Saturday, 28 April 2012

Markets - Credit - Mutiny on the Euro Bounty

"The ship of democracy, which has weathered all storms, may sink through the mutiny of those on board."
Grover Cleveland - 22nd and 24th President of the United States.

Recently in one of our usual credit rambling "Plain sailing until a White Squall", we ventured towards sailing analogies. Looking at the recent developments aboard our European ship, while the weather has clearly been slightly less accommodative in recent weeks with deterioration of economic indicators (Spanish unemployment reaching 24.4%, France unemployment highest since September 1999, Economic sentiment indicator tumbling to 92.8 from 94.5 in March, etc.), we thought our reference to the mutiny which occurred on the Bounty, would be very appropriate in the current context.
The mutiny on the Bounty was a mutiny that occurred aboard the British Royal Navy ship HMS Bounty on 28 April 1789. The mutiny was led by Fletcher Christian against the commanding officer, William Bligh. According to most accounts, the sailors were attracted to the "idyllic life" on the Pacific island of Tahiti and repelled by the harsh treatment from their captain.
As well as Fletcher Christian and part of the crew, our European "sailors" (politicians) were attracted to the "idyllic" initial cheap funding environment provided by a single currency umbrella. The recent austerity "harsh treatments" measures imposed by the captain of the ship (European Commission) which we reviewed in our recent conversation ("The Charge of the Light Euro Brigade") seems to be clearly pushing some of the members of the crew towards mutiny. This explains somewhat, why the European ship is attempting to change tack, moving towards growth, and like our good credit friend put it:
"The word “Growth” will be added to the title of the existing Fiscal Compact. It will make a lot of European politicians happy !
Please celebrate the new name of the "Plan": The Fiscal and Growth Compact!
To paraphrase the famous: “The King is dead ! Long live the King !”...The Austerity is dead ! Long live the Austerity !”

In addition to the rebellion of various crew members aboard our European ship, although the captain is trying to change tack towards growth (with good intent, but growth, like wind speed, cannot be decided solely by political intent...), the Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on, according to their respective CEOs, Alfredo Saenz and Angel Cano according to Spanish newspaper El Confidencial. This is the direct result of the Greek fallout and the disappearance of "Risk-free" ("The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" - Macronomics, September 2011) or political free lunch (we could not resist the irony). The European Banking Association has directed its members to establish a maximum of allocation of capital specifically towards public debt, therefore imposing limits and guidelines. As a reminder, banks are required by the EBA to reach a 9% level of Core Tier 1 Capital by June 2012. Unintended consequences, once more...
Back in our September conversation, we quoted Dr Jochen Felsenheimer from asset management company "assénagon", we would like to quote him again looking at the current context:
 "Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."

So, one has to wonder whether the mutiny aboard our European Ship will lead to our European politicians "sailors" taking control of the ship, sailing away from austerity and conserve popular support, or will  our European banking "sailors" backed by the ECB (courtesy of LTRO 1 and 2) will take control of the ship.
Before we go through our usual quick credit overview and focus on the Spanish banking situation in addition to interesting bond tenders this time in the Spanish RMBS space, here is a final rambling of ours relating to the "Mutiny on the Bounty". The name of the ship sent on the 7th of November 1790 to search for the Bounty and the mutineers was HMS Pandora, under the command of Captain Edward Edwards. Ironically, the fourteen, mutineers and loyal crew alike captured were imprisoned in a makeshift cell on Pandora's deck, which they derisively called "Pandora's Box". Pandora was wrecked on the Great Barrier Reef on 29 August 1791 during the journey home from the South Pacific.  Four mutineers and 31 of Pandora's crew died in the wreck and Captain Edward Edwards was court-martialed on 17 September 1792 for the loss of the ship, but that's another story...(or is it really?). Time for an unfortunate, but necessary (we think) long conversation.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
Spanish 10-year yields briefly topped 6 percent again early on Friday after Standard and Poor's ratings firm late on Thursday cut the country's credit rating to BBB+ (Investment Grade still) on concern about the government's exposure to its ailing banks, ending below 6% at around 5.89% for Spain. Meanwhile Italy sold 5.95 billion euros worth of bonds at higher interest rates than at last month's auction. The yield on the 10-year notes offered at the auction rose to 5.84% from the 5.24% coupon generated in the March 29th auction. Investors bid for 1.48 times the amount offered, down from 1.65 times in March. The Italian Treasury sold as well 2.42 billion euro worth of five-year bonds, with the yield rising to 4.86% from 4.18% compared to a month ago.

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 25 bps (35 bps in our previous post) above Italy, with both countries widening in synch - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields well entrenched below 2% yield (near the lows of 2011) - source Bloomberg:

Many pundits have recently asked if "Europe was turning Japanese", of course it is. It's D,  D for deflation. German 2 year notes versus Japan 2 year notes - source Bloomberg:
We agree on the Japanese outlook but differ on the reasons they put forward in their conclusion relating to the current strength of the Euro versus the dollar (Sorry George).
We believe the Euro is strong for two reasons, first being swap lines between the FED and the ECB, second being the FOMC decision to delay its interest rate decision until 2014 effectively putting a floor to the Euro. At the beginning of the year many strategists were forecasting a weaker Euro, since the FOMC decision on the 25th of January, it has not happened. In our conversation "The law of unintended consequences" - Macronomics 25th of January 2012, we had already referred to Martin Sibileau's analysis:
Why would we see the Euro flirting with a $1.33 level?
"That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.

