBs' only legal obligation is to keep the ECB informed."

The Irish stealth QE...ELA as percentage of GDP.
"A year ago, Ireland's ELA operations were revealed suddenly and forcefully by the ECB due to the risk of continued monetary financing of the government. Indeed, the central bank of Ireland was sparing banks the need to restructure by providing them with cheap liquidity. It was thus also indirectly subsidising the Irish government by relieving it from the need to put expensive equity in its banks.
A two-third majority at the ECB's Governing Council would be needed to put an end to such (potentially very large) ELA operations by other NCBs in the future. With much more than one country concerned, such a game of chicken could well turn quickly into a nightmare. Indeed, such a vote would be politically very delicate to hold (the majority threshold is high) and thus likely to trigger panic in the market.
Hence, with contagion spreading to the Eurozone core, a very sensible fear on Germany's side is that monetary financing of fiscal deficit turns widespread. This would jeopardise two pillars of the European Monetary Union: (i) fiscal discipline would be even more relaxed because of the very monetary financing allowed by ELA and (ii) high (if not rising) inflation would eventually ensue from this feedback loop."
source Credit-Agricole Cheuvreux - Quantitative Easing euroZone (QE-Z): surviving Near-Death Experience.

This is the reason Germany is asking for stricter fiscal discipline. A sustainable fiscal federation in the long term is needed of course, backed by a European Central Treasury. In relation to our "Tale of Two Central Banks", you cannot ask the ECB to suddenly morph into a Fed. This process will undoubtedly take time and a due process, but a larger involvement of the ECB is so far conditional to stricter fiscal discipline. Truth is both Germany and France are trying to make amend for their mistake in violating the European Stability Pact in 2003, a subject we discussed in January 2011 in our post "The moral hazard mistake of 2003 - The violation of the European Stability Pact":

"The ECB had to step in and follow a tighter monetary policy.
Between 2003 and 2004 it allowed real interest rates in the Eurozone to fall to zero. The ECB also abandoned the so-called monetary pillar of its strategy -- "a prudent cross-check that looked at the rate at which money supply was growing". For several years, money growth exceeded the ECB's target rate of growth of 4.5 per cent a year. This equated to overreliance on credit in the Eurozone. It made the Eurozone government fiscal balances over dependent on tax revenues from activities that were based on borrowing, namely housing and construction: hence the housing bust in Spain, Ireland, etc."

On another credit note, and in direct relation to our previous warning to subordinate bondholders from our last post, Lloyds, this time around, announced a bond tender on LT2 (subordinate debt), John Glover and Gavin Finch in Bloomberg article - Lloyds Offers to Exchange Up to $7.7 Billion of Junior Notes - 1st of December 2011 indicated:

"Lloyds Banking Group Plc, 41 percent owned by the British taxpayer, offered to exchange as much as $7.7 billion of capital notes for new bonds to boost capital.
Lloyds asked investors in the Tier 2 securities to swap their holdings at a discount to face value of as much as 30 percent, it said in a statement. The transaction will contribute about 20 percent of the bank’s funding needs for next year, according to London-based spokeswoman Nicole Sharp.
“In light of ongoing market volatility and regulatory uncertainty, the group is undertaking an exchange offer on its Tier 2 capital securities which are eligible for call in 2012,” Sharp said in an e-mail. “The exchange offer also provides the group with an opportunity to improve the quality of the group’s capital base.” Regulators are pushing banks to boost their capital, or ability to absorb losses, before taxpayers have to step in. Bank of England Governor Mervyn King urged lenders today to step up efforts to bolster their defenses against the euro area’s debt turmoil, which now looks like a “systemic crisis.” By exchanging Tier 2 notes, banks are getting rid of securities that, under new rules, will start to lose their value as capital notes from 2013. Lenders also get a boost to their capital against losses by swapping the debt at a discount."

Lloyds launched an exchange on all (11 LT2 and 2 UT2) securities with call date in 2012 ("with the exception of those already being treated on an economic basis") into a new LT2 2021 "callable" in 2016 but without step up, coupon range 5yr MS+850-1000bp (depending of currencies) and added "It is the intention of the Group that all decisions to exercise calls on any Existing Notes (the securities targeted in this exchange offer) that remain outstanding after 31 January 2012, will be made with reference to the prevailing regulatory, economic, and market conditions at the time."

