Sunday, 29 January 2012

Markets update - Credit - Great Expectations

"Take nothing on its looks; take everything on evidence. There's no better rule."
Charles Dickens, Great Expectations

Another reference to Charles Dickens, following on our conversation "A Tale of Two Central Banks", given the importance of the rally year to date in the credit space. Indeed, it seems to us markets have "Great Expectations", and although Charles Dickens decided to rewrite the end of his book as the ending was deemed too sad, we think it would be preposterous for us to revise our negative stance on Europe, given the current PSI overhang reminiscent of a Damocles sword and the acceleration in the deterioration of the Portuguese situation (which warrants cautious monitoring in the coming weeks/months).

In our credit conversation we will go through the significant tightening witnessed since the implementation of the LTRO supported by the latest FOMC decision by the FED.

The Credit Indices Itraxx overview - Source Bloomberg:
The Itraxx Crossover 5 year CDS index (50 European high yield companies) has dropped 30 bps to around 606 bps, reaching its lowest level since August 17 according to Bloomberg. The Itraxx Main Europe 5 year CDS index (125 European companies investment grade) dropped to 140 bps whereas Itraxx Financial Senior Index (linked to senior debt of 25 banks and insurance companies)  declined to 211 bps, the lowest level since October 28 whereas Itraxx Financial Subordinated 5 year CDS index is at a 5 months low at 372 bps.

Itraxx Financial Senior 5 year CDS index, a significant tightening movement since the December tender by the ECB, as of the 26th of January - source Bloomberg:

Itraxx Crossover 5 year CDS index, a significant tightening movement as well, as of the 26th of January - source Bloomberg:
30 bps tighter on Friday, a significant move for the European High Yield credit risk indicator.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

The liquidity picture, as per our 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 started on the 18th of January and the deposits level parked at the ECB remains elevated, while both the Itraxx Financial Senior Index and 3 months Libor-OIS is receding thanks to the ECB's recent intervention to support the financial sector.

The current European bond picture with Italy starting much tighter again in conjunction with Spain and France receding towards 3% yield for 10 years government bonds - source Bloomberg:

"Flight to quality" picture, with tighter Germany 10 year Government bond and falling 5 year CDS spread for Germany - Source Bloomberg:

Itraxx Financial Senior 5 year CDS crossing again with the Eurostoxx, indicating the strength of the rally so far year to date - source Bloomberg:

Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread, a new record - source Bloomberg:

While the Greek PSI will be taking center stage on the 30 and 31st of January at the next European summit, all eyes are on the next LTRO, to see how the next carry trade will play out and how banks will participate. Given the trend is your friend, with Central Banks flooding the markets, we can expect to see tighter spreads still in the credit space thanks to the ongoing support.

Our subordinated bond tender theme initiated in 2011 is still playing out in 2012. BNP Paribas offered to buy back 3 billion euros worth of hybrid securities known as "Cashes" between 45% and 47% of par value, indicating more pain for subordinated bond holders. These securities were issued initially by Fortis Bank. BNP Paribas took control of Fortis in 2009, taking a 75% stake. BNP Paribas was not alone in tendering some subordinated bonds, Credit Agricole as well offered to repurchase subordinated debt. We expect all non-compliant Tier1 paper in Basel 3 to either be called or bought back.

In relation to the new issue space for Senior Unsecured space, given the positive tone in credit, it is not surprising to see a flurry of new issues. Lloyds came to the market to raise 1.5 billion euros, on 5 year. Lloyds priced its new issue 305 bps more than the benchmark swap rate. Last time Lloyds issued Senior Unsecured bonds was March 2011 at 190 bps more than the benchmark swap rate. A 244 bps premium. The game is still the same, conceding consequent large premiums in the race to raise capital.

But back to our title "Great Expectations", given we sit in the skeptical camp in relation to the outcome of the European crisis. It appears that 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 as well as a senior fellow at the Peterson Institute for International Economics had some interesting thoughts in his latest column published by Bloomberg on 23rd of January entitled "Europe’s Debt Crisis Is Still Likely to End Badly":

"History is full of fixed exchange-rate arrangements that broke down. In fact, a cynic might even point out that all attempts to fix exchange rates, whether against gold, the dollar or other currencies, ultimately fail.
Think about the gold standard in its various permutations: the post-World War II Bretton Woods system, attempts by East Asian countries to peg their exchange rates in the 1990s, or even the ultimately disastrous Argentine currency peg from 1991 to 2002. They all illustrate that holding on to an exchange peg for too long is a classic policy mistake. Usually when it ends, there is a great deal of concern about the future, but such worries are often overblown: A depreciation in the exchange rate can help an economic recovery, as long as the lid can be kept on inflation.

Good Times Over

But Europe’s problem isn’t just that some countries have the wrong exchange rate, and no way to adjust it within the existing system. The main issue is that governments borrowed heavily during the good times, which are most definitely at an end.
Italy has more than 1.9 trillion euros ($2.5 trillion) in debt outstanding. Bringing this under control through austerity alone is unlikely to work. In countries such as Greece and Ireland, the economic contraction is further undermining fiscal sustainability."

In our last conversation we were pondering whether the recent FOMC decision was in fact putting a floor under the Euro versus the US dollar. A weaker Euro would undoubtedly help European exports, and therefore boost growth, which would help mitigate current debt dynamics in various European countries. We would therefore have to agree with Simon Johnson that the Greek restructuring exercise will be followed by others, Portugal is of course the most likely candidate as highlighted by CDS levels, but others could follow...:

"But at some point in every fixed exchange-rate regime, even the most powerful people have to confront basic arithmetic. When budget deficits cannot be financed, when enough capital is flowing out, and when the central bank has gone beyond the limits of what is responsible, it is always time to move the exchange rate.
When the country that devalues has borrowed heavily in a foreign currency - as the euro effectively is for Italy at this point -- there is a sovereign debt crisis and usually a restructuring of the government’s obligations. Avoiding some version of this in the euro area will be hard."

In our last conversation we also argued that European growth would linger, putting additional pressure on unemployment and debt dynamics. With Spanish unemployment reaching 22.9%, the highest in 15 years, and with Spanish economy contracting 0.3 percent in the fourth quarter, we have a hard time believing in a happy ending, but contrary to Charles Dickens masterpiece, we currently see no need in rewriting the ending for our "European flutter" story.

As reported by Bloomberg, Stephen Roach from Morgan Stanley, seems to agree, the focus is going to be on rising unemployment in Europe and the recession:

"The euro area is in a “fairly protracted recession” and European leaders will shift their focus toward fighting rising unemployment, said Stephen Roach, non-executive chairman of Morgan Stanley Asia.

Stephen Roach also added in the same article:

“Europe is in a recession now, and it’s likely to be a fairly protracted one with a very limited recovery in the years ahead.”

On a final note, Bloomberg chart of the day:
 The CHART OF THE DAY shows the price of Greek notes maturing on March 20 fell to a record-low 36.35 percent of face value on the 26th of January as Greece struggled to reach an accord with private creditors to cut its debt. A bond-swap agreement is needed for the nation to get a second financing package before the 14.5 billion-euro ($19 billion) payment comes due. “It’s pricing in an increased chance for either a forced restructuring before its maturity, or a fully-fledged default,” said David Schnautz, a fixed-income strategist at Commerzbank AG in London. “Chances for the bond to be redeemed in full have been scaled back.”