There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance."  - Martin Sibileau

Europe's horrible circularity case - Martin Sibileau

By tying itself to Europe via swap lines, the FED has increased its credit risk and exposure to Europe:
"If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU." - Martin Sibileau

More downgrades mean more margin calls, more margin calls means more liquidation and more Euros being bought and dollars being sold, with a growing shortage of AAA assets, Europe is moving towards mutiny on the Euro Bounty ship...
"Europe’s economy is faltering as spending cuts across the region undermine hiring and consumer confidence. Investors have favored German government bonds amid rising fiscal tension in Italy and Spain and the resignation of Dutch Prime Minister Mark Rutte this week after failing to garner support for proposed spending cuts." - source Bloomberg. German 2-Year to U.S. Bill Rate: Chart of the Day:
"The CHART OF THE DAY shows the yield on the German note declined on the 26th of April, touching a record 0.089 percent, while the rate on the three-month U.S. Treasury bill was unchanged at 0.0864 percent. The German note yield is down from a 2012 high of 0.357 percent on March 16, and a five-year average of 1.93 percent. The three-month U.S. bill rate rose to a 2012 high of 0.117 percent on Feb. 14, after touching zero on Jan. 10." - source Bloomberg.

Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO  Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid.”
We discussed Spanish issues at length in our conversation "Spanish Denial".
It looks to us, that Alfredo Saenz is, like many, in denial, as a reminder:
"Denial (also called abnegation) is a defense mechanism postulated by Sigmund Freud, in which a person is faced with a fact that is too uncomfortable to accept and rejects it instead, insisting that it is not true despite what may be overwhelming evidence. The subject may use:
-simple denial: deny the reality of the unpleasant fact altogether
-minimisation: admit the fact but deny its seriousness (a combination of denial and rationalization)
-projection: admit both the fact and seriousness but deny responsibility.
The concept of denial is particularly important to the study of addiction." - source Wikipedia
No offense taken, we have heard similar denials before:
"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.

Time for some facts and "inconvenient truths, as CreditSights put it in their recent report on Spanish banks - We Need to Talk About Real Estate:
"BBVA and Santander reported 1Q12 ROEs that look resilient in the current context, but they are likely to be as good as it gets this year, with the impact of the new real estate provisioning rules postponed into the remaining nine months of the year, and other nonperforming loans still rising."
ROE respectively at 10% for BBVA and 8% for Santander.

Spanish banks actual total return on CDS since the 13th of February: Bankia's CDS was -7.85% (Bankia was formed on December 3, 2010 as a result of the "union" of seven Spanish financial institutions and has been recently facing additional pressure by the Spanish government for another merger...), compared with a negative return of -1.35% on the benchmark, iTraxx Senior Financials. BBVA and Santander are meaningful underperformers, with negative returns of -5.29% and -5.13% respectively over the same period.

The Royal Decree Law enacted in February 2012 established the provisioning needed for the Spanish banking sector at 35 billion euros with another 15 billion of real estate coverage coming in the form of a separate capital buffer to be completed by December 2012. Banks going through an integration process, which expands their balance sheet by at least 20%, can get an extension until June 2013 at the latest but, according to CreditSights, doesn't apply to the major banks such as BBVA, Santander.
And, when it comes to provisioning, as CreditSights put it frankly in their report, the job has not really been done meaningfully:
"In pre-tax terms, BBVA and Santander need to provide around €2.3 bln each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA), postponing the impact to the next three quarters of this year. This contrasts with CaixaBank, which met its 2012 RDL requirement of €2.4 bln in the first quarter, through the combination of a €1.8 bln release of generic provisions and a €601 mln impairment charge through the income statement. BBVA has said that it expects to spread the remaining impairments about evenly through the next three quarters, for a post-tax impact of approximately €500 mln per quarter. Santander is likely to take more than a third of its RDL charge in the second quarter, when it will get the offsetting benefit of around €900 mln capital gains on the sale of a minority stake in its Colombian unit."

Relating to real estate outstanding exposure for BBVA and Santander and transparency, CreditSights added:
"Neither of the major international banks splits out how much of its total 1Q12 impairments are against real estate (either developers or mortgages), and this lack of disclosure about the P and L impact of real estate is frustrating, even if better breakdowns are provided for the balance sheet, in terms of outstanding exposures and accumulated reserve coverage."

Sovereign exposure for Santander and BBVA according to CreditSights:
Santander - "Santander revealed that it had taken €35 bln across both LTROs in Spain, but said that all of this and more remains at the ECB, where it has deposits totalling €37 bln. Nevertheless it did increase its exposure to the Spanish sovereign somewhat, mentioning a €6-7 bln increase during the quarter to €35 bln within the asset/liability management portfolio, which is accounted for as Available-for-Sale."
BBVA - "BBVA said that it took €11 bln in the December LTRO, and then a similar amount again in February, for a total in the region of €22 bln. About two-thirds of this has been allocated to repay other short-term collateralised funding and meet upcoming maturities of covered bonds and other debt. Of the remaining third, about half has been left on deposit at the ECB, and the other half has been invested in the asset/liability management portfolio. However, exposure to the Spanish sovereign has not been increased, and new investments for the portfolio have been concentrated in instruments issued by core eurozone sovereigns or supranationals, plus non-Spanish covered bonds and senior bank paper. BBVA says that it now has €53 bln in Spanish sovereign exposure (both debt and loans)."

