Thursday, 31 May 2012

Risk-Off Correlations - When Opposites attract

"Commodities tend to zig when the equity markets zag."
Jim Rogers

Looking at the recent sell-off in broad asset classes with the spill-off from the ongoing European crisis, we thought it would be interesting to look into asset correlation movements during "Risk-Off" periods such as today. We already touched in 2011 on asset correlation during the sell-off experienced in our conversation "Misery loves company".

More recently in our conversation "St Elmo's fire", we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We argued at the time:
"We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern."
Indeed, both SPX and Oil prices are lower, with Oil dropping another 1.67% toady to 86.35 dollars.

We also indicated that Oil prices were poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss and Son Inc.’s chief executive officer as reported by Bloomberg:
"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years."
- source Bloomberg.

Commodities, like in 2011, have experienced some significant retracement in conjunction with equities with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30 last week. The metal was 1.5 percent lower last week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low as well and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg. Even Gold Bullion wasn't spared and declined 1.9 percent last week as the dollar advanced 1.1 percent against a six-currency basket including the euro, which is poised for its biggest weekly drop in five months versus the U.S. currency according to Bloomberg.

Moving back to Oil and SPX, it seems other pundits as well are following the same disconnect between Oil and SPX as indicated by the below graph from Daiwa produced on Bloomberg, wondering:
** 3yr OIL V SPX: SPX to reset? ** Or Oil to bounce?

Truth is, in similar fashion to 2011, positive correlation between growth assets is most notable when investors are most concerned about risk according to AMP Capital's Oliver - source Bloomberg:
By Sungwoo Park and Saeromi Shin -May 31 (Bloomberg):
"The relationship between commodities and equities is the strongest in more than a year and near a 16-year record, as risks posed by Europe’s debt crisis and a global slowdown make the asset categories “more closely intertwined.”
The CHART OF THE DAY shows the 200-day correlation coefficient between the Standard and Poor’s GSCI Spot Index of 24 raw materials and the MSCI All-Country World Index of shares rose to 0.73 on May 25, the highest since January 2011 and near the strongest since at least 1994, data compiled by Bloomberg show. A correlation of 1 indicates the gauges move in lockstep, a value of zero shows there is no relationship.
When investors are most concerned about risk, “positive correlation between growth assets is most notable,” said Shane Oliver, head of investment strategy at AMP Capital Investors Ltd., which has almost $124 billion under management. “Everyone is looking at the same threats to growth, and so they are all selling together.”
The S and P GSCI index declined 4.2 percent this year through May 29 while the MSCI equities gauge gained 1.5 percent in the period. By contrast, the Dollar Index, a measure of the greenback against six currencies, touched a 20-month high on May 25. Investors are seeking safer assets, such as the dollar, as Europe wrestles with Greece’s debt and the possibility of that nation exiting the euro. Also of concern is the slowest economic expansion in about three years in China, the world’s biggest consumer of metals and cotton. Copper slipped to a four-month low last week, while cotton tumbled to a two-year low. Commodities and stocks have become “far more closely intertwined” as resources have taken on a greater role amid China’s economic expansion and increasing consumption in emerging-market nations, Oliver said. In 2000, after a 25-year commodity bear market, resource companies had low weightings in share gauges. “This has now reversed,” he said. When global risks are perceived as limited, “individual assets are largely driven by their own fundamentals and so the correlation between growth assets such as equities and commodities was low,” Oliver said. “In the current environment of heightened macro instability due to debt problems in Europe and the U.S., this is no longer the case. It’s either ‘risk on’ or ‘risk off’ with growth assets moving together.”

In fact, the only commodity that appears to be running scarce in "Risk-Off" periods appears to be the dollar - source Bloomberg:
According to John Detrixhe from Bloomberg on the 29th of May:
"The dollar is proving scarce, even after the Federal Reserve flooded the financial system with an extra $2.3 trillion, as the amount of the highest-quality assets available worldwide shrinks.
From last year’s low on July 27, the greenback has risen against all 16 of its major peers. Intercontinental Exchange Inc.’s Dollar Index surged 12 percent, higher now than when the Fed began creating dollars to buy bonds under its extraordinary stimulus measures at the end of 2008.
International investors and financial institutions that are required to own only the highest quality assets to meet investment guidelines or new regulations are finding fewer options beyond dollar-denominated assets. The U.S. is one of only five major economies with credit-default swaps on their debt trading at less than 100 basis points, meaning they are viewed as almost risk free. A year ago, eight Group-of-10 nations fit that category, data compiled by Bloomberg show."

From the same article:
"The greenback’s share of global foreign-exchange reserves climbed in the last three-months of 2011 to 62.1 percent, the highest since June 2010, while holdings of euros fell to the lowest since September 2006 at 25 percent, according to the latest quarterly data from the International Monetary Fund.
Foreign official holdings of U.S. government debt increased in each of the first three months of 2012, climbing by 3.24 percent to $3.73 trillion in the best start to a year since2009, according to data from the Treasury Department."
- source Bloomberg.

Whereas opposite attracts during "Risk-Off" periods, it looks like the greenback is still working so far as a powerful magnet.

"Which would you rather have, capital lined up on your borders, trying to get into your country or trying to get out of your country? We are the capital magnet of this planet and we are the savior for not only people, for not only freedom, but also for capital."
Arthur Laffer

Stay tuned!

Wednesday, 30 May 2012

Credit - The Daughters of Danaus

"In Greek mythology, the Daughters of Danaus or Danaids (also Danaides or Danaïdes) were the fifty daughters of Danaus. They were to marry the fifty sons of Danaus's twin brother Aegyptus, a mythical king of Egypt. In the most common version of the myth, all but one of them kill their husbands on their wedding night, and are condemned to spend eternity carrying water in a sieve or perforated device. In the classical tradition, they come to represent the futility of a repetitive task that can never be completed (see also Sisyphus)." - source Wikipedia

Moving back to the theme of Greek Mythology, given rising uncertainties on the upcoming Greek election, we thought this time around we would use this classical analogy. As in the classical tradition, the futility of the repetitive task of the ECB in injecting liquidity into the system to maintain afloat peripheral banks saddled with non-performing assets, (which by the way does not translate into meaningful credit growth in peripheral economies) we wonder how long Europe's muddle through situation will go on. The punishment of the Danaides was that they were forced to carry a jug to fill a bathtub (pithos) without a bottom (or with a leak) to wash their sins off. Because the water was always leaking they would forever try to fill the tub (or deficits in relation to Europe). As we indicated in our conversation relating to the growth divergence between the United States and Europe ("Growth divergence between US and Europe? It's the credit conditions stupid...", it is all about Stocks versus Flows. Yes, we ramble again with our Danaids analogy and their never ending task of filling the tub because we posited the following in various conversations:
"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 will have to depreciate."

Until we see a clear reduction in deficits, (which we might never see in true Danaides punishment or fashion), the ECB liabilities will indeed depreciate. Of course everyone is now awaiting the fateful Greek elections in June, to see if some of our European Danaides are ready to "expedite the divorce" or to whether our European Danaides will listen to their marriage counselors (the United States and the IMF) and go for "Shared Marriage Property". In the Greek legend, Hypermnestra (Germany) was the only Danaid to refuse to follow the orders of her father Danaus (European Commission) to execute her husband Lynceus (alter the ECB mandate) given that he had respected her on their wedding night. While the Danaides were punished in the underworld by being forced to carry water through a jug with holes, or a sieve, so the water always leaked out, Hypermnestra, however, went straight to Elysium.
Back in November, in a conversation with Cullen Roche on Pragmatic Capitalism - "The Impossible Refinancing Burden...", we argued:
"To put it simply there is no way Italy can refinance without the ECB acting as lender of last resort. The EFSF has not enough firepower to support both peripherals and the bank recapitalization process. It is either one or the other. Given the issue of circularity and the need for economic growth to break debt dynamics, I do not see the solvency issue resolved without the ECB stepping in. The big question is, would Germany allow the ECB to alter its DNA given it would contravene the Lisbon treaty, if it starts intervening massively? I have some doubt about it, and it is a scary prospect. So far the Bundestag and German Constitutional court have stepped in to rein in the expansion of the EFSF, because they do not want to betray German people. Either they know it is not the solution and are buying some time to allow for more integration within Europe and using it as a bargaining tool to force Greece and others to concede their independence somewhat in exchange of stronger support, or, the game is for Germany to buy some time and leave and join force with Austria, Finland, the Netherlands, and leave peripherals on their own."
Could Germany be like Hypermnestra and decide to go her own way as the Danaides story goes? But once again we divagate in our thoughts.

