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!


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