Meaning that future calls will be on "economic basis" for the new security. We could summarise the above as follows:
"Dear LT2 subordinated bondholders tender your bonds or the 2012 call gets it, but it doesn't mean the 2016 call won't get it either..."
Oh dear...
Lloyds Isin - XS0195810717 - source Bloomberg, closing cash price before tender 72.2, exchanged price 77.25. A 22.75% "haircut"...
And my good credit friend to opine:
"A nice “slow death” for subordinated bondholders…"

For more on this particular bond tender, FT Alphaville Joseph Cotterill goes into the detail in his post - "Debt swaps: we can do this the easy way or…"

In our previous post we voiced our concern on subordinated bank debt:
"Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again."
It still looks our concerns are clearly justified.

On a final note I leave you with Bloomberg Chart of the Day showing "Derivative traders are hedging for the risk that European policy makers fail to end the sovereign- debt crisis that a coordinated central-bank move this week to cheapen dollar funding didn’t resolve."
"The CHART OF THE DAY shows that the one-year U.S. interest-rate swap spread rose yesterday following a plunge the prior day after the Federal Reserve and five other central banks cut by half percentage-point the rate on emergency dollar swap lines. The chart also shows that options traders’ projection of the pace of future swap-rate swings is more than 27 percent above the year’s low.
Swap spreads are based on expectations for the dollar London interbank offered rate, or Libor, and are used as a gauge of investor perceptions of banking-sector credit risk. The swap’s floating rate is indexed to three month Libor, which fell yesterday for the first time since July 25."

"Our liquidity is fine. As a matter of fact, it's better than fine. It's strong."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Tuesday, 29 November 2011

Markets update - Credit - The Eye of the Storm.

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
Vincent Van Gogh

As we move towards the nth European summit of the last chance on the 9th of December and with liquidity becoming scarce by the day, in today's post we will review ongoing liquidity issues, as well as some recent market developments and some previous calls.

On the recent price action, my good credit friend commented:
"As equity traders still enjoy a kind of Bull Run based on very thin air, credit traders keep on focusing on facts that could alter the metrics for the months to come, or, on events that could change the credit momentum. Even though European politicians have finally understood what needs to be done to place their economies on a strong footing, they are facing many hurdles, as political agendas collide with the needed structural reforms. So, it will take a lot of time, and time is a luxury that market participants cannot afford. Why? Because the overall system and our society does value “time” as something that humanity as a whole is short of. Consequently, we are experiencing a major social shift in term of savings behaviour and capital allocation. This is what I call a global re-pricing of all assets, which bears a lot of risks if it occurs disorderly."

But first, as always, it is time for a credit market overview before our long conversation.

The worsening liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with contagion to core Europe - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS, following the failed auction casting doubt on the safe haven status of German bonds which had prevailed so far this year - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:
While we have somewhat receded since our last post, in relation to CDS credit indices levels, volatility remains elevated, and liquidity is becoming an issue, given bid-offer spread for Itraxx Financial Subordinate 5 year CDS is 10 bps whereas it is is only 5 bps on the Itraxx Crossover 5 year CDS index (European High Yield gauge).
A market maker commented:

"Another fairly thin session as we approach Dec 9. Environment continues to be tough to trade -- just take a look at some of the intraday index moves. It becomes increasingly more difficult if you're a single name bank cds trader and trying to "hedge" your book. You are guaranteed to lose money on almost every occasion as you cross bid/offer."
Intraday movement remains indeed very elevated in the Credit Indices space:
Itraxx Financial Senior 5 year index closed around 340 bps (today's range was 330-355).
Itraxx Financial Subordinate 5 year index closed around 588 bps (today's range 569-626...).

Itraxx Financial Senior 5 year CDS versus Itraxx Subordinate 5 year CDS - source Bloomberg:

The same market maker commented on the above:

"Snr vs Sub relationship in Index is also not moving. You would have expected the spread to decompress in the widening but it did not even blink. The only real explanation for this, is because nobody feels like buying Sub protection at these levels; which is fair if you don't think LT2 will get haircut and believe CDS will go to zero one day (post Basel III)."