There is increased speculation about the creation of a "bad bank" to manage the real estate and other problems plaguing Spanish banks balance sheets. We have indeed, seen this movie before in Ireland as indicated by JP Morgan's recent note "Chronicle of a Banking Crisis Foretold", published on the 26th of April:
"While concerns with the Spanish banking sector have focused mainly on real estate developer exposures, we think that residential mortgage portfolios are potentially the next leg downward in a prolonged banking  crisis where sector solvency remains at risk. Despite the relatively resilient performance of residential mortgage portfolios to date, which can be rationalized by specific factors such as social security support, lender forbearance and mortgage affordability, we think that the readacross from the developments in the Irish mortgage market highlight the scope for a material worsening as unemployment levels increase. In a scenario where the PD (Probability of Default) and LGD (Loss Given Default) in Spain approach those currently witnessed in Ireland, we would expect net post provisioning losses of €59bn for sector mortgage portfolios."

As our good credit friend put it:
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

The ticking bomb of unemployment benefits exhaustion:
"In our mind, the social security net that operates in Spain has therefore done much to initially shield mortgage portfolios from having to recognise significantly deteriorating performance owing to the increase in unemployment. However, owing to the fact that these relatively generous welfare benefits are time-limited, the system has likely provided a postponement in mortgage portfolio performance deterioration rather than a solution to the underlying problem." - JP Morgan

JP Morgan is wondering in their note if Ireland could be used as a proxy for the real estate Spanish woes:
"Ireland: Predictive Paddy Power?
Having attempted to rationalise the behaviour of mortgage NPLs, it is important to determine where these indicators can go to from here and the impact that this can have on sector solvency. In our opinion, the risk posed by the residential mortgage portfolios is of a non-trivial nature given this asset class represents circa 37% of the total loan portfolios for Spanish financial institutions."

For JP Morgan analysts, moving from a Spanish to an Irish scenario could cost the system an extra 55 billion euros. Consolidation of the banking system has been so far the approach to resolving the issues by the regulators in Spain:
"Spanish banks will be given 12 months to comply with the new provisioning requirements, unless they are involved in further sector consolidation in which case they would be allowed 24 months to comply. In our opinion, this is indicative that domestic Spanish policymakers are still adopting the same strategy since the outset of the banking crisis, which is basically using consolidation as a means of improving the robustness of the sector, a strategy which to date has yielded limited results in our opinion." - JP Morgan

JP Morgan also estimates there is material further downside risk in relation to the "Non-Problematic" Real Estate Developer Loans which could potentially lead according to their analysts to an additional losses/provisioning requirements of 68 billion euro against the current non problematic real estate developer portfolio in the event that this would experience significant asset quality issues:
"Downside Risk in the ‘Non-Problematic’ Real Estate Developer Loans:
While the thrust of the provisioning reforms have focused on the problematic real estate developer exposure, which totals €175bn, there has been less attention paid to the real estate developer loans, which are currently deemed performing (€148bn), with only a 7% general provision being required. We think that given the rate of attrition, both in terms of non-performing loans and asset deflation pressures, it would be particularly heroic to assume that a 7% general provision would be sufficient to cover eventual losses for this segment of the loan portfolio. We would have to make the assumption that potentially a material proportion of these assets may already be subject to significant asset quality issues and where the actual losses may require a similar level of coverage as proposed for the problematic assets. As a result, if we contrast the required 7% provisioning rate for the performing real estate developer loans versus the 53% provisioning rate expected by the Bank of Spain for the currently problematic real estate developer exposures, then this would require an additional provisioning requirement of 46%. This would imply that the Spanish banks would require additional provisioning for losses of €68bn in a worst case scenario that the entire real estate developer lending portfolio had to experience asset quality issues."

Spanish Corporate Loan Portfolio Profile - source JP Morgan - Bank of Spain:

Spanish Corporate Loan Portfolio NPLs evolution - source JP Morgan - Bank of Spain:

"While the scale of the NPLs in the real estate developer and construction portfolio have experienced a rapid initial acceleration, mainly as a result of these sectors being at the heart of the crisis, we would expect that with a broadening of economic pressures to other corporate sectors that the level of delinquencies should invariably increase as well. We do not think that the new provisioning regime makes any allowance for this, which is in our opinion a significant weakness given that this would represent a significant part of the overall loan portfolio." - JP Morgan

Interestingly enough, while consolidation is being underway and encouraged by Spanish authorities, this week two bond tenders caught our attention, this time in the Spanish RMBS space, from Banco de Sabadell for an aggregate principal outstanding post amortisation amount of around 1,270 million euro and Banco CAM for 5,693 million euro. The decline in prices for these securities would have been steeper if not for the tender offers...

On a final note, following the rating downgrade of Spain by two notches by Standard and Poor's, Spanish Financial CDS widened on Friday given rating downgrades for these institutions will undoubtedly follow, as indicated by CDS data provider CMA:
[Graph Name]

"Am I a fool? I don't think I'm a fool. But I think I sure was fooled.
Kenneth Lay - CEO and chairman of Enron from 1985 until his resignation on January 23, 2002.

Stay tuned!

