Saturday, 12 May 2012

Credit - Interval of Distrust

"Realism doesn't mean outright pessimism" - Max Lerner - American journalist.

"The principle behind confidence intervals was formulated to provide an answer to the question raised in statistical inference of how to deal with the uncertainty inherent in results derived from data that are themselves only a randomly selected subset of an entire statistical population of possible datasets. There are other answers, notably that provided by Bayesian inference in the form of credible intervals. The idea of confidence intervals is that they correspond to a chosen rule for determining the confidence bounds, where this rule is essentially determined before any data are obtained, or before an experiment is done. The criterion for choosing this rule is that, over all possible datasets that might be obtained, there is a high probability that the interval determined by the rule will include the true value of the quantity under consideration. That is a fairly straightforward and reasonable way of specifying a rule for determining uncertainty intervals. The Bayesian approach appears to offer intervals that can, subject to acceptance of an interpretation of "probability" as Bayesian probability, be interpreted as meaning that the specific interval calculated from a given dataset has a certain probability of including the true value, conditional on the data and other information available. The confidence interval approach does not allow this, since in this formulation and at this same stage, both the bounds of interval and the true values are fixed values and there is no randomness involved." - Philosophical issues - source Wikipedia

Given recent events relating to significant losses suffered by JP Morgan due to (mis)-measured VaR (Value at Risk), we thought our title would be appropriate, following the aforementioned events. JP Morgan restated its 1Q12 VaR associated with its Chief Investment Office from 67 million USD to 129 million USD. A VaR of 67 million USD at a 95% confidence level (hence our title...) implied that JP Morgan should not have incurred losses in excess of 67 million USD on more than three business days during the quarter. But we ramble again. We will refrain going into more details about yet another example of being fooled by randomness in true Nassim Taleb fashion, or the mis-behavior of markets as depicted by the great Benoit Mandelbrot. We already touched on "optimism bias" in our "Bayesian Thoughts" conversation:
"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."
Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Hopefully for JP Morgan, should their bonds widen significantly, they might be in a position to recoup some of these losses courtesy of FAS 159 and DVA... So in our credit conversation "The Tempest" where we touched on the issues of the banking system in Spain leading to the recent "partial" nationalization of Bankia (for now...Spanish Government to convert 4.5 billion euro of FROB aid previously given to Bankia group parent BFA into shares, giving government as much as 45% ownership), we will focus this time around on the ongoing deleveraging process and the impact of upcoming downgrades in the financial sector (Moody's is reviewing 114 European financial institutions). But first, a credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:
Credit markets this week have indeed hit "bad weather" courtesy of the news flow in both Spain and Greece, with the Itraxx Crossover 5 year CDS index (High Yield risk gauge, 50 European entities) crossing the 700 bps level and 40 bps wider since last Friday, a new series 17 high since the last rebalancing of the index which occurred on the 20th of March this year. Once again the dominating force in the widening movement was in the financial space, with a clear underperformance for the Itraxx Financial Subordinate 5 year CDS index, wider by around 12 bps to 438 bps (40 bps wider since last week) whereas Itraxx Financial Senior 5 year index was wider by around 7 bps to 266 bps (20bps wider since last Friday). Credit Agricole posted a 75% drop in first quarter earnings impacted by exposure to Greece and the Spanish Government pushed forward a plan to ramp up provisions in the financial sector.

Since November last year we have been arguing about the heightened probability of seeing more and more debt to equity swaps in the financial space (and no, it wasn't a question of "optimism bias" from our part or outright pessimism...). In fact we learnt that the governing body of the Credit-Defaults swap markets ISDA and its credit steering committee are about to begin a formal process to revamp the CDS contracts to take into account how debt-to-equity exchanges would be treated after bankruptcy, as indicated by Matthew Leising in Bloomberg on the 9th of May - ISDA Said to Begin Biggest Revision to Credit Swaps Since 2009:
"Credit-default swaps users will meet this week in New York and London to discuss changes to the contracts in what may become the biggest revisions since 2009, according to people familiar with the situation.
Possible changes to standard contracts, which are governed by the International Swaps and Derivatives Association, include how debt-for equity exchanges would be treated after a bankruptcy, specifying that credit swaps only cover losses from defaults that occur after their purchase and clarifying how the date of a so-called credit event is determined, said the people, who asked not to be named because the discussions are private."

The importance of debt-for equity exchanges in CDS contracts from the same article:
"The concern arose in the bankruptcy of CIT Group Inc. when the commercial lender proposed to exchange its debt for equity before the credit swaps settlement date, one of the people said. Because only bonds and loans are deliverable under the current standard swaps contract, that left the possibility of having no debt with which to settle the contracts."