In relation to LT2, as a reminder from our September credit conversation "Credit - Crash Test for Dummies":

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."
In our September post we discussed:
"If a financial entity is able to buy back its LT2 debt below par, it generates earnings and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."
We would have to disagree with the market maker in the sense that we could go wider still on the Itraxx Subordinate 5 year CDS index, given the market doesn't fathom the possibility of getting haircuts on LT2 subordinate bonds. It has happened and will happen again for weaker financial institutions in the peripheral countries.

Tracy Alloway in FT Alphaville on the 22nd of October described what happened in Ireland, for Anglo Irish Bank subordinate bondholders in her post - "Anglo Irish’s burden-sharing template":

"The bank is offering holders of some of its outstanding sub-debt to swap their notes for new Irish government guaranteed bonds that will be due in 2011 with a coupon of three-month Euribor plus 3.75 per cent. Holders of the €1.57bn worth of three Lower Tier 2 (LT2) bonds will receive just 20 cents on the euro. Investors in about €377m of perpetual junior debt will get even less — 5 cents on the euro."
And Tracy also reminded us what happened in 2009 in the UK in relation to the Bradford and Bingley precedent:

"In 2009, the nationalised British bank enforced burden-sharing on both LT2 debt and perpetuals — offering 45 pence for every pound of LT2, and 25 pence on perpetuals. That was a premium of about 10 to 12 points at the time.

Bradford and Bingley burden-sharing, however, also came with a ‘special resolution regime.’ The UK government went ahead and changed the terms of outstanding Bradford & Bingley subordinated bondsallowing the bank to defer coupon and principal payments."

And Tracy concluded at the time:
"The future is here, and it bites for bondholders."

We already know the score given the flurry of bond tenders which we had seen coming fast and furious following Spanish bank Santander's bond tender. Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again and Itraxx Financial Subordinate CDS index could go wider still. This time is different? Probably not, given the European Banking Association's willingness to ensure European banks reach 9% Core Tier 1 capital ratio by 2012.

"Something has gotta give" - subordinated bondholders or shareholders, or both, we argued recently.

It seems Moody's Investors Services is confirming our September assumption given it is considering lowering debt ratings for banks in 15 European nations to reflect the potential removal of government support. This will likely help banks quietly retire their LT2 bonds at even more discounted levels, shoring up in the process somewhat their Core Tier 1 capital. According to Jacob Greber and Chitra Somayaji in their Bloomberg article - Moody’s Considers Bank Debt Downgrade in 15 European Nations published on the 29th of November:
"All subordinated, junior-subordinated and Tier 3 debt ratings of 87 banks in countries where the subordinated debt incorporates an assumption of government support were placed on review for downgrade, the ratings company said in a statement today. The subordinated debt may be cut on average by two levels, with the rest lowered by one grade, it said.
Lenders in Spain, Italy, Austria and France have the most ratings to be reviewed as governments in Europe face limited financial flexibility and consider reducing support to creditors, the rating company said. Moody’s has said that a “rapid escalation” of Europe’s sovereign debt crisis threatens the entire region."

The difficulties for banks to issue term funding debt have been a recurring theme in our conversations. The two journalists from Bloomberg also added:

"Banks will cut bond sales by 60 percent in Europe next year as the sovereign debt crisis drives up issuance costs, Societe Generale predicts. Lenders will sell 50 billion euros ($67 billion) of senior notes, down from a euro-era low of 121 billion euros so far this year, according to the French bank.
The extra yield that investors demand to hold European bank bonds is the highest since May 5, 2009, widening to 424 basis points on Nov. 25 from 336 on Oct. 31, Bank of America Merrill Lynch’s EUR Corporates Banking index shows."

In the great European bank deleveraging process, not even German bank Commerzbank is immune according to Bloomberg journalists Nicholas Comfort and Aaron Kirchfeld - Debt Crisis Puts Commerzbank Back to Drawing Board Fighting Aid:

"Commerzbank AG Chief Executive Officer Martin Blessing spent the last three years trying to free Germany’s second-largest lender from the shackles of government aid needed to survive the 2008 credit crunch. Europe’s debt crisis may put him right back where he started.
Blessing, 48, this year pulled off a capital increase of 11 billion euro($14.6 billion), among the biggest ever in Germany.
The stock sale, a conversion of shares held by the government and excess capital enabled the Frankfurt-based lender to repay 14.3 billion euros of government aid in June. Blessing has pledged not to accept state funds again, even as Commerzbank comes under pressure to boost capital to meet tougher requirements.
European leaders are demanding banks bolster their capacity to withstand losses after financial firms agreed to accept losses on Greek sovereign debt. Commerzbank, told by the European Banking Authority last month that it may need 2.94 billion euros in fresh capital, may have to raise as much as 5 billion euros in a worst-case scenario, people familiar with the situation said last week. “If the bank’s capital requirements rise significantly, it would be very hard for Commerzbank to reach them with the traditional measures they have to hand,” said Michael Seufert, an analyst with Norddeutsche Landesbank Girozentrale in Hanover. “Taking state aid again would be the very last option they’d try as it would be seen as a signal of weakness.”

So subordinate bondholders beware as the article added:
"Commerzbank is exploring options including buying back hybrid bonds and placing sovereign holdings in an external entity, or bad bank, one of the people said. The goal remains to avoid taking state aid. The bank already announced plans to scale back risk-weighted assets and new loans, and to sell non-strategic businesses.
The bank may have to seek assistance from Germany’s Soffin bank-rescue fund, which the government plans to reactivate, if the EBA significantly raises its capital requirements, one person said last week.
Commerzbank’s consideration of putting sovereign debt into a bad bank was reported by the Financial Times on Nov. 25, while the Financial Times Deutschland said yesterday the bank is weighing buying back as much as 1 billion euros of hybrid bonds in exchange for new shares."

In our conversation "Goodwill Hunting Redux", we were expecting this eventuality of debt to equity to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process."

As for mortgage insurer PMI we mentioned in our post "Credit Terminal Velocity", in August, where we discussed the future for the mortgage insurance business, it is indeed goodbye PMI.
By Mary Childs and Sapna Maheshwari, November 29 (Bloomberg):
"Bondholders are unlikely to recover as much as PMI Group Inc., the guarantor of U.S. home loans that filed for bankruptcy protection last week, indicated in its Chapter 11 petition, debt-market trading shows.
PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgage debt, reported $225 million of assets and $736 million of debt as of Aug. 4 in its Nov. 23 filing. That means senior bondholders would get about 30 cents on the dollar. Credit-default swaps on Walnut Creek, California-based PMI signal a recovery expectation of 20 cents on the dollar for its senior bonds, according to data provider CMA. The company’s $250 million of 6 percent senior unsecured notes due in September 2016 traded at 22.75 cents on the dollar on Nov. 23
The insurer’s assets may have deteriorated since August, according to analysts at debt researcher CreditSights Inc. They said in a Nov. 27 note that the assets in the filing were higher than they are now and the company likely would be liquidated."

The Bloomberg team interviewed a fixed-income strategist on the subject:
"“The fundamental question behind whether a company can restructure or must liquidate in bankruptcy is whether that company has a viable business model,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in an e-mail. “Whether PMI is able to restructure or ends up in liquidation is essentially a referendum on the mortgage insurance industry as a whole.” Mortgage insurance may not be a sustainable business because home prices have proven to move in sync, making it difficult for providers to diversify, he said.
If mortgage insurance pricing rebounds, PMI’s liquidation would reduce competition and allow for better conditions for those who remain such as Radian Group Inc. and Genworth Financial Inc., LeBas said."

Survival of the fittest...PMI 5 year CDS in upfront price, indicating the recovery for Senior bonds will be in the region of 26 cents to the dollar, definitely less than the assumed 40% recovery rate in the senior CDS - source Bloomberg:

On a final note I leave you with Bloomberg Chart of the day, showing that "Investors are shifting haven demand out of core Europe and in to foreign markets as the region’s debt crisis reaches its most fiscally sound nations, according to UBS AG."

"The CHART OF THE DAY shows the 120-day correlation coefficient between French and German 10-year yields and the euro-dollar has fallen from highs earlier this month. The correlation between U.S. Treasuries and the currency pair continues to increase as the common currency is sold to buy debt outside the euro zone. The measure for 10-year U.K. gilts also remains stronger than Germany and France."

"The only safe ship in a storm is leadership."
Faye Wattleton

Stay tuned!