Tuesday, 24 April 2012

Markets - Credit - The Charge of the Light Euro Brigade

Lord Cardigan: [returning from the charge] "Has anybody seen my regiment?"
The Charge of the Light Brigade - 1968 movie inspired from the real historical events.

Staying on the theme of military blunders, we thought this time around we would venture towards the infamous Charge of the Light Brigade, a charge of the British cavalry led by Lord Cardigan against Russian forces during the Battle of Balaclava on 25 October 1854 in the Crimean War. The charge was the result of a miscommunication in such a way that the brigade attempted a much more difficult objective than intended by the overall commander Lord Raglan.  The charge was aimed at the wrong target leading to the near annihilation of the Light Brigade. Previously we discussed in our conversation "A Deficit Target Too Far" how overly ambitious were the budget deficits targets set up by European leaders.
Looking at the lackluster European PMI figures recently released, we thought this title would therefore be more than an appropriate analogy. While the historical charge produced no decisive gains and resulted in very high casualties, the austerity measures imposed to the peripheral countries are pushing them towards a deflationary spiral, with high economic casualties in the process and rising unemployment.

The divergence between US and European PMI indexes has been increasing to the widest difference since 2008 - source Bloomberg:

This divergence can as well be seen in the perception of credit risk for Investment Grade. There is a growing divergence between the CDX IG 5 year CDS index and the European Itraxx Main Europe CDS 5 year index (125 Investment Grade entities), reaching a spread difference of 48 bps and steadily rising towards the highest point reached of 64 bps in September 2011:
This difference in investment grade credit is as well significant between core European countries and Peripheral countries, reflecting the correlation with Sovereign risk.

As indicated by Jonathan Tyce from Bloomberg:
"Pressure to deliver on austerity measures increased as the Eurogroup and IMF boosted war chests. While the euro zone budget deficit fell to 4.1% (from 6.2%) in 2011 as austerity measures took hold, gearing is rising, with debt-to-GDP two points higher at 87.2%. Should sovereign fears overwhelm, gearing concerns may outweigh the benefits of austerity."
Austerity measures announced - "The Charge of the Light Euro Brigade"- source Bloomberg:
When it comes to Spanish bad debts at 18 years high, it is still tracking unemployment - Source Bloomberg:
"Spanish banking system bad debt reached an eighteen-year high in February with doubtful loans now exceeding 140 billion euros. ECB data show total capital and reserves of Spanish monetary financial institutions at 380 billion euros in February, 100 billion higher yoy. As bad debt rises, concerns will increase that a larger capital cushion will be required." - source Bloomberg.

CreditSights in their recent Euro Financial Movers report from the 22nd of April indicated the following in relation to Spanish Banks:
"Spanish banks are increasingly coming under the microscope. NPLs are rising, sovereign risk indicators are deteriorating again, and CaixaBank's 1Q12 results were hit hard by real estate provisions.
One way or another, Spain was the driver of news in the European banking sector last week as concerns over the country's finances intensified. New data from the Bank of Spain on doubtful loans statistics showed that non performing loans for the banking system rose to 9.2% in February, more than doubling on a yearly basis, another indicator of how fragile the system is. Meanwhile, latest statistics showed that Spanish banks increased their holdings of Spanish government bonds by €41 bln between the end of November 2011 and the end of January 2012, on the back of the 3-year LTRO. This increase in government bonds holdings by domestic banks in both Spain and Italy coincided with a dramatic decline in the foreign holdings of those two countries' government bonds. BBVA (-2%) had gross sovereign exposure to Spain of €56.5 bln at end-2011, of which around half was direct exposure to local authorities and half was in sovereign bonds. However, despite the latest ECB data, the bank tells us there is unlikely to be a huge change in this figure when it reports its 1Q12 results on 25 April (see below). In its FY11 conference call, Santander (-2%) disclosed that it had a net sovereign exposure to Spain of around €25-€30 bln, later confirmed to be towards the lower end of this range."

The current European bond picture with the recent rise in Spanish and Italian yields  - source Bloomberg:

The pain in Spain - Spain 5 year Sovereign CDS versus Italy's 5 year sovereign CDS falling to 35 bps above Italy, with both countries widening in synch for now - source Bloomberg:

In another recent note, CreditSights made the following key points relating to the ongoing recycling process of ECB reserves in Italy and Spain:
"-The ECB’s provisions of liquidity to Italian and Spanish banks has partly been used by those banks to increase their holdings of domestic government bonds
-Spanish and Italian banks have increased their holdings by 41 billion euro and 19 billion euro between the end of November and the end of January following the first three year LTRO. That increase in holdings by domestic banks has coincided with a dramatic decline in foreign holdings of those two countries’ government bonds. The result is an increase in concentration of government bond holdings within those two countries banks.
-The repayment of a government bond sees the holders receiving deposits with their domestic central bank as a payment; i.e central bank reserve. Given that Italian and Spanish banks have so far proved willing to buy government bonds with any excess reserves, then if they are increasingly the holder of those bonds then they may continue to be willing to recycle any reserves they receive back into government bonds.
-That means that funding the interest-expense component of the budget deficit and refinancing any maturities may have been made easier as a result of an increasing proportion of government bonds now being held by domestic banks.
-And given that Italy’s budget deficit is entirely the product of needing to fund the government interest expense, that concentration of risk may favour Italy versus Spain which has a substantial primary budget deficit to fund."
We agree with CreditSights, namely that from a pure budget deficit point of view, Italy appears to us in a more favorable situation than Spain, validating therefore our more negative stance on the latter.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is still pointing towards the lowest level reached in 2011- source Bloomberg:
We previously saw a spike in Germany's sovereign CDS back on the 29th of November 2011 ("The Eye of The storm"), prior to the German "failed" auction which lead to a significant widening of the German Bund yield above 2.30%, when Germany's sovereign 5 year CDS went above the 100 bps level.