It is time for a credit overview, focusing again on Spain and its financial woes as well as credit contraction in Europe, but before we do, we thought it would be appropriate to move back to the issue of circularity namely the Danaides punishment which we discussed in October last year. The issue of circularity we mentioned last year could not be clearer than the graph realised by Martin Sibileau in his post - "The EU must not recapitalize banks":
And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."
Of course this circular reasoning can be applied to the ongoing debates of Spanish banks recapitalization in general and Bankia in particular. Only 5.3 billion euro is outstanding in the recapitalization fund FROB, the 19 billion needed for the exercise are not currently available.
To make matters worse, not only are deposits flights a cause for concern, as we argued in our conversation - "St Elmo's fire": "Deposits flows are indeed key factors in determining the stability of any financial system in peripheral countries", but, Bankia's assumptions for mortgages defaults, heighten concerns for the Spanish Mortgage Sector as indicated by Bloomberg:
"Bankia increased its range for mortgage defaults to 8% to 10% as part of updated assumptions underpinning its 19 billion euro bailout. Spanish mortgage data show that at FY11, 18.3 billion euros of 644 billion of total mortgages were in default. Each 1% increase toward the 8% level would require 1.9 billion of provisions, assuming 30% coverage." - source Bloomberg.

As far as the Danaides punishment/Circularity issues goes, the Spanish banking woes threaten to cancel out austerity benefits meaning that we will not see meaningful reduction of deficits due to this vicious circle and deflation trap Spain is victim of:
"With sell-side estimates of the cost of addressing Spain's 184 billion euros of problematic real-estate loans exceeding 70 billion, the positive impact of Spain's 37 billion of targeted austerity cuts are rapidly being offset by deepening bank troubles. Spanish stress test results in late June will prove key to confidence in the announced measures." - source Bloomberg.

As far as the correlation between Sovereigns and Financials is when it comes to a widening trend - source Bloomberg.:
"Spain's beleaguered taxpayers may be forced to underwrite a direct capital injection of up to 19 billion euros after the ECB rejected a capital plan that involved injecting sovereign bonds into the parent, and using ECB facilities to convert these to cash. Citing the risk of monetary financing, the ECB's rejection may drive Spanish CDS to new highs." - source Bloomberg

Spanish and Italian Financials 5 year CDS drifting wider - source Bloomberg.
Back in October we agreed with Martin Sibileau's view:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:
 Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge), moving back to Friday's wide levels, drifting by 17 bps on the day. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk.

Meanwhile the price action in the European Bond Space has been worsening with Spain reaching new alarming levels rising 24 basis points on the day to 6.74 percent (closing on the fateful 7% level which triggered the rescue of both Ireland and Portugal), with Italy surging as well following a disappointing auction - source Bloomberg:
The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) touching a new record low, with 5 years Germany Sovereign CDS falling below 100 bps - source Bloomberg:
Survival of the fittest, a question of preservation of capital rather than capital appreciation. We are getting closer to our initial target of 1.25% yield for German Bund we discussed in our conversation "Interval of Distrust".

The 2 year German notes touching a record low of 0.002% against the 10 Year German bund - source Bloomberg:

That Japanese European feeling - 2 year German Notes evolution versus 2 making new lows versus 2 year Japanese Notes - source Bloomberg:

Moving back to Spanish banking woes it is similar to Ireland, given the cost of "Zombie Developers' Loans plaguing the balance sheets as indicated by Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans":
"Spanish banks are masking their full exposure to soured property loans while they continue to prop up zombie developers, leading to credit-rating downgrades and plummeting share prices.
Spain is working to clean up its banks, requiring lenders set aside more for possible losses on loans deemed performing to developers like Metrovacesa SA, which hasn’t completed a project in more than a year and has none under way. While that represents about 30 billion euros ($38 billion) of increased provisions, it’s not enough because many loans said to be performing aren’t being repaid, according to Mikel Echavarren, chairman of Irea, a Madrid-based finance company specializing in real estate."

The game of extend and pretend is alive and well in the Spanish banking sector as indicated by the same article:
"Many Spanish banks are avoiding property sales so they don’t have to make mark to market valuations, which reflect current prices. Instead, they’re giving developers new loans to pay debt coming due to prevent defaults, said Ruben Manso, an economist at Mansolivar & IAX and a former Bank of Spain inspector."
“The larger banks have been selling bits and pieces and can absorb the losses,” Manso said. “Smaller savings banks are acting in bad faith in their refusal to allow transactions and saying they can’t mark to market because there isn’t one.”
The example of Metrovacesca, the fall from grace, has it was once Spain's largest developer:
" The Madrid-based company, which once owned HSBC Holdings Plc’s London headquarters and had about a 50 billion-euro market value, was taken over by creditors in 2009 after its largest shareholder struggled to service billions of euros of debt.
 Santander, BBVA, Banco Espanola de Credito SA, Banco Popular SA, Banco Sabadell SA and Bankia, canceled 2.2 billion euros of debts owed by the Sanahuja family in return for about 55 percent of Metrovacesa and purchased a further 10.8 percent of the stock in a deal that valued the company at 57 euros a share. The banks now own about 96 percent of Metrovacesa.
Santander and its Banesto unit, which now own about 35 percent of Metrovacesa, value the stake at 772 million euros, or 2.24 euros a share, according to a spokesman for Santander, who declined to be identified citing company policy. In 2009 and 2011, they made provisions of 269 million euros and 100 million euros against their holding, according to a 2011 report by Santander’s auditor." -
source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".

"Zombie" Metrovacesa:
"Metrovacesa has racked up 1.8 billion euros of losses since 2008. It has debt of 5.1 billion euros and property assets valued at 3.9 billion euros."
source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".
Metrovacesa trades at 39 cents a share from an original valuation of 57 euros...

Keeping the "Zombie" alive:
"In August, its lenders renegotiated the terms of 3.6 billion euros of its debt, extending maturities on 2.47 billion euros of obligations and granting a five-year grace period for interest payments on 1.12 billion euros of loans."
source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".
Applying the Irish "Zombie" treatment:
"Before Ireland’s real-estate crash, banks including Anglo Irish avoided getting appraisals to avoid bringing them before audit committees, according to four people familiar with the matter, who declined to be identified because the information is private.
Anglo Irish gave developers capital to finish projects in 2008 using personal loans. That way, the bank’s primary loan would continue to appear as performing, Irish developer Simon Kelly, who together with his family owes banks 800 million euros, said in a phone interview." - source Bloomberg - "Spain Fails to Count Cost of Zombie Developers’ Loans".
The Bank of Spain allows loans that are refinanced before turning delinquent and interest-only loans to be considered “normal” or “performing” on banks’ books. The extend and pretend game.

As we argued in our conversation - "Peripheral Banks, Kneecap Recap"
"We believe debt to equity swaps will likely happen for weaker banks as well as full nationalization for some."
As our good credit friend said in November 2011:
"The path will be very painful for both shareholders and bondholders."