Wednesday, 23 November 2011

Markets update - Credit - The song of Roland

"In The Song of Roland, Roland carries his olifant (ivory hunting horns made from elephant tusks) while serving on the rearguard of Charlemagne's army. When they are attacked at the Battle of Roncevaux, Oliver tells Roland to use it to call for aid, but he refuses. Roland finally relents, but the battle is already lost. He tries to destroy the olifant along with his sword Durendal, lest they fall into enemy hands. In the end, Roland blows the horn, but the force required bursts his temple, resulting in death." - Source Wikipedia.

The recent developments in our ongoing European tragedy inspired me this time around to use this particular legendary reference namely "The song of Roland". It is an interesting analogy as Oliver (European leaders) are asking Roland (Germany) to use the Olifant (to unleash the unlimited resources of the ECB) to call for aid (ECB). In the end, Roland blows the horn...but is it already too late for Europe?

But yet again, I divagate in my thoughts. Time for a Credit Market overview as there are many items to discuss, some of our calls, as well as one of an earlier subject we previously discussed, namely the consequences of the disappearance of risk-free rates in Europe.

The Credit Indices Itraxx overview - Source Bloomberg:
New records across the board in an environment where: liquidity is dwindling and volatility higher still.
A market maker commented:
"Nobody wants to be short risk coming into year end and the European Council meeting. This market is really tough to trade."
Itraxx Financial Senior 5 year CDS index breaking a new record closing around 342 bps (Intraday range 304-339 bps), Itraxx Financial Subordinate 5 year CDS index getting close to 600 bps mark around 591 bps (intraday range 540 - 588 bps).
The same market maker added:
"SovX, Fins Snr and Fins Sub have now reached a new all time record as London is closing. And main (Itraxx Europe 5 year CDS index - investment grade gauge) is only a couple of basis points away from its March 2009 record of 214 bps. Will it be enough for Germany to change its mind and allow the ECB to come to the rescue? I don't think so as despite the move there is no real pain out there from clients or dealers. We need French OAT to sell off more or get a large European Bank to run out of assets to pledge to the ECB. We are going to put more hope on the Dec 9th meeting and at these levels of stress and where indices are trading I would not want to be short anymore. I am missing the capitulation leg to go long risk but we are not too far away from that level. "
Will we hear Roland's olifant?

As my good credit friend put it about today's moves:
"Very large widening of credit indices! Sub Financial is at the widest ever and there is no reason to expect any significant pull back as the global picture is terrible. The momentum is gaining steam and speed, and I suspect we will have a panic and a capitulation very soon. A Global Re-Pricing of all assets is on its way, so we could gap hard anytime. Fasten your seat belt!"
Here is an update from our previous post "Mind the Gap", finally the disconnect we mentioned on the 15th of November between the German Bund and the Eurostoxx has ended and the gap closed - source Bloomberg:

But interestingly there was no flight to quality this time around, given the very poor auction of the German debt agency today. Newedge Chicago had to say the following on the results:
"The German debt agency sold EUR 3.644bn of its new 10y Bund 2% Jan 2022 this morning. The Buba retained a massive EUR 2.356bn. Demand was very poor at EUR 3.889bn for a modest 1.1 bid/cover. Without the massive Buba's retention the auction would have been heavily undersubscribed."
It seems there is a buyer strike going on in Europe, courtesy of the disappearance of the failed notion of risk-free, which is at the foundation of the "Modern Portfolio Theory". We previously discussed this phenomena back in September in our post - "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"

We argued at the time:
"Safe havens no longer exist. The game was based on confidence, on risk-free interest rates and fiat-money based on the trust we had in our governments."
and added:
"Confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues."
One of the indicator we have been following in our various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is broken - source Bloomberg:
From March onwards German Bund yields had been moving in lockstep with 10 year Swedish government yields. The spread broke the 25 bps high level reached in August and widened significantly to close at 52 bps. A very significant move.

My good credit friend and I discussed the following points:
"Now that the concept of “risk free assets” is being removed from what some people call “modern finance”, there is a slow understanding that every investment bears a “credit risk”. So now comes “re-pricing time”! To be true to ourselves, there has never been such a thing as “risk free” investments, and there has never been such a thing as “modern finance” but only “modern products”, sophisticated ones created by mathematicians. Once more, the “modern finance” concept is just a “wording” to cover up human beings' fears and greed. How good and reassuring it is to invest without risk and make nice profits! But such a thing cannot last, as it does not really exist."
So, dear friends, welcome to a credit world! Where defaults can happen and repayment of principal cannot be taken for granted.