Moving back to the "Charge of the Light Euro Brigade" towards austerity, as recession and the debt crisis worsen, according to Citigroup and as reported by Bloomberg article from Lorenzo Totaro from the 19th of April, peripheral countries face additional downgrades, in this deflationary spiral:
"Spain and Italy will be downgraded by Moody’s Investors Service and Standard and Poor’s this year as the recession and debt crisis worsen, economists and strategists at Citigroup Inc. said.
Their credit ratings, along with those of Ireland and Portugal, will be lowered at least one level over the next two to three quarters, Citigroup said in a report published late yesterday. “Deficits will overshoot official forecasts in all the peripheral Economic Monetary Union countries this year and in 2013,” according to the report.
“Spain will need to enter some form of a Troika program” this year, Citigroup economists including London-based Juergen Michels wrote, referring to the aid package for Greece monitored by the European Union, the European Central Bank and the International Monetary Fund. Prime Minister Mariano Rajoy has repeatedly said that Spain won’t need a bailout."
Indeed, as we argued recently in our conversation "A Deficit Target Too Far", similar to Operation Market Garden of September 1944 as per our rambling, the targets are undoubtedly overly ambitious.

In relation to potential rating dowgrades, both Italy and Spain were put on negative watch on February 13, when Moody's downgraded six European countries (Italy from A3 to A2 and Spain to A3 from A1). Moody's move closely followed Standard and Poor's ratings cut for 9 European countries.

From the same article, Citigroup is expecting the following in relation to ratings action:
"By year-end, Italy may be downgraded one level to BBB by S and P and to Baa1 by Moody’s, as the economy probably shrinks more than the government’s forecasted contraction of 1.2 percent for 2012, the Citigroup analysts said. “The falling public support for Monti in opinion polls suggests that the government will have increasing difficulties in going ahead with the implementation of structural reforms,” according to the report. Over the next two to three years, “we expect Italy’s rating by S and P to go down by two notches in total and to settle at BBB- and its Moody’s rating to go down by three notches to settle at Baa3.”

While Lord Cardigan's nearly annihilated Light Brigade (following their fateful charge of Russian artillery guns) were rescued by the French light cavalry, the Chasseurs d'Afrique (they cleared the Fedyukhin Heights to ensure the Light Brigade would not be hit by fire from that flank and later provided cover for the remaining elements), despite the headlines of a USD 430 billion additional funding for the IMF, as Nomura put it in their  recent report (EM to the rescue? Not quite yet), the additional resources available upfront will likely be smaller meaning no meaningful cavalry to rescue our Light Euro Brigade:
"However, of the USD434.3bn committed we think only some USD95.3bn is what one might call ‘real’ and new contributions from non-eurozone countries that are available up front. They include Japan (which is recommitting USD50bn that was already available to the IMF, but was due to be returned, and an additional, new USD10bn). USD200bn is then ‘recycled’ eurozone commitments that cannot be made available to the EFSF or ESM, but which member states are happy to commit to the IMF. This brings the total new funds available to USD295.3bn.
Some Asian countries have promised money (such as Indonesia, Malaysia and Thailand), but they are consulting locally and the amount may only total around USD20bn between them. The Czech Republic has also committed USD2.0bn, but is awaiting a guarantee agreement between its central bank and the government for any potential losses.
On top of this is an additional USD72.0bn from the BRICS. However, this money is dependent on progress on quota reform at the June G20 meeting. There has been no indication of the different contributions between the countries for this amount. As such, as with previous meetings of the BRICS or G20, up-front commitment is still unclear. Similarly, USD15.0bn from the UK that will be subject to IMF quota reforms is being ratified."

And Nomura to conclude their note:
"So, overall the view six months ago that EMs could save the day has hardly come to fruition yet, with difficult progression on quotas required and very few committing money up front. Other developed countries remain dominant in size and number.
In our view, EMs will want to ensure that the IMF retains its original mandate of helping sovereign countries with balance of payments problems by pushing for meaningful reforms through conditionality. There is already much concern in the IMF about the distraction of the eurozone from the plight of many EMs globally. The recent World Economic Outlook and its fiscal and financial cousins highlighted the issues for many of the EMs (in particular deleveraging) so the risks are well known. EMs also remain divided overall on global monetary system reforms and on pushing a joint front on IFIs as demonstrated by the leadership ‘contest’ for the new World Bank President. Unlike with the IMF leadership succession, there was a very credible candidate available for the World Bank in Ngozi Okonjo-Iweala, yet the BRICS failed to join together to support her. Perhaps on IMF funding issues it is easier for the current stance by EMs as the US has not already contributed. That may mean that any progress in EMs providing backstop facilities to the eurozone will remain slow at best, and fail to materialise at worst."
Oh dear...