"Unintended consequences" and fixing flaws relating to Sovereign CDS contracts, the Greek example as reported by Matthew Leising in Bloomberg :
"Credit swaps payouts after a government debt exchange would be tied to the ratio of the face value of the new bonds to the old bonds. That would seek to prevent scenarios where payments are limited to swaps buyers because the new bonds are trading close to par, a concern of market participants after Greece undertook the biggest sovereign-debt restructuring in history. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt."
Good intentions, given you probably want to "cash in" while you can on your Sovereign CDS contract, but as the Greek example is clearly showing, new bonds have not been trading close to par for very long...
"Greece’s 10-year bond price has dropped below that of the security it replaced in the biggest-ever debt restructuring two months ago, suggesting investors are betting the nation will default.
The CHART OF THE DAY shows the price of Greece’s 2 percent bond maturing in 2023 sank to 18.995 percent of face value yesterday, below the 19.005 closing level of the bond it superseded. The security, which began trading after the March 9 debt restructure, has tumbled as deadlocked talks over the formation of a new government reignited concern Greece won’t meet the terms of two international bailouts, increasing the risk it will leave the euro currency bloc and fail to pay back its creditors." - source Bloomberg.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
Spanish bonds came back above 6% while German bund yields hit record new lows. In our conversation "The European Opprobrium" back in February, our good credit friend and ourselves had been discussing the following:
"Will subordination of private bondholders versus the ECB lead to insubordination?
If true, here are the questions you should ask yourself:
Will the new bonds be senior to the old bonds? If so, expect private investors to go on strike and buy much less sovereign bonds as they will be subordinated to the ones owned by Public institutions in the future. Also, some private investors may decide to try their chance in Court and argue against the subordination de facto."
When it comes to Spanish debt we have already started to see "insubordination" leading to a private investor "buyers strike" ("Mutiny on the Euro Bounty"):
"The Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on."
So next week auctions for both Spain and Italy should be interesting, given the bank recapitalization exercise taking place which could further more erode confidence in Spanish sovereign debt. The additional burden of providing support for the "problematic" 184 billion euros of assets identified by the Bank of Spain is indeed a cause for concern in relation to the financial aspect of the operation. The government is expected to demand banks to set aside a further 35 billion euros to cover sound loans in their real estate portfolios. The government has already obliged banks to make provisions of 54 billion euros to cover bad assets, and in our last conversation, we already touched on the level of provisions already passed by Spanish banks. Some banks haven't really started (BBVA, Santander need to provide around 2.3 billion euro each in 2012 under the RDL). The government asked the banks to set aside 30 percent of their sound loans to house builders, up from a current 7 percent, but the banks, including major players Santander and BBVA, had pushed back with a lower number (call it "insubordination" or mutiny...).

If it were only Spanish banks being on a "buyers strike"...
"Gao Xiqing, president of China Investment Corp., said the nation’s sovereign wealth fund has stopped buying European government debt on concerns about the region’s financial turmoil: “If European governments want to issue bonds, CIC is not a main target institutional investor,”
source Bloomberg - CIC Stops Buying Europe Government Debt on Crisis Concern.

No wonder our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields dipping below 1.50% is so telling (10 bps tighter in a week). It is indeed deflation (デフレ). - source Bloomberg:
In this game of survival of the fittest, as we posited before, it is all about capital preservation rather than capital appreciation. As David Rosenberg put it recently: We are no longer in the era of capital appreciation and growth. "The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows – equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd."

We agree with Nomura's recent note - European political implications: new bund target 1.25%:
"Recent developments have reinforced our strategy recommendations: short non-core markets, and stay long Bunds. We are close to our 1.50% initial target on 10yr Bunds, but see the rally extending further so move our target to 1.25% on DBR 1.75% 07/22. This new target could be breached if no fresh policy response to the crisis emerges. After all, we still believe that absent a proportional policy response, a break-up of the euro is probable rather than possible."

The "D" world (Deflation - Deleveraging) - 2 year German Notes evolution versus 2 making again new lows versus 2 year Japanese Notes - source Bloomberg:
In a deleveraging/deflationary world:
"The corner stone of asset management is not capital “appreciation” but capital “preservation”."