"The problems you sow, are the troubles you're reaping,
Still, my guitar gently weeps."
The Beatles - George Harrison - 1968 - While My Guitar Gently Weeps - unused line.

Stay tuned!

Wednesday, 25 January 2012

Markets update - Credit - The law of unintended consequences

"It is easy to dodge our responsibilities, but we cannot dodge the consequences of dodging our responsibilities."
Josiah Stamp

"The law of unintended consequences has come to be used as an adage or idiomatic warning that an intervention in a complex system tends to create unanticipated and often undesirable outcomes." - source Wikipedia

According to Robert Merton Senior there are five causes of unanticipated consequences:
"1.Ignorance (It is impossible to anticipate everything, thereby leading to incomplete analysis)
2.Error (Incorrect analysis of the problem or following habits that worked in the past but may not apply to the current situation)
3.Immediate interest, which may override long-term interests
4.Basic values may require or prohibit certain actions even if the long-term result might be unfavorable (these long-term consequences may eventually cause changes in basic values)
5.Self-defeating prophecy (Fear of some consequence drives people to find solutions before the problem occurs, thus the non-occurrence of the problem is unanticipated.)" - source Wikipedia.

So in this latest post, the latest FOMC's decision has brought to our attention another analogy, the law of unintended consequences. In this credit conversation, while going through our usual credit overview, we will be revisiting some of our calls with some additional subordinated bond haircuts (Unicredit this time around) creating more pain for subordinated bondholders, Portugal in the headlights (which does not come to us as a surprise), and we will attempt to analyse the latest FOMC's decision relative to the existing swap lines agreement between the Fed and the ECB and the consequences that come to our mind.

Time for our Credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Not much has changed since our previous post, the Markit Itraxx SovX Western Europe 5 year CDS index (representing 15 countries)  is marginally tighter, around 332 bps points whereas both Itraxx Financial Senior 5 year index and Subordinated index are wider by a couple of basis points. Not a lot of volatility going on.

In relation to the liquidity picture, it is more of the same as well, as per our 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 Italy starting to widen again slightly in conjunction with Spain - source Bloomberg

Some change in "Flight to quality" picture, with wider Germany 10 year Government bond flirting again with the 2% yield level  and falling 5 year CDS spread for Germany - Source Bloomberg:

 The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view - source Bloomberg:

It is of no surprise to us to see Portugal taking center stage, following on current Greek negotiations with private bondholders (PSI). In fact we first noticed the decoupling between Ireland and Portugal in August last year in our post "Ireland June trade surplus - A glimmer of hope?":
"But, we are starting to see divergence between Portugal and Ireland, not only in the CDS 5 year space, but also in the 10 year government bond space:
Ireland 5 year CDS versus Portugal 5 year CDS, correlation was one and breaking since a couple of weeks."
Ireland 5 year sovereign CDS versus Portugal 5 year sovereign CDS spread.
Portugal 5 year Sovereign CDS has reached a new record level at 1312 bps, representing a cumulated probability of default of over 67% according to CDS data provider CMA.
The LTRO sparked rally on both financial stocks and senior bonds so far this year. But in relation to Portugal Sovereign CDS versus Portuguese banks financial CDS there is indeed an interesting dislocation as highlighted by a credit trader. Banco Espirito Santo senior 5 year CDS trades around 865 bps, 200 bps tighter year to date, whereas Portugal Sovereign CDS is around 240 bps wider year to date.   This is indeed the direct consequences of the ECB intervention as highlighted by Bank of America Merrill Lynch in our previous conversation, mainly due to the fall in correlation between the banks and the sovereign spreads. This dislocation is only a function of the outlook for peripheral sovereign debt given current banks'exposure to the periphery. While banks have indeed inherited from unconditional support from the ECB courtesy of the three years LTRO, as indicated in Nomura's recent note from the 24th of January entitled "36-month LTROs: A pyrrhic victory?", sovereign so far have not received unconditional support:
"Through these operations the ECB is providing an interim solution to the liability side of bank balance sheets; it is not intended to resolve the significant impairment on the asset side. Although there has been a large repricing of the front-end of sovereign curves into and since the operation, we do not think this demand will persist as the ECB’s operation is not about adjusting the dynamics of the stock or flow demand problems faced by European sovereigns."

We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities of the ECB will have to depreciate. It is therefore not a surprise to see the ECB's current reluctance in getting a haircut on their Greek holdings in relation to the ongoing negotiations revolving around the Greek PSI.

But back to the title of our conversation, the law of unintended consequences, given Nomura in their report indicated the following:

"In light of the LTRO-spurred rally, we analyse whether the LTRO has indeed
formed a sea-change in the eurozone debt crisis. We conclude that:
The 3yr LTRO significantly reduced the tail-risk of a liquidity-driven
collapse by a European bank...
...but that the ECB liquidity will have adverse unintended consequences
for private sector financing of banks

...and that it is more expensive funding than commonly viewed
...which provides an effective floor to front-end rates as driven by ECB liquidity...
...both of which will limit the size of next month's LTRO... such, without non-bank investor demand, we do not think the LTRO will lead to a durable flow of liquidity into Europe's non-core bond markets...
...meaning that we retain our bearish strategic view on non-core European bond markets."

Nomura also adding:

"LTROs are increasingly punitive and lead to subordination of senior unsecured bank debt. The haircut structure and increased asset usage effectively means that further ECB liquidity is increasingly punitive, utilising ever more balance sheet. The more the facility is used the greater the degree of subordination to senior creditors, which previously would have partially relied on the assets, now pledged to the ECB, as security against senior debt. This problem is particularly pertinent given that banks have already been using the covered bond markets to raise funds, which require over-collateralisation in order to achieve higher ratings and to meet the criteria laid down by the ECB in order to be deemed eligible collateral for operations."

Meaning dwindling quality collateral to pledge in the process, the law of unintended consequences...which we thing will of course lead the ECB to lower again its collateral standards in the near future.

Which brings us to the most recent subordinated bond tender offer by Unicredit and this is what our good credit friend had to say:
"Unicredit announced this morning a tender offer on Tier 1 and Upper Tier 2 bonds for a total of 3 billion euro. Prices range from 50% to 86% depending on the securities...Which is a nice haircut for subordinated bondholders!

At the same time, the Italian bank plans euro 25 billion covered bond issue (which reminds me of what happened with the Irish Banks covered bonds)."

Nomura expects the second round of LTRO in February to be not only smaller but to have the following effect:

"In aggregate we think that the total level of funds taken down through the ECB operation will be less than the previous round. In our estimation this is likely to be in the €200-300bn range.

If the size is bigger than this, perhaps in the range of €500bn or greater, the effect on bank balance sheets in Europe will be distinctly negative in our view, and would make future wholesale and term funding from private sector sources significantly more difficult."

For more on the subject Joseph Cotterill in FT Alphaville goes into more details about the impact of the LTRO in his post - "Margin call, the LTRO movie"

In "A Tale of Two Central Banks" we argued:

"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."

This leads us to the latest FOMC's decision in relation to the existing swap lines agreement between the Fed and the ECB and the unintended consequences that come to our thoughts as indicated by Martin Sibileau:

"The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits."
Hence the difference between the FED and the ECB, with the ECB financing flows (deficits).