As far as Spanish banks are concerned we agree with our good credit friend:
"The headlines for the last few days came from Spain with Bankia being about to nationalized. But where the money will come from? The FROB has almost no money left, so the talks in the street are about the Spanish government injecting about Euro 20 billion in the bank.
Let's get serious for a moment. Should the Spanish government injects these funds, it will have to go to the markets to raise them, and considering the actual yield of the 10 years government bond, there is a good possibility for the yield to jump to 7% or above, a level which may push the State to ask for a bail-out. The country will be downgraded, funding access will be definitely closed. A story we have already seen with smaller countries (Portugal and Ireland). The effect will be devastating for growth which will contract further.
The only solution might be to "wipe-out" the current shareholders and to ask bondholders to fork the bill (subordinated debt bought back at big discount or converted to equities). If it is not enough, senior bondholders should be asked to participate. We could see in the process some class actions from shareholders and bondholders against Bankia, and even Deloitte which certified last year results (they have been restated from a small profit to euro 3.3 billion loss).
According to the Spanish newspaper “Expansion”, two other banks(NGB and CatalunyaBanc) are asking for Euro 30 billion capital injection. If confirmed, the bill to bail out the banking system will rise dramatically to Euro 50 billion! And there may be other banks asking for capital (we are convinced there will be)."

In relation to credit conditions, they have not been improving but in fact deteriorating. According to The Economist's credit-crunch index, credit is now tighter in the euro area than it was at the height of the financial crisis (five days moving average of six normalised indices on bank lending, Euribor-OIS spread, Euo-USD swap spread and five-year CDS for financial, industrial and sovereign sectors):
"This is having a detrimental effect on the real economy, as demonstrated in the following three charts. When the index was last at a similar level during 2008-09, economic output tanked, unemployment shot up and stockmarkets plummeted. Unless policymakers find a lasting and credible solution soon, it seems likely that the same will happen again."  - The Economist.

Nomura in today's Euro area April money and credit data survey indicated overall disappointing and worrying data for the ECB:
"This morning‟s money and credit data for April continue to point to even more subdued growth in the monetary aggregates. The headline numbers show a worrying trend, with the M3 annual growth rate declining to 2.5% from 3.1% in March and the annual growth in loans to the private sector (adjusted for sales and securitisation) declining to 0.8% from 1.1% in March.
The main drag on private sector lending, however, was within the OFC sector: loans declined by €30bn in April following the €8bn drop in March, with the annual growth rate turning negative at -1.5% from 2.3% in March. So it appears that the OFC sector has used part of their overnight deposits to pay down bank loans and possibly shifted part of the overnight deposits into non-euro area assets. A similar pattern was observed in Q4 2011.
In sum, today's money and credit data were disappointing and likely reflect both the continued deleveraging forces weighing on the bank's balance sheets and the heightened financial market uncertainty affecting especially portfolio decisions of the OFI (Other Financial Institutional)  sector. The ECB will certainly be scrutinising today's numbers for signs that the LTRO funds are finding their way into the wider economy. It is hard to argue that the credit outlook has improved in recent months. But whether today's money and credit numbers are sufficiently poor to prompt an ECB policy response as early as next week is the critical question. Given today's deterioration in financial market sentiment, the calls for immediate ECB action are clearly getting louder. For now, we stick with our call of no change in policy rates this month, followed by a 50bp rate cut in July but we now see a 30% probability of a 25bp rate cut already at next Wednesday's ECB meeting."

On a final note as far as Dr Copper is concern, it still spelling the D word, D for Deflation and Deleveraging:
"The CHART OF THE DAY shows that copper, sometimes referred to as the metal with a Ph.D in economics, tumbled to a four-month low on May 23 and is down 9.6 percent for the month, heading for the biggest slump since September. Since May 16, inflation expectations have gained 6.2 percent, based on the spread between five-year fixed-rate bonds and Treasury Inflation Protected Securities.
Copper, used to make wires and pipes, has dropped along with other raw materials as the risk of faltering global growth eroded the outlook for demand. Expecting prices to rise is “irrational” given ebbing economic expansion, suggesting expectations will fall in coming months, said Nariman Behravesh, the chief economist at IHS Inc. and a former Federal Reserve official." - source Bloomberg.

"It's the irrational things that interest me."
Harrison Birtwistle

Stay tuned!


Tuesday, 29 May 2012

Credit - The return of Cov-Lite loans and all that jazz...

Definition of Credit Market insanity:

"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."
"The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses."

As a reminder from our 2011 conversation, we referred to what Bethany McLean, known for her work on the Enron scandal and the 2008 financial crisis, said in her article - Corporate Subprime - The default crisis that never happened:
"When most of us think about the credit bubble that burst in 2008, we think about the lax terms of mortgage loans. But many corporations, particularly those that were bought out by private equity firms, also got debt on lax terms. This debt was known as "covenant-lite," because the normal terms of corporate credit—such as a requirement that a company, say, maintain a certain level of profits—were waived by deal-hungry lenders.
After it all went pop, banks regretted the cov-lite loans almost as much as mortgage originators regretted their "no documentation" loans to home buyers. Cov-lite loans plunged in price. At his retirement dinner in May 2007, Anthony Bolton, Fidelity's investment guru, said, "Covenant-lite borrowing … will come back at some stage to haunt the banks." Indeed, Goldman Sachs and other big firms took massive losses when they sold or marked down the price of the bonds they were stuck holding. One person involved in negotiating these deals says his banking clients swore, "Never again."
But less than three years later, cov-lite loans are back. "With a vengeance," my friend David Pesikoff, a Texas-based hedge-fund manager, assures me. Has the world of finance gone insane? Not necessarily. The return of cov-lite loans makes a certain sense in the current financial environment. But I find myself wondering what that says about the current financial environment."

Old habits die hard:
"Cov-lite loans were used to finance some of the biggest, best-known deals of the era, like KKR's buyout of Alliance Boots and Thomas H. Lee and Bain Capital's buyout of Clear Channel. According to the credit rating agency Standard and Poor's, $32 billion in cov-lite loans were issued between 1997 and 2006."

According to Nicole Bullock from Financial Times on the 10th of May in her article - Cov-lite loans make post-crisis comeback:
"In April, companies obtained $7.6bn of cov-lite loans, equivalent to more than 40 per cent of so-called institutional loans extended to companies in the US, according to S and P Capital IQ LCD, a research group. That is the highest monthly proportion since May 2007.
Cov-lite loans extend credit to low-rated corporate borrowers, but strip out some of the traditional protection for lenders. That protection is financial covenants that trigger a default if a borrower’s financial health declines while it is still making agreed interest payments.
When the global financial crisis hit, it was feared cov-lite loans would lead to huge losses for investors. Those losses, though, have yet to materialise, opening the door to a revival of such deals during bouts of market strength."

"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market.

Standard and Poors indicated in a LCD Daily Wrap-up from the 27th of April, such a resurgence of these bad financing habits coming back to play:
"Ineos’ new covenant-lite financing was in focus on the 27th of April after allocating late in the morning. The $2 billion, six-year term loan (L+525, 1.25% LIBOR floor) was pegged at 100.25/100.625, which is off the session’s highs but well above issuance at 98.5 and either side of par on the break. The $375 million, three-year tranche (L+425, 1.25% floor) that was targeted to older-vintage CLOs was also trading at a healthy premium to 99 issuance, rising to 100.25/101 by afternoon."

also on the 27th from the same LCD Daily:
"Schrader cov-lite loans allocate, break atop OIDs
Accounts today received allocations of the first- and second-lienfinancing backing Madison Dearborn’s acquisition of Schrader International. The $235 million, six-year first-lien term loan freed to trade at 98.5/99.5, from issuance at 98, sources said. It cleared the market at L+500, with a 1.25% LIBOR floor, and is covered by a 101, one-year soft call premium. At 98 issuance, the loan yields roughly 6.84% to maturity, which narrows to 6.62% at the midpoint of the bid/ask on the break.
The $100 million, seven-year second-lien term loan broke into a 98.75/99.75 market, from issuance at 97.5, sources added. The second-lien is priced at L+925, with a 1.25% floor; it carries 103, 102, 101 call premiums in years 1-3, respectively. It yields about 11.5% to maturity, or 11.09% at the midpoint of the bid/ask."
As reported, Barclays, Goldman Sachs, and Citi yesterday sweetened pricing on the deal as they stripped maintenance covenants from the term loans. The first-lien term loan launched to market with leverage and interest-coverage tests, while the second-lien originally included a leverage test.
Original price talk, meanwhile, was L+450-475, with a 1.25% floor and a 98.5 offer price on the fi rst-lien, and L+850-900, with a 1.25% LIBOR floor and a 98 offer price on the second-lien.
In addition to dropping covenants, the excess-cash-flow-sweep thresholds were been revised; the sweep starts at 50%, falling to 25% at 3.5x and to 0% when leverage is less than 3x. Previously, the respective step-downs occurred at 3.75x and 3x, sources said."