On a final note, in relation to the results from the first round of the presidential election in France, we were not surprise by the score of Marine Le Pen's National Front. It was not a Black Swan. It was indeed well expected. Economic crisis lead to rise in populism throughout history.
France’s Lead in Asylum Seekers Boosts Le Pen: Chart of the Day - source Bloomberg:
"The CHART OF THE DAY shows that under President Nicolas Sarkozy, France received 6.1 applicants for every $1 of gross domestic product per capita. The U.S. placed second with 5.9, followed by Germany at 4.4, Turkey at 4.1 and the U.K. at 4, according to data from the Office of the United Nations High Commissioner for Refugees." - source Bloomberg

In July 2010 in our conversation - "I promise to pay the bearer on demand...- Panics and Populism", we argued the following:
"Populism movements are deeply correlated to Panics and Depression throughout human history.
The emergence of the Tea Party movement in the US in 2009 is reminiscent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war. The Greenback Party was born because of the Great Depression of 1873."
We would add that the same process of rise in populist movements and extremism happened in Europe in the 1930s.

We also argued:
"The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.
The panic of 1873 was followed by a similar panic in 1893 in the US.
Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.
The market overbuilding and the real estate bubble led to the financial crisis of 2007 which started with subprime."

"Those who cannot remember the past are condemned to repeat it."
George Santayana (16 December 1863 – 26 September 1952)

Stay Tuned!

Saturday, 21 April 2012

The European Clunker - European car sales, a clear indicator of deflation

Clunker definition: "A thing that is totally unsuccessful."

1. A decrepit machine, especially an old car; a rattletrap.
2. A failure; a flop.

While we recently we focused on Shipping as a leading deflationary indicator, we thought this time around we would focus our attention on European car sales. We will look at the impact various "cash for clunkers" plans in Europe have had on European car sales and their recent evolution, pointing towards more evidence of a serious bout of deflation in the European space. In addition to reviewing the evolution of car sales in various European countries, it is important, we think, to look at the age segmentation of the European car markets by countries and demographic trends as well.

We will start by the recent evolution of European Car Sales in various European countries.

PASSENGER CARS: registrations down 7.7% in first quarter 2012- source ACEA
Brussels, 17/04/2012 - "In March, demand for new cars in the EU* was negative for the sixth consecutive month, with a decline of 7.0% compared to March last year. While retaining their importance in terms of volumes (1,453,407 new cars), March registrations have not been at this level since 1998. Over the first quarter, the EU market shrank by 7.7%, compared to the same period a year ago, with a total of 3,312,657 new registrations.
Results in March were diverse across the EU* as Italy (-26.7%), France (-23.2%) and Spain (-4.5%) saw their markets contract whereas the UK (+1.8%) and Germany (+3.4%) performed better than they did in the same month a year earlier."

Whereas the drop in car sales were much more severe in Portugal and Greece, respectively by: -49.2%) and -42.6%.
Meanwhile, in Iceland, car sales were up by + 101.1 % March. Re-Iceland, we rest our case...(Iceland - The Great Debt Escape).
For the complete breakdown, by countries for March please check:
Car Sales Statistics.

Evolution of Car sales in Spain from 1995 onwards - source Bloomberg/OECD:
Falling of the proverbial cliff back to...1995 levels.

Evolution of Car sales in Italy from 1995 onwards - source Bloomberg/OECD:
Below 1995 levels...

Evolution of Car sales in Portugal from 1995 onwards - source Bloomberg/OECD:

Evolution of Car sales in Ireland from 1995 onwards - source Bloomberg/OECD:
Again back to 1995 levels...

Evolution of Car sales in Greece, we could only go back to 1999 onwards - source Bloomberg/OECD:
A bottomless pit?

We previously mentioned the uptick in car sales in Iceland for March (+101%).
Evolution of Car sales in Iceland from 1995 onwards - source Bloomberg/OECD:
Again back to 1995 levels but you can clearly notice the upward trend in car sales from the abysmal bottom reached early 2009 at 110K but, still a long way to go to move back to the average of 1136K from 1995 to 2012.

Evolution of Car sales in France from 1995 onwards - source Bloomberg/OECD:
The noticeable spike in car sales in the 2009 and 2010 period in France but as well noticeable in additional countries can be attributed to the various "cash for clunkers" programs implemented in various countries:
Austria, Cyprus, France, Germany, Italy, Luxembourg, Portugal, Romania, Slovakia, Spain.
The summary of the various "cash for clunkers" programs by countries can be found here:
Cash for Clunkers, Here and There - Bill Chameides, April 24th 2009.

In relation to France, the former French minister of Economic Affairs, Christine Lagarde, announced in September 2009 that the country's cash-for-clunkers scheme, called "prime à la casse", would be extended for two additional years at the time. The initial plan was to end the program by the end of 2009, but the government believed at the time that the car market would likely crash if the stimulus Euros were withdrawn. Of course it would have crashed; it was only delaying the inevitable. Particularly because of the "sensitivity" of French car manufacturers to European car sales in peripheral countries.
Renault and PSA Peugeot Citroën car sales have dropped by 20% in the first quarter, whereas GM, Ford and Toyota Europe dropped by respectively 10%, 7.6% and 2.1% on the same period.

Therefore it isn't really a surprise, looking at the performance of the Peugeot stock price, to see the share back to 1991 levels... - source Bloomberg:

On a Credit level, Moody's downgraded Peugeot's credit rating to junk status with a negative outlook, citing "severe deterioration" of its finances, General Motors recently bought more than 335 million dollars worth of shares of PSA Peugeot Citroen giving them a 7% stake in the French company. 10 years ago, GM did a similar deal with FIAT which eventually cost GM 2 billion dollars to get out of the tie up but that's another story...