Unintended Consequences according to Martin Sibileau:

"With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unaddressed. All these factors only contribute to prolong the recession and a high unemployment rate."

Given today's decision of the FOMC to maintain US rates low until late 2014, it seems to us that the European recession can only be prolonged as indicated by Rcube Global Macro research in our previous conversation, increasing the likelihood of a Euro Breakup.

Again, like any cognitive behavioral therapist, we tend to watch the process rather than focus solely on the content.

Does the FOMC's latest decision put a floor to the drop of the euro versus the dollar? Are the FED's swap lines and latest FOMC decision delaying a painful adjustment in Europe? We wonder.

"Logical consequences are the scarecrows of fools and the beacons of wise men."
Thomas Huxley

Stay tuned!

Friday, 20 January 2012

Markets update - Credit - The European Overdiagnosis

"Analysis does not set out to make pathological reactions impossible, but to give the patient's ego freedom to decide one way or another."
Sigmund Freud

Following on our meditations on Bayesian outcomes, and the "European Principle of Indifference", it appeared to us appropriate this time around to focus on the unintended consequences of applying nonsensical decisions to nonsensical results, hence, we have decided this time around to use the analogy of overdiagnosis relating to our European issues:

"Overdiagnosis is the diagnosis of "disease" that will never cause symptoms or death during a patient's lifetime. Overdiagnosis is the least familiar side effect of testing for early forms of disease – and, arguably, the most important. It is a problem because it turns people into patients unnecessarily and because it leads to treatments that can only cause harm." - source Wikipedia

Indeed, this analogy seems to us particularly right relating to the current European and American "Balance Sheet Recession" which has been a recurring theme from Richard Koo, chief economist at Nomura Research Institute, as pointed out by Cullen Roche on Pragmatic Capitalism - "DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION":

"This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again."

So, in a longer credit conversation than usual, we will first have a credit overview given recent significant price action (tightening spreads and much better tone in the credit space), before dealing more directly with the current" European Overdiagnosis" and unintended consequences courtesy of my global macro friends at Rcube Global Macro Research, quantifying "The likelihood of a Euro Breakup" in their latest paper, which follows on their previous analysis of Eurozone's core issue, namely Unit Labor Cost Divergence, which we discussed in our "European Flutter".

The Credit Indices Itraxx overview - Source Bloomberg:

"The Markit iTraxx Financial Index of credit-default swaps linked to the senior debt of 25 European banks and insurers now costs a record 120.5 basis points less than the Markit iTraxx SovX Western Europe Index of swaps on 15 governments. That compares with a 28 basis-point gap at the end of November and a previous high of 118 in July. Historically, it costs more to insure banks than governments." - source Bloomberg news - Abigail Moses and John Glover.

The Year of the Dragon should be rebranded the Year of the European Central Bank, given the significant tightening in credit indices which we have witnessed in Europe since the beginning of the year as indicated by Bank of America Merrill Lynch research - The ECB trade - 17th of January:

"The ECB funding “put”
Away from S&P’s downgrade distraction, we think funding stresses in the credit market have improved significantly over the last month. Three themes paint a better picture. Firstly, ECB 3yr LTROs have had big take-up, and more is to come.
Secondly, fixed-rate senior unsecured bank issuance has reached €15bn YTD, half of the entire 2H supply last year. And finally, as our banks colleagues highlight, government guarantee schemes can be a powerful solution to a bank funding crisis. With the ECB helping to transform funding pressures in credit, we think short-dated spreads can keep rallying."

As indicated above the fall in the Itraxx Financial Senior 5 year index has been significant versus the SOVx 5 year index (relating to 15 European sovereign CDS) courtesy of the breakdown in the correlation between Sovereign and credit spreads, as indicated by Bank of America Merrill Lynch in their report:

"Sovereign and credit spreads - the correlation is finally breaking
Thanks to ECB intervention, credit spreads have been much less correlated to sovereign spreads over the last month (although still positive). In fact, our work shows that the correlation between bank and sovereign spreads has fallen from 90% in mid December last year, to 40% currently. This isn’t far from the lowest correlation between the two since the start of 2010. How long this lasts will ultimately be a function of the outlook for peripheral sovereign debt, given banks’big exposure to the periphery."

In fact as my good macro friend pointed out early January, it is interesting to track the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):
Volatility has been falling faster than the Itraxx Crossover index and the index is clearly trying to catch up at the moment.

In relation to the liquidity picture, it has somewhat  improved as indicated in our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:
New reserve period for deposits started on the 18th. It will be significantly important to track upcoming peripheral government bonds auctions, given that, while the ECB's intervention is clearly supportive for banks, volatility will depend on the Greek PSI outcome, upcoming downgrades for banks and corporate rating downgrades (following up on sovereign downgrades and which have already started).

As Bank America Merrill Lynch put it in a note published on the 16th of January - "Perhaps it's not so bad after all":
"Banks better placed than sovereigns?
It is certainly the case that European banks have a lender of last resort who is dealing very flexibly with their needs – something the ECB has so far proved reluctant to do with sovereign debt."

But, there is a catch and Bank of America Merrill Lynch report from the 17th is on target:
"It isn't all about European banks' sovereign exposure - its also about private sector lending, not just sovereign bond holdings."
"How long the low correlation between bank and sovereign spreads lasts will ultimately be a function of the outlook for peripheral sovereign debt, and Standard and Poor’s sovereign downgrades don’t help. Despite the ECB’s welcome funding, European banks’ exposure to sovereigns remains vast, as chart 7 shows. Note European banks’ large private sector lending to peripheral countries." - source Bank of America Merrill Lynch.

And Bank of America Merrill Lynch to conclude their note with the following advice in relation to credit in 2012: "a more trading, "macro-driven" credit market."

Truth is, while everyone is anxious about the results relating to the Greek PSI, Sovereign CDS wise, Portugal looks to be the ideal candidate for some additional haircuts as we indicated in our last post "The European Principle of Indifference".
Sovereign CDS, between Ireland and Portugal, a new record between both countries with a spread difference of 604 bps - source Bloomberg:
Portugal 5 year Sovereign CDS is now at 1245 bps, which according to CDS data provider CMA equates to a cumulated probability of default of 65.67% within 5 years.

Meanwhile, the disconnect between the 10 year German Bund and the Eurostoxx is still noticeable but today we saw some widening courtesy of German Bund 10 year spread climbing 9 bps and closing on the 2% level, (we noticed this disconnect first time around in November in our post "Mind the Gap...") - source Bloomberg:

In relation to our previous conversations relating to bond tenders and other steps taken by banks to shore up capital requrements (BBVA benefiting from a tax credit courtesy of a goodwill impairment as discussed recently), it was interesting to see the Wall Street Journal catching up with us in relation to the unusual steps taken by some European banks to raise capital in order to reach the 9% Core Tier 1 Capital threshold set up for June 2012 -
"Banks Seeking Capital Ideas - European Lenders Are Taking Unusual Steps to Meet Their Cash Requirements". But what also caught our attention was seeing Bank of America entering as well the raising capital game of bond tenders, offering to buy back 1.5 billion dollars worth of subordinated bonds on the 19th of January. As reported by Zeke Faux in Bloomberg:
"Bank of America is reducing long-term debt as Chief Executive Officer Brian T. Moynihan, 52, seeks to cut holdings, expenses and staff while raising capital to meet demands from regulators for a larger cushion against losses."
So European bankers, please take solace, you are not alone.
"The bank is offering about 95 cents for those securities, it said in the statement", according to Bloomberg, on 6.22% Subordinated bonds due in September 2026, which amounts to a smaller haircut than what we have witnessed in Europe recently on some subordinated bond tenders last couple of months.