Corporate loans typically include provisions, or what we call covenants. They can trigger a "default" if finances deteriorate, even if the borrower is still paying interest. This forces the company to negotiate with the bank lenders, often allowing them to force a restructuring. Covenants also act as early warning system when the credit metrics of company start to deteriorate.

According to Moody's, as reported by Patricia Kuo and Katrina Nicholas in Bloomberg today - Europe Leveraged Loan Defaults May Rise to 25%, Moody’s Say:
"At least 25 percent of unrated European leveraged buyout companies with debt due by 2015 may default as the economy worsens and private-equity owners refuse to inject capital, according to Moody’s Investors Service.
An analysis of European LBO companies found that 254 had a combined 133 billion euros ($167 billion) of debt due by the end of 2015, with more than half owed by 36 borrowers, Moody’s said in a report.
“The 2014-2015 refinancing risk remains large and worrisome given our expectations of protracted macroeconomic weakness combined with the weak average credit quality of this universe,” analysts led by London-based Chetan Modi wrote in the report. “We do not expect that private equity sponsors will inject further capital into their own distressed companies
primarily to assist their lenders.”

From the same article:
"Some 125 billion euros of syndicated corporate loans are maturing before the end of 2013 in countries on Europe’s periphery, according to data compiled by Bloomberg. Companies in Asia outside of Japan have more than $110 billion of U.S. dollar-denominated loans maturing in the same period, the data show.
A similar risk of leveraged loan defaults doesn’t exist in Asia, according to Neil McDonald (Hong Kong-based head of law firm Hogan Lovells International LLP’s business restructuring and insolvency practice in Asia), who has advised commercial banks on their debt obligations to Dubai World and bondholders of Sino-Forest Corp. and China Forestry Holdings Co."

Standard and Poor's Leveraged Loan Index Description (Market Value Index Level) - source Bloomberg:

The Europe leverage loan price picture - source Bloomberg:

Looking at the above graph, we do think investors happened to  have been very lucky, once. Indeed, as any statistician would tell you, it was a good outcome for a bad risk. It doesn't mean a good outcome is going to happen again...

"You can't bank on the outcome."
Daniel Berrigan

Stay tuned!

Sunday, 27 May 2012

Australia and the Iron Ore conundrum

"The most fatal illusion is the narrow point of view. Since life is growth and motion, a fixed point of view kills anybody who has one."
Brooks Atkinson

Following up on our recent Shipping conversations ("Shipping is a leading credit indicator - A follow up"; "Shipping is a leading deflationary indicator"), we thought we would venture towards "Down Under", namely Australia given the recent weakness of Chinese Iron-Ore Inventory which have been declining for four weeks and are now below 2011 highs represent a serious conundrum for Australia's economic growth in general and AUD-USD in particular.
Source Deutsche Bank Shipping Weekly - 21st of May 2012

In fact since the beginning of the year both the Brazilian Real as well as the Australian Dollar have experienced a significant weakness versus the US Dollar - source Bloomberg.
While both commodities depending currencies had moved in synch versus the US dollar, the correlation between both broke last year leading to significant divergence between both currencies.
In a recent note entitled "Iron Ore Summer Slowdown" published by Deutsche Bank, their analysts indicated the following:
"Iron ore exports from Brazil have disappointed. Export levels have been poor due to various factors including adverse weather and infrastructure challenges. We expect that export levels are likely to exceed 25mt/month over the next couple of quarters. This normalisation of Brazilian exports could put additional pressure on the market as well.
Certainly we would expect that both Brazilian and Australian producers will be sensitive to the demand requirements of their customers, Europe and China principally, who we expect will be under considerable pressure over the summer slowdown period. On this basis one would expect that exports may drift lower in response to this. Nevertheless we believe that the ability of the key suppliers to ship tonnage to market will improve over this time-frame."

As Dylan Grice put it in his note "Australians be worried: someone is calling your country a miracle!" from the 25th of April:
"Australia's two biggest commodity exports are iron ore and coal. According to the RBA Australia has increased its iron ore capacity by 150Mtpa in the last five years, from 300Mtpa to 450Mpta. Planned capacity increases over the next five years amount to a further 200Mtpa (see chart below). Nearly all of it will go to China to feed the burgeoning steel industry there. But how healthy is China's iron ore demand? If its steel prospects were so attractive why does Wuhan Iron and Steel for one think pigs are the future? Why has the company recently announced plans to invest nearly $5bn over the next five years in industries in which it has no expertise, such as pig, fish and organic vegetable farming? Probably because steelmakers are now loss making and there is excess capacity. And if they have no confidence in the Chinese steel industry, why should Australia?"

In fact Deutsche Bank analysts in their note "Iron Ore Summer Slowdown" remain cautious near term:
"DB steel analysts in China are cautious near-term. After average daily production volumes reached 2.03mt/day in April, utilisation rates are now starting to moderate as end-use demand fails to materialise. In fact we understand that fabricators have high levels of finished inventories. Furthermore, steel inventories while falling are being drawn down at a slower rate than is usual for this time of year."

China growth cooling and implications for Iron Ore:
"Our China steel team expects that Chinese steel production growth will average nearly 4% YoY in 2012(reaching 710mt), as compared to 7.3% growth last year. Utilisation rates are forecast to fall to 86% in 2012.
However we anticipate that these figures may be downgraded if in fact a Chinese economic recovery is delayed or if GDP growth is lower than anticipated. We have concerns about the weakness of the three major fixed asset investment (FAI) pillars (infrastructure, real estate and manufacturing). As our team has indicated previously, excessive manufacturing growth in 2011(which was the highest since 2006) is worrying as it potentially sets the stage for a capex down-cycle for the sector in 2012. Of note, the aggregate capex for Chinese companies under DB analyst coverage is projected to decline in 2012." - source Deutsche Bank.

As indicated by Reuters on the 24th of May:
"Spot iron ore prices have fallen to a 6-1/2 month low below $130 a tonne this week, as steel mills in top consumer China deferred shipments and curbed fresh buying after domestic steel prices hovered near their cheapest in half a year.
Plummeting steel prices, which have shed 6 percent in May, coupled with doubts about domestic demand, are keeping China's army of steelmakers on edge, making them reluctant to commit to new orders.
With growing uncertainty over whether iron ore prices will continue to drop, Chinese steel mills have been picking up material they do need from ore piled at ports rather than making forward bookings with miners, which can take at least 20 days to arrive from Australia."

From the same article:
"If prices were to hit $120 a tonne, it could lead to the closure of some high-cost Chinese miners."
Source Deutsche Bank - "Iron Ore Summer Slowdown" - 17th of May 2012

It's still a game of survival of the fittest in this deflationary environment...

And as Dylan Grice put it in his note focusing on Australia:
"If Chinese resource demand holds up everything will probably be fine. But if it doesn't, well, everything won't be. In fact, there might be trouble anyway. The improvement in Australia's terms of trade (the ratio of its export prices to its import prices) has been spectacular thanks to the bull run in commodities. It should be running large current account surpluses, like Norway. But it isn't. It's running a deficit of 3%. So the AUD is overvalued and vulnerable."

Hence our negative view on Australian Dollar.

"All truth, in the long run, is only common sense clarified."
Thomas Huxley

Stay tuned!