Moving back to our "European clunker" story, it is important to look at the age segmentation of the European car markets by countries as a follow up on European car sales. Every year French consumer credit company CETELEM publishes a report relating to the trends in driving habits of youths. While the 2012 is not yet available, the 2011 makes some very interesting points:
"Beyond the economic context, the list of facts and societal trends limiting the potential growth of the automobile trade is long. A sluggish demography in conjunction with a saturation of car rates ownership condemn the expansion of the car market. Economic growth will limit the speed of the renewal of European car parks and therefore car sales. Also, in this already unfavourable context for the automotive industry, car usage continues to decline in European countries. The number of kilometers traveled each year has been steadily declining over the last ten years."

Evolution of average kilometers per year since 2000 in selected European countries, (index basis 100 in 2000) - source BIPE, Enerdata, Insee:

Clearly the high level of youth unemployment in Europe is a BIG negative for the European car industry given, on average, according to CETELEM, the average age of a buyer of a "new car" is...50 years old.
Average age of a buyer of a new car in Europe in 2009 by countries - source BIPE
51.5 years on average in France...
According to CETELEM, 29% of buyers of a new car in Europe had more than 60 years old in 2009 whereas 11% were below 30 years old. The secondary market is the main source for youths to access the car market in Europe.

Here is the structure of the European market in 2009 per age brackets - source BIPE:

More interestingly in the CETELEM market survey, in countries such as Spain and Italy, the proportion of buyers of new cars below 30 years of age has been higher than in France or Germany in percentage terms - source BIPE:

CETELEM indicating in their report that 63% of below 30 years old by second hand cars, 18% more than above 50 years old. It is in Spain that young Spanish have displayed the biggest attraction to "new cars". Two thirds of young Spanish have indicated in their 2009 survey they had purchased a new car, followed closely by young Italians and Belgians.

With unemployment in Spain closing on 25% and youth unemployment above 50% in 2012, new car sales will undoubtedly fall even more in the near future...
The car market in Europe is saturated. In the US you can find 800 light vehicles for 1000 inhabitants whereas in Europe it is below 700 in the eight countries studied by CETELEM according to their report. The European market will never reach the American level. The European car market is not only saturated but matured, hence the growing reliance of car manufacturers on emerging markets. In addition to this, the rising prices in gas prices, is weighting even more on the industry as a whole.

Add to the mix demographic trends in Europe, the future for the European car market is bleak to say the least:
Part of below 30 years old of age in the total population by European countries in percentage terms - source BIPE-Eurostat:
Youths in Europe are in the front line in relation to repaying the massive debt accumulated by the previous generation as well as maintaining the pension system. We have indeed an interesting toxic cocktail mix, which not only doesn't bode well for the car industry (with a saturated market), but doesn't bode well either for the "relations" between generations and trigger a "generational conflict" with the increasing worrying trend in youth unemployment. The evolution of the economic situation in Europe, could well lead to a European "Fall", in the footsteps of the Arab "Spring"...we might be rambling again...

"Events are called inevitable only after they have occurred."
Mason Cooley

Stay tuned!

Wednesday, 18 April 2012

Markets - Credit - A Deficit Target Too Far

"I think we may be going a bridge too far."
British Lieutenant-General Frederick Browning, deputy commander of the First Allied Airborne Army to Field Marshal Bernard Montgomery

Our title follows up on our previous conversation "All Quiet on the Western Front", where we discussed our BIG reservations relating to the unachievable Spanish deficit target of 3% in 2013. This week's analogy refers to the overly ambitious Operation Market Garden of September 1944 in relation to the overly ambitious deficit targets set up by European leaders for Spain. It wasn't really a surprise to see Italy today following the footsteps of Spain and revising its budget deficit target for 2013 from 0.1% to 0.5%. They have as well revised their 2012 GDP contraction from 0.5% to 1.2% with a GDP growth target of 0.5% for 2013. Oh well...Initially, Operation Market Garden was marginally successful and several bridges between Eindhoven and Nijmegen were captured. However, General Horrocks' XXX Corps ground force's advance was delayed by the demolition of a bridge over the Wilhelmina Canal, as well as an extremely overstretched supply line (ESM and EFSF firepower are overstretched as far as Spain and Italy are concerned)...a bridge too far, and certainly a deficit target too for Spain, but here we go, we ramble again. Before we revisit the overly ambitious plan for Spain, and review France as the new barometer of Euro Risk with the upcoming first round of the presidential elections, it is time for our usual credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Since last the last rebalancing of credit indices on the 20th of March, Itraxx Credit indices have been overall wider, with SOVx Western Europe 5 year CDS index (representing CDS of 15 European countries, with Cyprus replacing Greece since its "selective default") wider by 26%.  Itraxx Crossover 5 year CDS index (High Yield risk gauge - 50 European companies) was wider by 12.5 bps in the early afternoon, 125 bps wider since the roll date of the 20th of March.