But back to our main story, namely European politicians' "Overdiagnosis". What could happen if austerity bites too much, could it lead to Euro Breakup? This is what my friends at Rcube Global Macro Reasearch have recently worked on:

The Likelihood of a Euro Breakup

Since late November, the 2 year yields of both too-big-to-fail PIIGS have crashed (by 350bp for Italy and 320bp for Spain). This indicates that the latest initiatives to save the Euro – most notably the LTRO – have succeeded in lowering the perceived short-term risk of a Euro breakup. This is undeniably a bullish signal for risky assets in the short term. On the other hand, 10 year yields remain stubbornly high, especially in the case of Italy (which is still trading at around 6.5%). This shows that the market believes (as do we) that the question of the Euro’s long-term viability remains unresolved. In order to quantify the likelihood of a Euro exit for each endangered country, we have built a simple model based on CDS spreads and excess unit labor costs. Before showing the model itself, let’s explain why we don’t believe that solving the PIIGS’ government debt problems (through ECB initiatives and fiscal austerity) will be sufficient to prevent a Euro breakup.
In our recent paper about unit labor cost divergence (Macro Analytics 19/12/2011), we suggested that the Euro’s issues went beyond the current debt crisis. The Euro created competitiveness imbalances between Eurozone countries by preventing currency adjustments, which were prevalent in the period between the end of the Bretton Woods system (in 1971) and 1999:

We see some occasional swings, but the dominant pattern is a rather regular fall of most currencies – at different speeds - against the Deutsche Mark, the only exceptions being the Austrian schilling and the Dutch guilder. Unsurprisingly, countries whose currency deteriorated the most during this 28 year period were the PIIGS (the Greek Drachma led the trend with an impressive 95% devaluation against the DEM). When we look at unit labor costs compared to Germany between 1995 and 2012, we notice that countries’ rankings are close to being the opposite of their former currencies’ strength:

If we more thoroughly analyze the relationship between the devaluation rhythm of former currencies’ (+: depreciation, - : appreciation) during the 1971-1995 period and unit labor cost increases between 1995 and 2012, we find a Pearson correlation coefficient of 0.70, and a Spearman correlation coefficient of 0.87. This indicates a strong (albeit non-linear) relationship between those two data items.

Despite the stories about the Mileuristas in Spain, the Milleuristi in Italy and the 700€ Generation in Greece, wage-earners in the PIIGS faired relatively well on a productivity-adjusted basis during the 1995-2008 period, as if they were still being paid in a weak currency that justified regular wage increases. As an illustration of this, we recently learned that Italians now have the highest net worth amongst G8 countries, despite the dismal performance of Italy’s economy over the last decade (this is also a byproduct of Italy’s housing bubble).

Had the Euro never existed, it is fair to assume that PIIGS’ currencies would have naturally adjusted to compensate for their high relative unit labor costs. As countries renounced their ability to devaluate, their competitiveness suffered considerably. Even in the case of France, which is not (yet) considered as one of the PIIGS, its balance of trade went from +3.2% of GDP in 1997 to –3.0% in 2011.

By eliminating currency crises, which were common until the mid-1990s (and at the same time preventing evil “speculators” from making billions on them), the Euro built an economic crisis of far larger proportions. Once again, economics provides a good illustration of the old proverb “the road to hell is paved with good intentions”.  
It is an understatement to say that finding a politically acceptable solution to restore labor cost balance within the Euro framework will be difficult. In addition to the deep cuts that are currently being imposed on government budgets, real wages will have to fall across the board (and not only minimum wages). As people tend to think about money in nominal terms (Keynes’ money illusion), it might end up being easier to find a smart (i.e. non chaos-inducing) way to return to a system of floating currencies, rather than to impose years of internal devaluations.

This is the main reason why we believe that the question of the Euro’s long-term survival goes beyond knowing whether the ECB will finally use its proverbial bazooka during the next 12 months. Even if Greece’s government debt was reduced to zero (which could end up being the case someday), it would not change anything regarding its current lack of competiveness (exports: 7% of GDP, imports 21%). As an anecdote, we recently read that Greece had to import olive oil from … Germany.

A simple model to assess market-implied Euro exit probabilities:

We believe that a large part of Eurozone countries’ CDS spreads reflect their long-term probabilities of exiting the Euro, rather than their default risk within the Eurozone. Indeed, even though we’re not sovereign debt experts, it seems evident to us that if a country was to exit the Eurozone and switch to a new currency, it would have to convert its government debts to the new currency. This would most likely constitute a default in legal terms for most countries[1], but we cannot imagine a country keeping a huge debt denominated in a foreign currency. This would create a Weimar-type vicious circle and would inevitably crush the new currency into oblivion.  Additionally, defaulting without exiting the Euro would not solve the competitiveness issue of many European economies (we’ll soon be able to check this theory with Greece).

If we assume that new currencies would have to devaluate to readjust their unit labor costs to their 1995 level, we can work out theoretical recovery values after redenomination (from which we take a haircut of 20% to take into account overshooting). We then calculate 1-year and 5-year Euro implied exit probabilities by using a simple formula for default probability (Default Probability = Spread / ( 1 – Recovery Rate) ]. This gives us the following implied exit probabilities for the main EZ countries[2] that have a 5 year CDS spread higher than 100:

Despite the rather simplistic assumptions we made in our calculations, these levels appear to be close to what we would have expected: in the short-term (1 year or less), exit probabilities are rather low for most countries, with the exception of Ireland and Portugal. Too much political capital has been invested in the Euro by the last two generations of politicians. Additionally, it would be a mistake to believe that the system is out of ammunition. In a fiat money world, the ECB cannot run out of Euros.  Everything ultimately depends on politicians’ (especially Merkel’s) willingness to “save the Euro”. On its own, the ultimate kick in the can (massive debt monetization) would certainly extend the Euro’s life for quite a few years.  

Consequentely, we believe that the Euro will muddle through for a while, in a climate of painful fiscal tightening for most European countries…

However, if as we fear will be the case, austerity plans do little to address the underlying competitiveness problems faced by many countries, their growth rates will remain anemic. Instead of the rosy “J curve” that would have been promised to justify deep cuts in government expenses, weak EZ countries will experience the dreaded “L”. Rather than going through another purge, some countries will then make the choice to exit the Euro. In this context, the 5 year implied exit probabilities do not appear to be exaggerated to us. 

[1] Under ISDA rules, G7 countries (Germany, France and Italy) could decide to redenominate their debt without provoking a credit event.
[2] Outside from Greece whose default/exit probability is already 100%

"The physician must give heed to the region in which the patient lives, that is to say, to its type and peculiarities."

Stay Tuned!