Can Wall Street strategists be trusted?

"What we learn only through the ears makes less impression upon our minds than what is presented to the trustworthy eye."
Courtesy of our friends at Rcube Global Macro Research, here is a guest post dealing with "Strategists' Capitulation" from the 17th of May.

Can Wall Street strategists be trusted? History clearly suggests that they bring negative value in terms of asset allocation forecasting.

Even a casual look at the graphs shows that strategists are massively wrong
at extremes:

They were the most underweight right before the start of large bull market moves (1997 and 2009), and most overweight in 2001.

This is confirmed by the following quintile analysis (although there haven’t been enough cycles in strategists’ stock allocation cycles to draw strong statistical conclusions):

Currently, strategists are recommending the smallest percentage to equities in the last 15 years, matching 1997 and more ironically March 2009.
What this probably means is that European sovereign issues are already well discounted. For markets to move lower from here, additional catalysts need to arise.

We turned bearish a bit early in February selling European equities, and booked profits a bit early as well. The catalyst that pushed us to first go short and then reverse the positioning is mostly related to the global credit channel, which has now substantially improved.

We feel that investors are now underestimating the fact that, as a consequence of massive liquidity injections throughout the world since Q3 last year, bank funding conditions have improved enough for commercial banks to normalize their lending behavior/conditions. It is true in most EM countries, but also in Europe. In North America, banks are now aggressively easing their lending standards.

In some ways, this is what the recent strength on European and global earnings revision ratios implies.

In the US, yields already seem to be pricing an economic meltdown.

US 10yr yields are trading 3 standard deviations from the 30+ year downtrend.

Relative deviation from 100 days moving averages between bonds and stocks has just hit the 20% historical threshold level.

All this to say that while we are not contrarian just for the sake of it, and believe there are still many large long-term threats out there, a combination of improved fundamentals and large underweights in risky assets sows the seeds for a substantial rebound over the next few months.

However, we'll add to our mildly long positions only after we see a catalyst that would reduce the tail risk in Europe.
"Trust dies but mistrust blossoms." - Sophocles

Stay tuned!

Saturday, 26 May 2012

Credit - St Elmo's fire

“But now St. Elmo's fire appeared, which they had so longed for, it settled at the bows of a fore stay, the masts and yards all being gone, and gave them hope of calmer airs.” - Ludovico Ariosto's epic poem Orlando furioso (1516).

"St. Elmo's fire is named after St. Erasmus of Formiae (also called St. Elmo, the Italian name for St. Erasmus), the patron saint of sailors. The phenomenon sometimes appeared on ships at sea during thunderstorms and was regarded by sailors with religious awe for its glowing ball of light, accounting for the name. Because it is a sign of electricity in the air and interferes with compass readings, sailors also regarded it as an omen of bad luck and stormy weather." - source Wikipedia

We decided once more to follow on one of our favorite theme of maritime analogies looking at the recent evolution of events. After all, our recent post of the 8th of May "The Tempest" was a reference to Shakespeare's late masterpiece of 1623. Our title "The Tempest" was also a closely affiliated to our chosen post title Saint Elmo's fire, displaying a more negative association than our opening quote, as evidence of the tempest inflicted by Ariel according to the command of Prospero in Shakespeare's play:
"Hast thou, spirit, Perform'd to point the tempest that I bade thee?"
"To every article. I boarded the king's ship; now on the beak, Now in the waist, the deck, in every cabin, I flamed amazement: sometime I'ld divide, And burn in many places; on the topmast, The yards and bowsprit, would I flame distinctly, Then meet and join."

As we ramble again in the opening of our post, in our usual habits, one of the earliest references to the St Elmo's fire phenomenon appeared apparently in Alcaeus's Fragment 34a (Ancient Greek lyric poet - 6 BC) about the Dioscuri, or Castor and Pollux. Why are we making a reference to the Dioscuri again you might wonder? Because in our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets" in reference to the Dioscuri we argued back in early November 2011 the following:
"So now the ECB has a stark choice, similar to the one Pollux was given by Zeus, to save his dying brother Castor by sharing his immortality with his mortal brother (namely European peripheral countries) or spend his time in Olympus (letting Europe fail, one country after another). The ECB is the only institution that can step in and become the lender of last resort, effectively becoming in essence a FED like entity which should be backed by a central treasury (and we discussed this point in our last conversation), or doing nothing and our Greek swan might take us to another path...
We know that Pollux made the right choice and enabling in the process, the two siblings to become the two brightest stars in the constellation (Gemini).
And the Dioscuri "characteristically intervened at the moment of crisis, aiding those who honored or trusted them." - Source Wikipedia."

St. Elmo's Fire is also a 1985 American coming-of-age film directed by Joel Schumacher, a prominent movie of the Brat Pack genre, revolving around a group of friends that have just graduated from Georgetown University and their adjustment to their post-university lives and the responsibilities of encroaching adulthood. Looking at the attitude of our "European Brat Pack", one has to wonder if our European Politicians will ever adjust to their respective responsibilities and embrace somewhat adulthood which would in effect determine whether our Saint Elmo's fire evolves towards a positive outcome in Ludovico Ariosto's fashion, (leading to the rise of the Dioscuri), or to the negative association of Saint Elmo's fire, namely disaster and tragedy. So for Europe, we think it's graduation time but we clearly divagate..."Misery Loves Company" we wrote in October 2011, and in similar fashion many asset classes have recently experienced similar pain due to the ongoing crisis particularly once again in Emerging Markets. In our long conversation, we will look at the broader impact and consequences following our usual credit overview.
The Itraxx CDS indices picture on Friday - source Bloomberg:
Yet another tale of ongoing volatility and a day of two halves. It started on a positive tone with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly in the morning before widening in the afternoon on the back of the negative news flow in the afternoon leading the indices to widened slightly further more than Thursday. The SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk.
As indicated by Senior Strategist Divyang Shah's recent article in IFR, severing the financial/sovereign link is easier said than done:
"In the US this has been made easy by the post-Lehman concerns over money market funds and temporary government insurance on non-interest bearing checking accounts that has helped to see total insured bank deposits rise to US$7.3tn at the end of June last year compared with US$5.9tn in the second quarter of 2008 (Fitch).
In the eurozone the insurance of deposits took the form of state guarantees which is why what had started out as a banking crisis also turned into a sovereign crisis for some eurozone states starting with Ireland.
The ECB’s Peter Praet today points towards the need to disconnect the banks from sovereign debt, but this is proving a little difficult. The focus on Spain currently and Bankia especially is about a more general concern that the sovereign does not have the resources in order to overhaul the Spanish banks/financials and thus external assistance in the form of ESM/EFSF funds will be required."

The risk of course of deposit flights is indeed a very serious cause for concerns as indicated in the same note by Divyang Shah:
"A Greek exit has simply accelerated concerns over the outlook for financials as investors question the viability of the euro. The FT this morning highlights how funds are dumping euro assets (“Big European funds dump euro assets”) but what matters is the trickle of deposits leaving the periphery.
Data shows that on a y/y basis (March 11–March12) corporates reduced their deposits in Spanish banks by €31bn while retail investors have reduced theirs by €11bn. The point at which this trickle turns into a flood is uncertain but it’s a risk that the eurozone does not want to flirt with especially as sovereign and financial risk is still intertwined."

Deposits flows are indeed key factors in determining the stability of any financial system in peripheral countries as indicated by Bloomberg:
"With an 18 billion euro recapitalization of Greece's banks agreed and access to standard ECB facilities set to reopen, May's 700 million euros of announced deposit withdrawals may reverse. In 2006, household deposits were 45% of total liabilities vs. 32% in March, while deposits from banks were 6% vs. 25%. Retail funding remains key for future stability." - source Bloomberg.

