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!

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