Tuesday, 17 January 2012

Markets update - Credit - The European Principle of Indifference

"Insanity: doing the same thing over and over again and expecting different results."
Albert Einstein

"In a macroscopic system, at least, it must be assumed that the physical laws which govern the system are not known well enough to predict the outcome. As observed some centuries ago by John Arbuthnot (in the preface of Of the Laws of Chance, 1692):

It is impossible for a Die, with such determin'd force and direction, not to fall on such determin'd side, only I don't know the force and direction which makes it fall on such determin'd side, and therefore I call it Chance, which is nothing but the want of art....
Given enough time and resources, there is no fundamental reason to suppose that suitably precise measurements could not be made, which would enable the prediction of the outcome of coins, dice, and cards with high accuracy: Persi Diaconis's work with coin-flipping machines is a practical example of this." - source Wikipedia

The "Principle of insufficient reason" was renamed the "Principle of Indifference" by the economist John Maynard Keynes (1921), who was careful to note that it applies only when there is no knowledge indicating unequal probabilities - source Wikipedia
Keynes was refuted by Frank Ramsey, but this is another story...

As a follow up to our Bayesian thoughts and following the recent Standard and Poor's downgrade of 9 European countries, our Principle of Indifference analogy relates to the European ongoing crisis. It seems our European politicians are applying the principle incorrectly, not only leading to nonsensical results, but as well as to nonsensical decisions (PSI on Greece, EFSF, and more). In this credit conversation, we will discuss collateral damage to our CPDO EFSF, again on Goodwill impairments ("Goodwill Hunting Redux") and more. But before, we go through the nitty-gritty; it is time for a quick Credit Market overview.

The Credit Indices Itraxx overview, slightly better in a quiet European session even after the downgrades - Source Bloomberg:
A fairly quiet day in the credit indices space with US being out. Overall credit indices were tighter while the Securities Markets Programme (courtesy of ECB) was in for the bid on the sovereign bond cash side.
The Itraxx Crossover 5 year index (50 High Yield companies) fell about 16 bps to close around 710 bps and Itraxx Main Europe 5 year index (125 European investment grade names) was tighter as well, around 167 bps, 5 bps tighter.

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:
Still record holding at the ECB's overnight facility earning 0.25%, one more days until the start of a new reserve period on the 18th.

The current European bond picture with more respite for Italy and Spain courtesy of SMP intervention (ECB) - source Bloomberg:

No change on "Flight to quality", with tighter Germany 10 year Government bond still trending towards record lows - Source Bloomberg:

And our interesting disconnect between the 10 year German Bund and the Eurostoxx is still there, (we first noticed this disconnect in our post "Mind the Gap..." - source Bloomberg:

But the most significant movement we saw today was relating to Sovereign CDS, between Ireland and Portugal, a new record 510 bps between both countries - source Bloomberg:
Ireland 5 year CDS was at 800 bps on the 27th of September 2011 (see our post"Much ado about nothing").

As a follow up on our conversation "Long hope - Short faith", we were expecting Austria's sovereign CDS to trade wider than France at some point, courtesy of the Austrian banking sector Hungarian issues. Following the downgrade of both countries last Friday, we are getting closer to the point - source Bloomberg:

In relation to our CPDO/EFSF, following up on Friday's action, Standard and Poor's has effectively downgraded the leveraged structure from AAA to AA+.
Back in our "European Flutter" conversation we argued:
"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..."

How would a downgrade of a member country affect EFSF? - source EFSF
"There is a credit enhancement structure used under the Framework Agreement which constitutes the EFSF. Therefore a downgrade of a member country would not necessarily lead to a downgrade of EFSF securities."
Time to update the presentation...

Standard and Poor's stated:
"We consider that credit enhancements that would offset what we view as the now-reduced creditworthiness of the EFSF's guarantors and securities backing the EFSF's issues are currently not in place. We have therefore lowered to 'AA+' the issuer credit rating of the EFSF, as well as the issue ratings on its long-term debt securities."

What is the credit enhancement structure?
"In order to ensure the highest possible credit rating, various credit enhancements were put into place:
- an over-guarantee of 120 per cent on each issue.
- an up-front cash reserve which equals the net present value of the margin of the EFSF loan.
- a loan specific cash buffer
Together these credit enhancements ensure that all loans provided by EFSF are backed by guarantees of the highest quality and sufficient liquid resource buffers. The available liquidity is invested in securities of the best quality." - source EFSF

But given's Germany's Supreme Court recent reluctance on increasing the EFSF's firepower without a popular vote, we seriously doubt the credit enhancements expected by Standard and Poor's to reverse their negative outlook will materialise in the near future for the EFSF given:

"Unlike the EFSF, ESM.s structure will comprise paid-in capital, callable capital and guarantees. This therefore means that the ESM would not require the credit enhancements (over-guarantee, cash buffer and cash reserve) that the EFSF requires in order to secure a AAA rating." - source EFSF

We already discussed at length the frailty of the EFSF - "EFSF - If you are in trouble - double".
- source EFSF

Could EFSF be considered as a Collateralized Debt Obligation (CDO)? - source EFSF
"No, EFSF is not a CDO. The essential difference between EFSF and a CDO is that EFSF debt has no tranche structure. There is no seniority and all investors have exactly the same rights. Secondly, EFSF bonds are covered by the guarantees from the euro area countries. However, a triple-AAA rating from all three leading credit rating agencies is not assigned lightly. EFSF has put into place additional credit enhancements through the use of a cash reserve and loan specific cash buffer which are immediately deducted from the loan made to a borrowing country in order to provide additional reassurance to investors. Consequently, all claims on the EFSF are 100% covered by AAA guarantors and cash."

We would have to agree, the EFSF is not a CDO, it is worse. More akin to a CPDO, and given it has no tranche structure and no seniority, as we argued previously "the loss in NAV can be significant", suffices to say, it can just be binary.

Following up on BayernLB's goodwill impairments discussed in our "Bayesian Thoughts", we forgot to mention BBVA which took a Goodwill impairment charge of 1.5 billion euros, which according to CreditSights counter-intuitively helps improve its regulatory capital by generating an immediate tax credit:

"The 400 million Euros tax credit is offset against current taxation and relates to a gross goodwill impairment charge of about 1.5 billion euros rather than 1.1 billion euros, because of rounding differences. 400 million euros equates to an increase in retained earnings flowing into Core Tier One versus the retained earnings that would have been achieved without the goodwill impairment of the tax credit. This is because the gross impairment of 1.5 billion euros does not affect Core Tier 1, since all outstanding goodwill is already discounted in the regulatory number, even though in accounting terms, shareholders'equity will be negatively affected on the balance sheet. The benefit in ratio terms is 14-15 bps worth of Core Tier 1(which stood at euros 25,979 million at 30 September under the EBA Criteria).
Our understanding is that BBVA will be able to offset this against tax payable for the whole of 2011. Although a tax charge is accrued quarterly in the P&L, it is actually paid on an annual basis, so the lack of sufficient pre-tax earnings in the fourth quarter alone should not prevent the group from offsetting the 400 millions euros against the tax that will be payable on the full-year 2011 earnings."

So, no earnings mean no Goodwill impairment impact on earnings and a convenient tax credit in conjunction with an improved regulatory capital.

So yes, "Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."
Indeed an interesting exercise in 2012.