In relation to Banks' "viability" and connection to sovereign risk, we have been sounding the alarm for a while in relation to subordinated bondholders about the very real risk of debt-to-equity swaps occurring in the financial bond space, meaning more pain and losses for both bondholders and shareholders alike. Time has come to warn senior unsecured creditors as well, as reported by Jim Brunsden and Ben Moshinsky in Bloomberg on Friday:
"The European Union will seek to give regulators the power to impose writedowns on senior unsecured creditors at failing banks as part of measures to prevent taxpayers from footing the bill for saving crisis-hit lenders.
The writedown powers would apply to senior unsecured debt and derivatives, while some other claims, including secured debt and deposits that are protected by government guarantee programs, would be shielded from the losses, according to draft plans obtained by Bloomberg News."
The plans are scheduled to be published on the 6th of June. The plans will have to be agreed on by finance ministers from the EU’s 27 member states and members of the European Parliament before they become law and the bail-in powers must be in place across the EU by the start of 2018.
So yes, our long standing assumptions are indeed correct, namely that debt-to-equity swaps are coming, it is part of the "liability" exercise needed to recapitalize ailing banks in Europe:
"As well as writing down claims, national regulators would also have the power to convert them into equity, according to the draft rules." - source Bloomberg.

When it comes to financial institutions in distress, it seems that more and more financial institutions are relying on ELA (Emergency Liquidity Assistance), which according to Bloomberg is increasingly being tapped - Frozen Europe Means ECB Must Resort to ELA for Banks:
"The first rule of ELA is you don’t talk about ELA.
Each ELA loan requires the assent of the ECB’s 23-member Governing Council and carries a penalty interest rate, though the terms are never made public. David Owen, chief European economist at Jefferies estimates that euro-area central banks are currently on the hook for about 150 billion euros ($189 billion) of ELA loans.
The program has been deployed in countries including Germany, Belgium, Ireland and now Greece. An ECB spokesman declined to comment on matters relating to ELA for this article.
The ECB buries information about ELA in its weekly financial statement. While it announced on April 24 that it was harmonizing the disclosure of ELA on the euro system’s balance sheet under “other claims on euro-area credit institutions,” this item contains more than just ELA. It stood at 212.5 billion euros this week, up from 184.7 billion euros three weeks ago.
The ECB has declined to divulge how much of the amount is accounted for by ELA."
When it comes to European Banking woes, which have been as well a regular feature in our conversations, Bankia share were suspended on Friday - source Bloomberg:
Bankia restated its 2011 results - saying it made a 2.98 billion euro loss for 2011 rather than the 309 million euros in profit it announced in February - and asked for the aid from Spain's bank bailout fund, FROB requesting 19 billion euro of financial support. Late Friday, rating agency Standard and Poor's downgraded Bankia, along with four other banks, to "junk" status: Bankinter, Banco Popular Espanol, Banca Civica, Banco Financiero y de Ahorros S.A.
Formed in December 2010 from merger of seven troubled banks, Bankia's most toxic assets were moved into holding company BFA.
Listed on the Madrid stock exchange in July 2011. Chairman Rodrigo Rato resigned earlier in the month before Bankia was "part-nationalized". Two weeks ago, the government intervened and awarded Bankia a 4.47 billion euro loan.

In our conversation "The Raft of the European Medusa", we discussed the ill-fate Bankia IPO which occurred in July 2011. Rodrigo Rato was the former Managing Director of the International Monetary Fund (IMF) from 2004 to 2007 and declared in relation to the July 2011 IPO for Bankia that it “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” in a speech on July 20 2011.
Individual investors bought about 60 percent of the shares on sale in the IPO we indicated previously.
How can one expect Spain's to restore investor confidence when:
-as we indicated in our conversation "The road to hell is paved with good intentions‏", Spanish Economy Minister expected Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and declared he did not expect Spain Mortgage defaults to rise much. Total bill amounts now to 23.47 billion euro and counting for Bankia so far...
-the former 9th IMF Managing Director Rodrigo Rato led a very questionable July 2011 Bankia IPO based on "irregular" and "insincere" financial accounts leading to significant losses for already rattled Spanish individual investors.
One has to wonder. We do.

Meanwhile the price action in the European Bond Space has been volatile to say the least.
The current European bond picture, a story of ongoing volatility for Italy and Spain, but with France, joining the fray with a significant drop in yield over two days, dropping more than 20 bps - source Bloomberg:

French OAT 10 year Government Bond Yield receding significantly on the 24th of May - source Bloomberg:
French bonds falling towards their lowest level of 2.50%, experiencing a significant "flight to quality" move which so far Germany had benefited mostly.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), with 5 years Germany Sovereign CDS above 100 bps - source Bloomberg:
"Demand at almost record highs for German bunds and the insurance to hedge against default on the securities indicates that investors are increasingly betting on the breakup of Europe’s monetary union.
The CHART OF THE DAY shows 10-year German bund yields at all-time lows and the cost to insure the benchmark European debt close to record highs. Yields on the securities fell as low as 1.35 percent today as investors seek a refuge while European leaders seek to keep Greece within the euro and the currency bloc’s debt crisis from worsening.
“The signals are counterintuitive, but the market is pricing in an increasing probability of a euro zone breakup,” said Jürgen Odenius, chief economist at Prudential Financial Inc.’s Prudential Fixed Income unit in Newark, New Jersey. “And betting that even though the German balance sheet will take a big hit, that their new currency, which doesn’t yet exist, would
appreciate tremendously.” Credit-default swaps on 10-year German debt rose to 126.09 on Friday, according to data compiled by Bloomberg." - source Bloomberg
This graph has indeed been a regular feature in our conversations for obvious reasons...

Another interesting graph we have been tracking with much interest displays the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
We do expect the SPX index to fall further in conjunction with Oil prices. We saw that "Misery loves company" back in 2011. In similar fashion, many various asset classes are experiencing significant correlation on the downside, following a similar pattern.

Oil prices are poised to fall further because drilling-rig use and stockpiles are at their highest levels in decades, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer as reported by Bloomberg:
"The CHART OF THE DAY compares weekly data on the number of oil rigs, as compiled by Baker Hughes Inc., with the Department of Energy’s weekly figures on crude inventories. Last week’s rig count of 1,382 was the highest in 30 years, Shaoul wrote yesterday in an e-mailed note. The number increased 45 percent from a year ago. Oil stockpiles totaled 382.5 million barrels, the most since mid-1990.
“Even though demand has remained steady, it has been overwhelmed by supply,” the New York-based analyst wrote. “The clear risk is that this will be resolved by sharply lower prices in the coming months.” Oil has tumbled 14 percent on the New York Mercantile Exchange this month. The loss exceeds an 11 percent decline in Brent crude, another benchmark, and would amount to the biggest monthly loss in two years." - source Bloomberg.
Commodities, like in 2011, experienced as well some significant retracement with Cash silver losing as much as 1.3 percent to $27.9275 an ounce and to around $28.30. The metal is 1.5 percent lower this week for a fifth weekly drop, the longest losing streak since July 2011. Raw materials slid to a five-month low this week and more than $4.3 trillion was erased from the value of global equities this month on concern that Greece will exit the euro as the region’s debt crisis deepens according to Bloomberg.

Emerging-markets stocks as well, have seen the longest string of weekly losses since 1994 according to Bloomberg:
"The MSCI Emerging Markets Index sank 0.4 percent to 898.57 at 12:42 p.m. in Hong Kong. The gauge has fallen 0.9 percent this week, poised for a 10th weekly decline, on concern that Europe’s debt crisis and China’s economic slowdown will curb demand for riskier assets."

So yes, "Misery" does indeed, love company, and in 2012 like it did in 2011:
"Emerging-market equity funds posted outflows of $1.5 billion in the week ended May 23, Markus Rosgen, Hong Kong-based analyst at Citigroup Inc. said in a report today. Overseas investors sold $5 billion of emerging-market stocks in Asia, the biggest weekly outflow this year, according to the report." source Bloomberg.
"Emerging-market dollar bonds may start to match declines for developing-nation stocks as the
Greek debt crisis further weakens the risk appetite of investors, according to Mizuho Securities Co.
The CHART OF THE DAY shows JPMorgan Chase & Co.’s Emerging Market Bond Index has dropped 2.4 percent this month, while the MSCI Emerging Markets Index of stocks plunged 12 percent. During a sell-off that started Sept. 8, the indexes fell in tandem, with dollar debt declining 5.5 percent in two weeks. The lower panel shows emerging-market credit-default swaps have being gaining since March, mirroring a rise in the cost to insure against losses leading up to early September."
  - source Bloomberg.
Dollar-denominated fixed-income securities from emerging-market nations have returned 4.2 percent so far in 2012.