Itraxx Crossover has been rising and Eurostoxx Volatility is rising to 23.45 - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is still pointing towards the lowest level reached in 2011, around 1.73% - source Bloomberg:
A game of capital preservation rather than a search for yield for European investors.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
As indicated by CreditSights in their recent note - Eurozone - Recycling ECB Reserves in Italy and Spain on the 17th of April, LTRO 1 and LTRO 2 have enabled Spanish and Italian banks to soak up domestic bonds:
"The ECB’s provisions of liquidity to Italian and Spanish banks have partly been used by those banks to increase their holdings of domestic government bonds.
Spanish and Italian banks have increased their holdings by 41 billion euro and 19 billion euro between the end of November and the end of January following the first three year LTRO. That increase in holdings by domestic banks has coincided with a dramatic decline in foreign holdings of those two countries’ government bonds. The result is an increase in concentration of government bond holdings within those two countries banks."

Given recent developments in revised deficit target objectives for both Italy and Spain, as well as the significant widening in credit spreads (Itraxx Financial Senior index indicating a rise in financial risk) and tightening of "safe haven" German bund, we would advise caution. In fact we have seen this movie before, so clearly "Mind the Gap" - source Bloomberg:

In fact Europe's volatility index V2X is well above VIX index and the divergence between both has been rising - source Bloomberg:

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:
While liquidity conditions have seriously improved since the end of 2011, thanks to the ECB's two rounds of LTRO, the LTRO "alkaloid" effect is somewhat fading hence the renewed tensions seen on the Itraxx Financial Senior Index indicating a deterioration in one of these indicators. According to Nomura in their report "Wilting growth and sovereign and bank pressures" from the 10th of April:
"Other areas of the funding markets are increasingly showing signs of stress, including the EUR-USD cross currency basis swap. This has been compressing across the tenors, primarily due to the Fed swap line, which was put in place in November 2011, but also due to lower volumes going through these markets given the unwind in USD operations by some banks leading to reduced USD funding through these sources. We could see a continuation of this renewed widening as tensions increase in the euro area."

Moving back to the subject of the overly ambitious deficit reduction plan for Spain in true Market Garden style, a recent report published by Exane BNP Paribas strikes a blow to the plan in a less courteous manner than British Lieutenant-General Frederick Browning : "Are deficit targets credible? In short no"

Exane BNP Paribas believes the GDP Growth for Spain will only amount to -1.1% versus an official estimated growth of 2.4% in 2013, leading to a budget deficit of -5.6%  in 2013 versus the overly optimistic objective of -3% discussed in the conclusion of our previous conversation. Clearly "A Deficit Target Too Far".

Exane BNP Paribas in their note convey several reasons for their estimate:
"Collapse in tax receipts puts additional pressure on spending cuts" - Source Exane BNP Paribas - Eurostat:
Regions account for 50% of spending in Spain - Source Exane BNP Paribas - OECD:
"-45% of Regions' spending goes to health and education - tough to cut.
-Regional governments missed targets significantly in 2011; targets for 2012 are too ambitious".
- Exane BNP Paribas

In their note Exane BNP Paribas is going further, public confidence in the government is waning, as indicated by recent polls from Spanish newspaper El Pais:

When austerity bites with high youth unemployment, risks of social stability are mounting, which could potentially lead to a European Autumn in similar fashion to the Arab Spring?

As far as credit flows to the real economy are concerned, the potential problematic loans currently sitting on Spanish banks balance sheet will undoubtedly weight heavily on economic growth in the near term as indicated by the latest rise in Non-performing loans to 8.16 percent in February according to the Bank of Spain, its highest level since 1994.
"Current consensus for 2012 Spanish GDP is for a contraction of 1.2%. As the government attempts to realize 37 billion euros of austerity savings, this figure may well increase unemployment and drive consumer spending lower. Santander's FY11 Spanish NPL ratio was 5.5%, with real estate loans at 28.6%. Lower GDP could drive these figures higher." - source Bloomberg

In fact according to Bloomberg Chart of the Day from the 17th of April, Spanish Mortgage Defaults may double on joblessness:
"The CHART OF THE DAY shows that unemployment was 24.5 percent when the mortgage default rate peaked at 5.5 percent in 1994. Even as the jobless rate rose to 23.6 percent this month, defaults are half as high at 2.7 percent." - source Bloomberg

European Subprime in the making? (we wondered in our last conversation), US Mortgage delinquencies peaked at 11.2% according to Bloomberg, Spain has yet to rise to these levels:
"Banesto, Santander's domestic subsidiary, revealed the percentage of problematic property loans had risen above 50% by 1Q, from 32% 12 months earlier. In February, the Bank of Spain announced 35 billion euros of provisions and 15 billion of capital to clean banks' balance sheets. These measures may be revisited should deterioration continue." - source Bloomberg

On a final note, we previously discussed at length France's "Grand Illusion", and France is clearly moving to center stage.
As indicated by Cheuvreux in their recent Cross Asset Research from the 16th of April:
"Spain is the 2012 epicenter of EZ financial stress. The return of pressures upon the vulnerable compartments of the EZ equity universe has been remarkably rapid even by the standards of the recent past because so many have been waiting for this accident to happen. The French election acts as a further accelerator."
We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. French CDS were driven wider today with apparently some heavy buying of CDS protection from real money accounts and Hedge Funds according to market makers in the French CDS space - source CMA
Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

"Everybody is ambitious. The question is whether he is ambitious to be or ambitious to do."
Jean Monnet - French political economist and diplomat, regarded by many as a chief architect of European Unity.

Stay Tuned!

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