Although Swedbank wasn't as lucky as BBVA, given, according to CreditSights:
"Swedbank: SEK 1.9 (215 millions euros) billion Latvian Goodwill Impairment in Q4 2011, a 49% impairment on the total goodwill of SEK 3,870 millions. The goodwill write-down will make a dent in Swedbank's FY11 profits when it reports on 14 February, but the size is manageable. Latvia remains a key market for Swedbank, but although economic growth revived in 2011, it is likely to show signs of slowdown in 2012."
On a final note, we leave you with Bloomberg Chart of the Day - "Collateral Damage’ to EFSF Fund":

Jan. 16 (Bloomberg) -- "Standard & Poor’s Jan. 13 downgrade of nine euro-area countries, including France and Italy, risks blunting trust in Europe’s main weapon against the debt crisis. The CHART OF THE DAY shows the zone’s average rating, calculated by Bloomberg from the three main evaluators’assessments, worsened to 3.56, implying three grades below the top level, from 3.27 on Dec. 31. The average is calculated by assigning each grading a number, with 1 as the top rating, and adjusting it for each country’s share in the bailout fund called the European Financial Stability Facility."
"In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule."
Friedrich Nietzsche

Stay tuned!

Thursday, 12 January 2012

Markets update - Credit - Bayesian thoughts

"In the Bayesian (or epistemological) interpretation, probability measures a degree of belief. Bayes' theorem then links the degree of belief in a proposition before and after accounting for evidence. For example, suppose somebody proposes that a biased coin is twice as likely to land heads than tails. Degree of belief in this might initially be 50%. The coin is then flipped a number of times to collect evidence. Belief may rise to 70% if the evidence supports the proposition." - source Wikipedia

Today's analogy refers to our rising degree of belief courtesy of Bayesian statistics but also to the well-studied "optimism bias" which most of us are affected by:
"The ability to anticipate is a hallmark of cognition. Inferences about what will occur in the future are critical to decision making, enabling us to prepare our actions so as to avoid harm and gain reward. Given the importance of these future projections, one might expect the brain to possess accurate, unbiased foresight. Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."
Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

But, here we go again, lost in our thought process once more. It is time for a credit market overview, the improved tone in the credit space and following up on our previous Hungarian story with an interesting goodwill write down, courtesy of BayernLB, what a surprise...

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:
While banks are still so far hoarding cash at the ECB's overnight facility earning 0.25% in the process (new reserve period starts on the 18th of January), liquidity picture is improving at least on the Libor OIS spread level, indicating clearly the 30th of November Central banks operation has had its effect on dollar funding issues.

The Credit Indices Itraxx overview, overall a better tone - Source Bloomberg:
Itraxx Financial Subordinate 5 year CDS index falling below the 500 bps level and closing around 480 bps, overall a better tone in the Credit space with a flurry of corporate bonds issuance, Spanish bond auctions, ECB keeping rates at 1% and more. Since the beginning of the year we have seen quite a few issues of Senior Financial Unsecured bonds issuance from core European banks:
Nordea Bank 2.24% 2014 (1 billion euros, quarterly floating) on the 4th of January,
Abn Amro Bank 4.75% 2019 (1 billion euros) on the 4th of January
ING 4.25% 2017 (1 billion euros) on the 6th of January,
UBS 3.125% 2019 (1.5 billion euros) on the 11th of January,
Rabobank 4% 2022 (1.75 billion euros) on the 11th of January,
Standard Chartered 4.125% 2019 (1 billion euros) on the 11th of January.

Itraxx Crossover 5 year index (High Yield gauge) evolution - Source Bloomberg:
The Itraxx Crossover represents 50 companies with mostly high-yield credit ratings. The index decreased by around 21 basis points today to 713 bps.

The most important news reported was by Handelsblatt about the European Banking Authority being likely to postpone the annual stress test for banks initially set up for June and published in 2012. Could it be in order to avoid spoiling the celebration of the London Olympics? It might be more realistically to do with the recent concerns of raising much needed capital in 2012 following the dreadful right issues results of Unicredit which we discussed previously and avoid a dreadful credit crunch for 2012 in the process. Deleveraging bank balance sheets in conjunction with reaching a core tier one capital level of 9% was indeed a recipe for disaster looking at 2012 wall of refinancing (somewhat alleviated by the 36 months LTRO operation conducted on the 21st of December by the ECB).

There is again an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, a point we touched in our post "Mind the Gap..." - source Bloomberg:
Volatility falling still in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

Could the disconnect be different this time?

Flight to quality mode is so far is still on, with Germany 10 year Government bond trending back towards record lows - Source Bloomberg:

One of the indicators 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 coming back following the scary German auction of the 23rd of November (see our post "The song of Roland") - source Bloomberg:

The current European bond picture with some respite for Italy and Spain - source Bloomberg:

Even our CPDO/EFSF is looking healthier in yields term back to the 3% levels - source Bloomberg:

But what made our credit friend and us really chuckle today, following up on our "Hungarian dances" post, was the news regarding BayernLB (Bayerische Landesbank, the second-
biggest German state-owned lender) which as reported today by Stefan Wagstyl in his column "beyondbrics" in the Financial Times has effectively been "bloodied in Budapest":

"Germany’s BayernLB said it would report a net loss for 2011 because it was writing down the value of its Hungarian subsidiary, MKB Bank."

Reminding us exactly of what discussed last time around:

"Tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process."

BayernLB anticipates net loss for 2011 under German accounting standards (HGB) due to Hungarian government actions - press release:
"12 January 2012
Munich - Due to the need to write down the book value of its holding in its Hungarian subsidiary MKB Bank, BayernLB currently anticipates that it will report a net loss for 2011 in its separate accounts under German accounting standards (HGB).

BayernLB is compelled to take this measure because actions by the Hungarian government, to include the extremely high bank levy and recently passed Foreign Currency Conversion Act, have substantially impaired MKB Bank's earnings prospects.
The writedown on the book value of its holding in MKB Bank will have a significant impact on BayernLB's net income under German accounting standards and thus overshadows the positive performance of its operating business with customers.

As a result of the expected loss in the HGB financial statements, BayernLB does not expect to service its equity capital instruments (profit participation certificates, silent partner contributions and BayernLB Capital Trust 1 securities) for financial year 2011.
As things currently stand, it will not be possible for the profit participation certificates and silent partner contributions to avoid sharing the loss. A definitive statement on the amount of the loss participation is not expected to be possible until the financial accounts have been approved at the end of April 2012."

Consequence: Bayern LB Capital Trust (Tier 1 ) Perp call 2017 – 6.2032% - $ 850 million – Isin XS0290135358. Price: 32/34 Down 7 points...

We have to say it again, like we did in our previous conversation and as well in November in our Goodwill conversation:

"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

So effectively, BayernLB equity capital instruments holders can kiss their coupon goodbye...

And my good credit friend to comment:

"And this kind of event will affect much more banks than expected by the market. I expect Austrian banks to make similar announcements very soon, with potential worse consequences considering their position in Central Europe."

EUR/HUF currency levels - source Bloomberg:
We were in agreement with Deutsche Bank in our last conversation:

"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

In fact according to Bloomberg, the likely choice seems so far towards partial loss of sovereignty, indeed we argued last time around, we have seen this movie before...

According to Bloomberg:

"London, January 12 (MTI) - There is a "good probability" that the Hungarian government will sign a Stand-by Arrangement with the IMF as early as the first quarter of this year, London-based emerging markets economists said on Thursday.
In its comprehensive 2012 outlook for the CEEMEA region released to investors in London, Morgan Stanley said a two-year programme of 15-20 billion euros would be sufficient to reassure markets about Hungary's funding needs."