"Emerging-market bond funds attracted $633 million in the week to May 16, taking inflows this year above $20 billion, according to U.S. research company EPFR Global. Some $15 billion of that was invested in dollar notes. About $2.3 billion was pulled from equity funds, the second week of withdrawals, paring inflows this year to $20.5 billion, EPFR said." - source Bloomberg
We've seen this movie before...

In relation to European economic data, it is hard to find any comforting news with euro-area unemployment rate climbing to 11 percent in April, the highest in data compiled by Bloomberg back to 1990, and worrisome PMI numbers coming clearly on the weak side.

The divergence between US and European PMI indexes - source Bloomberg:
Widest level reached since 2008, 9.80 between both PMI indexes.

On a final note, our good cross asset friend indicated to us an interesting correlation between the Japan Nikkei index and Japan's sovereign 5 year CDS since the beginning of March. The index has been falling whereas at the same time, Japan's sovereign CDS is rising. The bottom graph indicates so far a fairly muted volatility for the Nikkei index:

If Europe is moving towards a Japanese decade, there might be at least some solace for Spanish Golf players given that according to Bloomberg there has been a high correlation between Golf Membership fees and Tokyo land prices - source Bloomberg:
"The CHART OF THE DAY compares an index of commercial land prices in the Tokyo metropolitan area, compiled by the Japan Real Estate Institute, with the average membership price among Japan’s three most-expensive golf clubs. The average joining fees at Koganei Country Club, Tokyo Yomiuri Country Club and Yomiuri Golf Club this year have fallen about 40 percent compared to the full-year average in 2011, according to prices compiled by Nikkei Golf Corp., a Tokyo-based broker for membership trades.
Tokyo’s office vacancy rates increased to a record high of 9.23 percent in April from 9 percent a month earlier, pushing rents to a record low, according to Miki Shoji Co., a closely held office brokerage company. The vacancy rate was also 9.23 percent in January. The commercial property index peaked in early 1991, about a year after average prices for the country clubs reached a record high of 288 million yen ($3.62 million), the data show. Golf-membership prices soared in Japan during the 1980s bubble economy, then slumped as the country suffered through series of recessions the past two decades. At least 800 golf clubs went bankrupt since 1991, according to Meiji Golf, a Tokyo-based broker. Some of the most expensive clubs in Japan don’t allow memberships for women or foreigners."

"Markets can be as treacherous as the sea". - Macronomics

Stay tuned!

Tuesday, 22 May 2012

Credit - The road to hell is paved with good intentions‏

"The meaning of the phrase is that individuals may do bad things even though they intend the results to be good. An example is the economic policies of the 1920s and 1930s. These were intended to be a prudent response to the economic turmoil following World War I and the Wall Street Crash respectively, but they were one of the causes of the Great Depression and World War II in which millions of people suffered and died." - source Wikipedia
Back in January in our conversation "The European Overdiagnosis", our friends at Rcube Global Macro Research pointed out the inherent flaws of the European currency construct when discussing "The likelihood of a Euro Breakup": "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”.
Indeed, while today's price action marked somewhat a respite in the recent sell-off, the unintended consequences of the numerous mistakes made during the ongoing European crisis have yet to be really understand by our European politicians, still struggling to address the many issues of our "European flutter". In our credit conversation we will therefore look at the direct consequences of their actions, as well as looking at the potential outcome for Spanish subordinated bond holders in relation to the necessary exercise of capital increases that will need to take place for the Spanish banking system. But first our credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
The Itraxx Crossover 5 year CDS index (50 European High Yield companies - High Yield credit risk gauge) was tighter by 33 bps, moving back towards the 700 bps level. It touched 790 bps on Friday. While most indices were overall tighter including Itraxx Financial Senior 5 year CDS index (cost of insuring the senior debt of 25 European banks against default) and Itraxx Financial Subordinated 5 year CDS index, the price action is akin to short covering.

Itraxx Financial Senior index fell to a low of 181 bps in March and has been widening since, reaching 309 bps on the 18th of May, the highest level since the 19th of December - 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:

"Mind the Gap" we indicated on the 8th of May - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:
While volatility has somewhat receded slightly in relation to the V2X Eurostoxx, the German 10 year Bund remains tightly below the 1.50% level indicating the "flight to quality" mode experienced so far.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield),  with 5 year Germany Sovereign CDS above 100 bps. Back in November last year, when Germany's sovereign 5 year CDS went above the 100 bps level, the Bund experienced an impressive widening move above the 2% following the "failed" German auction. Could it be different this time? - source Bloomberg:

The current European bond picture, a story of ongoing volatility for Italy and Spain, with Spain 10 year yields receding towards the 6% level - source Bloomberg:

Truth is, the rising exposure of peripheral banks to government bonds has indeed boosted Sovereign Risk - source Bloomberg:
"While ECB cash injections significantly improved bank liquidity conditions, more than 300 billion euros of announced austerity measures have pressured the budgets of central and local governments. Total euro-zone bank lending to governments has grown 135 billion euros since 2009, tying banks' fates increasingly closely with their sovereigns." - source Bloomberg.

No wonder both the SOVx index (representing the sovereign risk of 15 Western European countries with Cyprus replacing Greece in the index) and the Itraxx Financial Senior 5 year index have moved in synch - source Bloomberg:
The ECB so far has been providing much needed support via LTRO operations to the European Financial sector, avoiding so far direct support of countries and suspending secondary government bonds buying via the Securities Market Programme (SMP). According to Fitch Ratings as reported by Gavin Finch in Bloomberg, a third LTRO operation could take place:
“If a third Longer Term Refinancing Operation is needed, we believe it will be provided,” James Longsdon, a managing director at Fitch’s financial institutions group in London, wrote in a report today. The timing is “unlikely to be imminent without a further significant shock, such as a Greek exit from the euro.”

It could be a possibility given that for weaker peripheral financial institutions, the ECB remains the ONLY source of funding for ailing institutions. The recent downgrades of both Spanish and Italian banks undertaken by rating agency Moody's means that many banks still face funding issues due to the over reliance of many European banks to wholesale funding.  According to Credit Suisse "Q2 issuance has been remarkably light so far, initially driven by earnings blackout periods, but since hampered by volatile market conditions. This lack of supply has been particularly acute for financials.":
"For senior unsecured benchmark deals, we have experienced negative net issuance of approximately EUR94bn since April 2011." - source Credit Suisse

Moody's downgrades of Italian banks were centered on the unsecured Italian Bank Maturities that needs to be replaced:
"Moody's Italian bank downgrade focused on poor wholesale funding access. In 2012 it suggests that only 20% of unsecured maturities will be replaced by new unsecured issues. A structural reliance on market funds poses "one of the biggest challenges for many banks," as Unicredit's 22.5 billion euros of 2012 maturities highlights." - source Bloomberg.

And with soaring Italian bad debt, increasing to 108 billion euros, shadowing Spain, the survival of the weaker players is conditioned by the willingness of the ECB in providing support:
"Moody's cited deteriorating conditions and risk of increasing bad debt in its downgrades of the Spanish and Italian banks. Italy's bad debt has risen 65 billion euros since the start of 2009, close behind Spain's 75 billion increase. Corporate bad debt now represents two-thirds of Italy's total and will likely rise should sovereign yields remain elevated." - source Bloomberg.