This is the current European bond picture with contagion now spreading to core Europe, not even the Netherlands or Finland were spared - source Bloomberg:

And our CPDO/EFSF is now closing towards the 4% yield - source Bloomberg:

The disturbing liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

In his credit letter published in August, Dr Jochen Felsenheimer from Assénagon made the following valid points:
"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."
As we previously discussed in our September post about "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" and relating to our assertion of moving to a credit world:
"The lower the confidence, the higher the rates issuers will have to pay to raise capital. Solvency of the issuer will ultimately determine the allocation of the capital."
To further illustrate the above, Credit Suisse published on the 23rd of November the following note entitled "Earthquake warning" and had to say the following:
"A more lasting source of despair is the lack of understanding of the issues in most key circles. It seems axiomatic that before a serious problem can be tackled, its nature has to be understood. If there’s a hole below the waterline in your boat and the water has caused engine failure, then tackling the leak becomes rather important as opposed to cursing the malign intent of the water while changing the plugs. Mapped to Europe, WHY are bond markets closing?
Of course; “evil New York hedge funds” and their CDS. How foolish of us to forget. That’s good, because we can ignore the correlation crisis.
Vetoes of the ECB as a lender of last resort are a case in point. It cannot be the lender of last resort because it is the lender of first resort, to the tune of €550 bio and counting (fast).
We risk excessive repetition but the accounting identity between a euro member state’s BoP deficit and the NCB’s balance at the ECB ensures that. So, to [editorialize] a recent comment from BuBa President Wiedemann, speaking on Italy and Spain: "In both cases, I am confident that these countries need no outside help but rather that they can comfortably help themselves [to limitless BoP funding at the ECB], and that the new governments will take the necessary measures [to ensure that they can continue to do so]". i.e., stay in the euro.
The Greek government had rumbled that ruse, as apparently had Sr Berlusconi; so both governments had to go, stat. But this particularly extreme form of the par pretence is on borrowed time. There is currently no exogenous constraint on the current account financing of any euro area member state. And if we accept that the present level of current account deficits is unsustainable, which has certainly been the view of private sector participants, then under “Stein’s law” ("If something cannot go on forever, it will stop") the only question is how it stops, and to a degree when.
This is the (currently binding) hole in the SS Euro."
In relation to EFSF Credit Suisse had to say the following:
"And, as with all the challenges in the euro area—anywhere--the key to managing a risk is to understand that it exists, for both buyer and seller. Relative to our analysis of the tranche structure of the euro area, we regard the observation that the EFSF has a tranche structure as being simple. Senior tranche, bond-holders; junior tranche, guarantor governments. As correlation rises, expected losses are transferred relatively to the senior tranches. So EFSF bonds will underperform in an environment where the risks systematize and outperform as they become more idiosyncratic. And the missed opportunity to restructure Greece in 2010 meant that an idiosyncratic crisis could not be tolerated—we always rejected the concept of a “Greek crisis”—so the underperformance of the EFSF is entirely accounted for conceptually, as well as more anecdotally in terms of France’s AAA rating and the like, which are manifestations of the same phenomenon."
Credit Suisse also made an important point in their recent note:
"European credit is wholly reliant on German credit. And of course, via the banking system and credit markets, German debt is very largely reliant on European. If we are heading, as we appear to be, where all non-German issuance is closed (and German not certain, for reasons we examine later, and as we saw on 23 November), then the whole structure turns on how much of the debt can be mutualized."
On a final note I leave you with Bloomberg Chart of the Day, showing the market positioning for a collapse of the euro:

"The CHART OF THE DAY shows options traders turned the most bearish ever on the euro on Nov. 16 and the currency fell to its least in more than a month against the dollar the following day. The euro, which traded at $1.3518 as of 7:16 a.m. in London on the 21st of November, probably will drop 4 percent to $1.30 by year-end, according the Nomura, Japan’s biggest brokerage. The lower panel shows wagers by hedge funds and large speculators on a euro decline, compared with bets on a gain, increased last week for the first time in a month after Italy’s 10-year bond yield rose to a euro-era record over Germany’s earlier this month."
"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end."

Stay tuned!

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