But given our current "Bayesian thoughts", and as indicated by Morgan Stanley in the same article:

"We think that the next few months should see Hungary's refinancing risks
fall significantly thanks to assistance provided by the IMF/EU". That said, "we think that even though there are good chances of a deal in the near term, the relationship with the IMF is likely to be rocky to say the least, as long as the current administration is in place... Therefore, the risk of some rift between Hungary and the EU/IMF a few months down the line remains intact", Morgan Stanley said."

So, all in all, we would have to agree with Dr. Constantin Gurdgiev, from his latest post entitle "Great Moderation or Great Delusion":

"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

And to use a baseball analogy from our Americans friends, don't try stealing third base in this market environment!

"Information: the negative reciprocal value of probability."
Claude Shannon

Stay tuned!

Friday, 6 January 2012

Markets update - Credit - The Hungarian dances

"Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."
Albert Einstein

In a continuation of our previous analogy to the European flutter, as we enter 2012, the recent evolutions of the situation in Hungary which we discussed in our post "Mind the Gap...", warrant us this time around to ramble around how reminiscent the collapse of the Austro-Hungarian dual monarchy and empire (1867–1918) is with our European flutter. Could Hungary be the trigger in 2012? Before we enter yet another long credit conversation, for a change this time around, before our market overview, it is of importance to highlight the current situation in Hungary and contagion to Central Eastern Europe.

Back in October in our post "Long hope - Short faith" we discussed the worrisome Hungarian situation, which was also the main subject of our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets".

We previously quoted an article by Geoffrey T. Smith from the Wall Street Journal on the subject and as we move into 2012, it will be paramount to monitor the risk of wholesale capital flight with the ongoing buildup of tensions in Hungary - "Austria Has a Déjà Vu Moment":

"the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

On the 4th of January, Hungary's 5 year sovereign CDS widened by 65 bps, quoted 690-730 bps in the market, with limited liquidity and the CDS curve inverting in the process, meaning short dated protection is becoming more expensive than the 5 year point. We have seen this happening before with Greece, Portugal and others. The situation warrants caution as the Hungarian effect is spreading to other countries according to a market maker, spreading to Poland and Czech sovereign CDS, both trading wider in the process, Poland around 290 bps for the 5 year CDS and around 180 bps for Czech CDS 5 year.

As indicated by Simon Foxman in Business Insider article - Hungary's Currency Hits New Lows Amid More Signs Of Upheaval:
"The Hungarian forint weakened to its lowest value against the euro since last month—near its lowest level ever—at 319.4 amid worries that the political situation there is becoming untenable. Increasing attention is being paid to the small Eastern European country, at the center of Europe's other debt crisis.

The Hungarian government is running short on cash after it passed a law last week that could compromise the independence of its central bank. That law flaunted guidance from the European Union and the International Monetary Fund, who provided the troubled country with €20 billion ($26 billion) a bailout back in 2008. Hungary is paying through the nose to borrow even short-term funding, and the cost of insuring Hungarian debt via credit default swaps hit a new record, at 655 basis points according to Bloomberg. It paid yields of 7.67% to borrow for a three-month term and raise 45 billion forint ($190 million) yesterday.

Domestic turbulence is complicating matters, with protestors taking to the street to protest the government's new constitution (which includes that controversial central bank law). According to the BBC, protests are focusing on three major issues:

·A clause that defends the "intellectual and spiritual unity of the nation," which opponents argue could result in repression of intellectual freedoms

·Inclusion of social issues like the right of the unborn child and the definition of marriage as a union between a man and a woman

·Changes to the electoral system which could empower the leading Fidesz party at the expense of the opposition

Popular support for the Fidesz party hit 18% in a December opinion poll cited by the BBC, although it still leads other parties. If the Hungarian government were unable to pay its bills, it could wreck the Austrian banking system, which has an estimated $226 billion in exposure to Eastern Europe and €1.14 trillion ($1.6 trillion) of assets held in the region. 10-year yields on Austrian government bonds—and indicator of stress on the country—are moving sharply higher this morning. They rose to 3.20%, the highest level since before a central bank stilled their rise earlier in the year."

At the time of our November conversation "Mind the Gap...", we reminded the new legislation which passed by the Hungarian government in relation to the ill-fated currency mortgages which burden Hungarian households:
"Under the new legislation borrowers can repay their mortgage in a single installment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
In November we commented:
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg. Given HUF/EUR is reaching new highs, Austrian banks exposed to these mortgages face significant additional losses. So yes, contagion to EM, and in particular Central Eastern Europe, which was highlighted as a key risk for 2011, is indeed starting to materialise early in 2012.

But before we delve more into the Hungarian dances (as a reference to the 21 lively Hungarian dance tunes by Johannes Brahms), and discuss some of our previous call for concerns, it is time for a quick market overview.

The 36 months LTRO set up on the 21st of December by the ECB is far from having the expected results in relation to alleviating concerns that banks will use the cheap funding provided to generate generous positive carry by buying peripheral bonds. 455 billion euros are deposited at the ECB earning a paltry 0.50% of interest for now - 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 Credit Indices Itraxx overview - Source Bloomberg:
Most credit indices remain in the "concern" area, with Itraxx Financial Subordinate 5 year CDS index around 530 bps, still indicating the unsecured subordinated financial market is shut down, while Itraxx Financial Senior 5 year CDS index is rising again towards the 300 bps in a very thin market. As indicated by a market maker, so far both clients and dealers are on the sidelines. The Itraxx SOVx index tied to 15 European Government sovereign CDS is on the rise as well getting closer towards its 385 record set up on the 25th of November. Similar story to what we wrote in January 2010, "European problems not going away in 2011", and not going away in 2012.

The current European bond picture, a story of ongoing volatility, with Spain now rising as well with Italy following recent news of regional funding issues in Spain (Valencia) - source Bloomberg:

So what about our CPDO EFSF? It seems French yields are now rising faster as we start a new year, Investors demanded a yield of 3.29% on the 3.25% OAT due in October 2021, last auction on 1st of December was 3.18% - source Bloomberg:

German 10 year government yield falling (flight to quality) while German 5 years sovereign CDS rising - source Bloomberg:

In relation to the deflation story still playing out in Europe, here is an update on 30 year Swiss bond yields now below 1%, nearly 100 bps lower than Japan 30 year bond yields - source Bloomberg:

But back to our main story, namely the Hungarian situation and contagion to Emerging Markets (EMEA).

During various credit conversations, we argued that the name of the game is survival of the fittest in the race to raise much needed capital. It seems Deutsche Bank is sharing our views as indicated in their Emerging Markets special publications published on the 6th of December entitled amusingly "Survival of the fittest":
EMEA dominates our list of the most vulnerable countries. Five countries (Hungary, Ukraine, Romania, Poland, and Egypt) show up as highly vulnerable, though for different reasons. Egypt’s underlying vulnerabilities, for example, are fiscal first and external second. Ukraine’s risks are mostly external. Hungary’s vulnerability reflects a combination of risks in all four areas."