In relation to Spain, rising unemployment, rising Non-performing loans and increasing fears of deposit flights (in relation to deposits flight, Greece’s banking system lost 9 billion euros of deposits this year and has seen outflows of 73 billion euros since the 2009 peak according to Bloomberg), reducing therefore the ability for banks in providing credit to support economic growth to the Spanish real economy, doesn't bode well for the its recovery prospects and overly ambitious budget deficits targets. As shown by Bloomberg chart below, Spain's 148 billion euros worth of NPLs dwarf austerity cuts:
"While Spain's bad debt ratio of 8.37% remains below its February 1994 high of 9.15%, its current bad debt outstanding is more than 6x the 1994 equivalent. With provision requirements increasing and a fourth bank clean up underway, further real estate deterioration will materially offset 37 billion of announced austerity cuts". - source Bloomberg.
Many pundits expect that Spain's ability in restoring investor confidence will be determined by the results of the audit of the banks' balance sheets which will be undertaken by Roland Berger Strategy Consultants and Oliver Wyman. While this operation is laudable, we think it is more akin to an operation of damage control and we do not believe it will change investor's willingness in investing in Europe given the growing foreign buyers strike plaguing the European Government market courtesy of "unintended consequences". The Greek PSI created de facto subordination of private sector creditors while protecting both the interests of the ECB and EIB (goodbye "pari passu" - "The European Opprobrium",  classes of bonds or shares having equal rights of payment or level of seniority).
In retrospect, we think our title is uncannily accurate, in relation to Spanish woes, caught in a vicious deflationary spiral: the road to hell is indeed paved with good intentions. We will not comment further on the overly ambitious deficit targets set up by the European Commission as we have been through this exercise previously ("A Deficit Target Too Far"). But, as the explanation goes, in relation to the colloquial expression used in our title, many mistakes were made leading to a flurry of unintended consequences. These errors are forcing our European politicians to try to change tack aboard the "European Bounty" and calling for a "Growth Compact" and asking again for Eurobonds, clearly facing rising risks of mutiny:
-upcoming Greek and Irish elections
-blunt refusal by Germany and Austria in relation to Eurobonds provided the Fiscal compact is not abided by all.
In a note published today by French broker Oddo, Bruno Cavalier indicates clearly the many mistakes taken since the Sovereign debt crisis broke out in 2010:
"The first error was the diagnosis in 2010, namely that the crisis of the euro had its main source, if not unique, in loose fiscal policies. If this point is not debatable in the case of Greece, it is not true for Ireland and Spain. Before 2008, both countries had scrupulously respected the public deficit criteria. Their current difficulties were not caused by an excessive public debt; they appeared when foreign capital financing their housing bubble ended abruptly. In fact, current problems in the euro area therefore reflect as much a fiscal crisis than a balance of payments crisis. However, the policy prescriptions are not necessarily the same in one case or another. Faced with a budget crisis, as in Greece, it is essential to run a thorough reform of the state, forcing us to rethink the tax system to make it more efficient and reduce public funds waste. Faced with a crisis of balance of payments, jeopardizing the banking system, the priority is different. There is  an urgent need to recapitalize institutions in big trouble, if any, by nationalizing them, it should be the priority in Spain. In this country, controlling public deficits cannot  obviously be ignored, but it is secondary to the need of cleaning up the banking system.
The second mistake was to try to subordinate private sector creditors in the context of public assistance programs  for peripheral countries in trouble. This is the famous "Deauville agreement" announced in October 2010 at the end of a Franco-German summit. The ECB, under Jean-Claude Trichet as president at the time, saw its decision immediately criticized. In fact, it resulted in government securities issued by euro area countries ceasing to be considered as "risk-free assets", they were previously even considered "risk-free" when they were not AAA. Risk premiums increased and the appetite for these securities declined, making it more difficult to control debt dynamics."

Of course there is an urgent need to recapitalize Spanish banks, although Spanish Economy Minister expects Bankia to only need 7 billion to 7.5 billion euro to meet provisional rule and doesn't expect Spain Mortgage defaults to rise much.  According to the IMF Spanish Banks losses could reach 260 billion euro and the sector as a whole could need help to the tune of 80 billion euro (5% of GDP). Today saw as well an acceleration in the consolidation of the Spanish banking sector with the replacement of Bancaja Chairman Olivas by Antonio Tirado, the Vice Chairman.

Moving on to our pet subject of subordinated bond holders, Spanish bond holders are likely to experience similar pain than Irish and Portuguese subordinated bond holders given that the need for capital raising will undoubtedly lead to "liability" exercises taking place. In a recent note published by Barclays comparing Spain to Ireland published on the 17th of May, they indicate the following:
"Recent developments in the Spanish banking sector have led investors to draw comparisons between the Spanish and Irish banking systems and analogies between the two are evident, in our view. Most notably, both countries are experiencing severe real estate market adjustments, as large imbalances accumulated over the decade prior to 2008 correct.
Loan losses soared in Ireland: It has been four years since the Irish lending boom came to an end, and the implied loss rate on all Irish bank loans based on the most recent provisioning data is 24%.
Eventually leading to realised losses for subordinated bondholders: The real estate related loan problems at Irish banks eventually caused subordinated bondholders to accept substantial realised losses. On average, subordinated bondholders recovered approximately 20% of par value.
Spanish banks have subordinated debt that could be used for burden sharing: In light of the similarities with Irish banks and the expected need for government capital injections into the Spanish banking system, the question of whether Spanish subordinated bondholders will eventually meet the same fate as their Irish counterparts becomes a legitimate one."

Of course we agree. We have long been warning that, there would be more pain to come for both subordinated bond holders and shareholders alike (see our recent post "Peripheral Banks, Kneecap Recap").

Barclays in their note added:
"Although bank bondholder involvement could help reduce Spain’s debt burden, authorities may avoid coercive burden-sharing because of elevated retail ownership of subordinated bank debt. Nonetheless, we acknowledge that there is downside risk to our base case loss estimates and that the risk of burden-sharing for subordinated bondholders of Spanish banks is material."
The Irish example on a subordinated bond LT2 demise - source Barclays:
"The process was incremental, beginning with the nationalisation of Anglo Irish, advancing with the creation of NAMA, and culminating with the passage of the Subordinated Liabilities Order. Ultimately, subordinated bondholders recovered approximately 20% of par value on average". - source Barclays.
Oh dear...

Ireland also took coercive actions in relation to subordinated bondholders:
"The Credit Institutions (Stabilisation) Act led to the Subordinated Liabilities Order (SLO), which was published on 14 April 2011 and was a key factor in the unfortunate fate of subordinated bondholders. The SLO enabled the State to exercise a wide range of powers over banking institutions, including modifying the terms of subordinated liabilities.
Specifically, the terms of lower-tier 2s were amended such that interest payments became optional and maturities were extended to 2035. The terms of upper-tier 2s were amended to remove all requirements to pay missed coupons. In addition, dividend stoppers were removed from both upper-tier 2 and tier 1s, eliminating the last of the structural leverage previously included in these securities." - source Barclays

In relation to Spain, Barclays indicated:
"Spanish banks have €65bn of subordinated debt outstanding, or €47bn excluding Banco Santander and BBVA. Under our base case scenario, where lifetime loan losses reach €198bn, which would exceed the current stock of provisions by €88bn, the government could be required to contribute €45-50bn to the recapitalisation of the banking sector. The need for public sector support could be reduced substantially through coercive bondholder involvement."

Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain:
One has to wonder if Spanish retail investors will be inflicted additional pain...

On a final note a chart from Bloomberg indicates US Banks CDS track Europe's higher as Spanish yields rise:
"In mid- to late-2007 European bank CDS were driven by liquidity fears and did not track yields particularly closely. As Spanish spreads rose again recently, sovereign fears have this time chased EU bank CDS levels higher. Even with limited sovereign exposure, U.S. banks' spreads are tracking Europe's closely, as fears regarding global growth heighten." - source Bloomberg.

"The safest road to hell is the gradual one - the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts."
C. S. Lewis -

Stay tuned!

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