According to Deutsche Bank, for 2012, EMEA countries will be facing many difficulties and will need IMF support:

"Current account balances have improved in the last few years and central banks have been able to build bigger buffers of foreign reserves. But the large stock of external debt accumulated during the middle of the last decade still leaves the region with large external burden. Much of this borrowing took place in foreign currencies – Swiss franc mortgages in Hungary (20% of GDP) being just one example – the local currency burden of which is now being inflated as those currencies come under pressure. With these debts needing to be serviced on an ongoing basis, many countries still face large external financing needs even as their current account positions have improved. This is particularly true of Hungary and Ukraine, which have gross external financing needs of 30% of GDP or above in 2012 despite a moderate current account deficit in Ukraine and a small surplus in Hungary."

IMF support?
"Three of these countries (Hungary, Ukraine and Egypt) may well need to tap the IMF for financial support next year. Ukraine already has an IMF program (of which USD 12bn or 6.5% of GDP is potentially still available) but is currently looking first to Russia for cheaper gas prices to reduce its external financing needs. Hungary is seeking the reassurance of a precautionary IMF program although negotiation on the policy condition has not yet started and could well be difficult. Egypt had reached agreement in principle on a USD 3bn (1.2% of GDP) arrangement with the IMF but has yet to proceed with the deal for political reasons."

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we already discussed at length the Western Europe banking deleveraging impact will have on Emerging Markets and in particular Central Eastern Europe. In their December note, Deutsche Bank also commented:

"The buildup of foreign currency debt was probably largely a reflection of relatively high and volatile inflation in some cases, leading to a large spread between domestic and foreign interest rates. But the availability of foreign currency loans was also facilitated by the rapid expansion of western European banks throughout much of the region. This has left many countries exposed to deleveraging by foreign banks as they seek to meet additional capital requirements imposed by the European Banking Authority. These requirements are largest for Greek, Italian, and Spanish banks, which may be a concern for Romania and Hungary (as well as Croatia, Serbia, and Bulgaria outside our sample) where Greek and Italian banks are most active. But other banks may also be reluctant to maintain their exposures in the region. Germany’s Commerzbank, for example, has indicated that it will temporarily suspend new lending outside of Germany and Poland. Austria’s central bank has also imposed limits on new lending in CEE by the subsidiaries of Austrian banks. And countries without strong parent-subsidiary ownership linkages are also unlikely to be immune. Turkish banks, for example, have substantially increased their short term external borrowing in the last couple of years (from foreign banks) and may face some difficulties in rolling these loans."

As indicated by Deutsche Bank, given Hungary exports to the euro area account for 40% of GDP, Hungary is arguably more exposed to a recession in Europe. The recent failed Hungarian auction and additional pressure on the Forint is definitely not helping.

And my good credit friend to comment on the 5th of January:
"The Hungarian Forint is under pressure again (EurHuf @ 321.50), and the country had problem raising 1 year T-Bills this morning (35 billion HUF instead of the 45 billion planned, the average yield rose to 9.96% versus 7.91% for the same kind of maturity on December 22nd). The cost of insuring Hungary’s debt through CDS reached an all-time high at 750 bps!

Basically, the country is now in a worst situation than Portugal, and without the IMF and EU assistance, the risk of a hard default is rising very quickly. Consequences for European banks exposed to this country are difficult to assess, but Erste Bank, Raiffeisen and some other players should suffer…"

And suffer they already have, not only with the legislation capping the exchange rate on currency mortgages provided to Hungarian households (putting them in a difficult situation) we mentioned above but, also in relation to Goodwill impairments (which we discussed in our conversation "Goodwill Hunting Redux").
As a reminder:
"Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October."
"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report in November (8.7 billion-euro impairment charge)".

It wasn't therefore a big surprise to us and our good credit friend to see a decline of 37% of UniCredit shares in three days following its 7.5 billion right issues priced with a 43% discount (selling shares for 1.943 euros each...).

Back in November in our Goodwill conversation we made the following warning:
"Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."

Given we already know that UniCredit made 60 billion USD worth of acquisition between 2005 and 2008, tracking goodwill impairments will indeed be a necessary exercise in 2012 as they can take a real chunk out of bank earnings in the process.

In relation to current bank exposure to Hungary, Deutsche Bank in their latest Hungarian sovereign risk review published on the 6th of December indicated the following:
"During the past days the Hungarian sovereign risk exposure has increased
significantly, taking the development of CDS prices as an indicator. Austrian banks have material exposure to Hungary, both via sovereign bonds and through loans. Erste Group has a total of EUR11bn in assets invested in Hungary (some EUR8bn in loans, some EUR3bn in sovereign exposure) while Raiffeisen Bank International has a total of EUR8bn in Hungarian assets (some EUR6bn in loans, some EUR2bn in sovereign exposure.
According to latest EBA data, as of 30 Sept 2011 the largest European banks have a total sovereign exposure of EUR31bn vis-a-vis Hungary. The data indicates the largest absolute exposures (combined net trading and banking book) are held by KBC with EUR6.9bn (of which EUR2.6bn was due within 3 months, so might have left the balance sheet by now), OTP with EUR4.2bn, Erste Group with EUR3.3bn, BayernLB with EUR2.2bn, Commerzbank with EUR2.0bn, Intesa with EUR1.7bn, ING with EUR1.7bn, RBI with EUR1.6bn. In some cases the maturity profile in the EBA spreadsheet was biased to short-term exposures, in some cases biased towards long-term exposures.
In relation to current market cap, high ratios result for KBC (c.220%), Erste Group (c.70%), RBI (c.40%) and Commerzbank (c.30%). A haircut on Hungarian sovereign exposure therefore would have meaningful implications for these institutions."

Continuing on the same Hungarian theme in Deutsche Bank EMEA Daily Compass published on the 6th of December, we have to agree with their assessment of the situation for Hungary:
"The failure of yesterday’s a12M bill auction has ignited fears that the situation in Hungary may spiral into a solvency crisis triggered by an inability to roll-over upcoming LOCAL debt maturities.
From a medium term perspective, a useful rule of thumb for assessing debt sustainability is to compare the marginal real yield required to roll-over the existing stock of debt and the real growth rate of the economy Over the past 10 years, real growth has averaged 2.4% y/y while yearly inflation stood on average at 5.9%, which suggests that at the current blended (local and external) marginal rate of refinancing (10.5%), a consistent fiscal primary surplus of 2.2% would be required to maintain current public debt levels stable. It is clear to us that such a theoretical outcome is not credible for the market, i.e. paradoxically yields have reached a level that is too high to motivate buyers to participate in the financing of an issuer that is running an unsustainable debt position."

Deutsche Bank to conclude their note making the following point:
"As a conclusion, we expect events to unfold rather quickly in Hungary. It may come down to a choice between a partial loss of sovereignty in economic management or of a debt restructuring, to be made at the highest political level."

And has clearly indicated by Bloomberg's Chart of the day of the 4th of January, we have seen this movie before...
"Hungary’s failure to secure an international bailout has pushed the cost of insuring its debt against default above that of Ireland for the first time since September 2010.
The CHART OF THE DAY shows that credit-default swaps on Hungary rose to 720 basis points in London on the 3rd of January, compared with 709 for Ireland, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Hungary’s default swaps surged to the highest on record on the third of January and the forint weakened to an all-time low versus the euro after Citigroup Inc. said an International Monetary Fund deal is unlikely in the next six months and European Commission spokesman Olivier Bailly said the European Union has no plans to resume aid talks."

"When there's uncertainty they always think there's another shoe to fall. There is no other shoe to fall."
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

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