In a recent note published by Credit Suisse focusing on Japan and deleveraging:
"It seems there is plenty of evidence to suggest that global overleveraging and bursting of various asset bubbles (ranging from banking to property to trade imbalances) is moving most developed countries/regions along similar progression line as what occurred in Japan over the past 20 years."
"As can be seen in the above graph, in 1998, the key developed economies (i.e., the US, the UK, Eurozone and Japan or G4) carried a total debt burden (public plus private) of around US$65 tn, or approximately 300% of the GDP.
However, by 2008 (amid the unfolding crisis), the overall level of debt expanded to US$131 tn or 370% of GDP. It continued to climb to US$140 tn or almost 400% of GDP by 2011. On the current trajectory, the overall level of debt should climb to almost US$143 tn by 2013 but should be slightly down in proportion to GDP to around 380%.
In order to place this debt burden into perspective, one should remember that since the end of World War II, the average burden was not much more than 240–250% (broadly 60% each for household, business, financials and government sectors). In other words, if the overall debt burden were to return back to more normal levels (say by the end of 2013), the overall debt level would need to decline towards US$100 tn (i.e., fall of US$35–40 tn).
A return to the 1998 levels would still require a drop in debt levels to around US$115–120 tn or a fall of up to US$20 tn." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Balance Sheet Recession? It's the private sector stupid!
"Clearly, the area of greatest expansion of debt burden between 1998 and 2008 occurred in the private sector. Once again, looking at G4, the overall private sector debt was around US$50 tn in 1998. However, by 2008, it reached US$100 tn, rising from 230% to almost 290% of GDP versus the historical average of around 190%. Since 2008, the private sector has embarked on a de-leveraging process, which is likely to reduce G4 private sector debt by around US$3–4 tn (by 2013), easing debt burden as a percentage of the economy to around 260–270%.
The other side of the private sector de-leveraging is a rising public sector debt. We estimate that by 2013, the public sector debt across G4 will rise to 120% of GDP (excluding significant contingent liabilities and unfunded liabilities). In other words, debt to GDP of the public sector, which was broadly in line with the historical average of around 60%, could easily double by 2013." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

So what happened in Europe? Bank leverage...
"There was a similar acceleration in Eurozone’s total and private sector leverage levels over the last 10–15 years (paralleling the US experience, except that most of the increase in Eurozone was driven by financial and corporate rather than household sectors). As can be seen below, Eurozone’s private sector’s leverage is currently close to 290%, up from just over 200% in 1998." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.
"Most of the key Eurozone economies have so far failed to achieve any meaningful reduction in private sector debt, with the prevailing levels broadly in line with the US and Japan for France and Spain (around 270–290% of GDP), although the Italian and German private sectors are far less leveraged.
At the same time, leverage of some of the more vulnerable economies such as Portugal and Ireland as well as larger non-Eurozone economies (such as the UK) remains uncomfortably high. Private sector debt to GDP in the UK is between 300% and 400% of GDP (depending on the degree of adjustment for the UK’s global financial hub status) while Irish private sector debt is a crushing 550–600% of the country’s GDP and Portugal’s private sector debt is close to 280–290%." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Moving on to our second subject of upcoming Moody's downgrade of 114 European financial institutions, Morgan Stanley caught our interest with their recent note on European banks - Who Will Catch the Falling Banks?":
"Moody’s review has been pushed back, but we don’t believe that indicates any softening in approach. With many bonds expected to drop out of the IG indices, or at least go sub-IG at Moody’s, we believe there are few investors willing to step in – at least at current levels – to meet any forced sellers/nervous holders."

We've been ranting like a broken record in relation to subordinate debt; Morgan Stanley's note is indeed confirming our long standing position:
"Downgrades in LT2 could be 5-6 notches, not ‘just’2-3, in our view. We are concerned that investors haven’t fully grasped that LT2 will be affected by Moody’s downgrades of senior ratings plus removal of support notching – with BNP’s LT2s potentially dropping five notches to Baa3 and UBS’ six notches to Ba1, for example.
59% of the € iBoxx Tier 1 index will have dropped out once Moody’s downgrades are done, compared to 1 January 2012, we expect. LT2 indices will see dropouts too, with an expected 19% in the same time period. The volume of falling angels – €18 billion of Tier 1 and €17 billion of LT2 – is unprecedented and hence we are concerned about subsequent price action.
Will HY buyers save them? We don’t think so. Our survey of HY investors suggests most don’t have to closely follow an index and a move from 25% to 32% of the €HY iBoxx index, still wouldn’t make those who don’t look at banks now suddenly get interested. In our view, prices have to cheapen significantly from here to attract them; the same going for insurers who have spent years de-risking bank capital. Retail investors are ratings insensitive, but demand here is not enough to avoid a price correction, in our view."

Bracing for a sell-off impact, from the same Morgan Stanley note:
"We appreciate that a number of Tier 1 index dropouts, including large names like UniCredit, have recently happened without much disturbance to the market. However, the sheer volume of bonds dropping out in the next couple of months will be unprecedented – following the Moody’s downgrades, we expect €18 billion of Tier 1 and €17 billion of LT2 to have dropped out of the € IG indices since the start of the year."
Hence our "interval of distrust"...Oh well...

In this deleveraging process, capital rules for bank capital have yet to be addressed. We have already argued like many before us, that contrary to many beliefs, Bank Equity is not expensive. It is a myth as clearly demonstrated by Anat R. Admati - “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”
We share the same views as Simon Johnson, the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management, as indicated in his latest views published in the New-York Times:
"Breaking Up Four Big Banks"
A view which is gathering traction, courtesy of the latest losses incurred in the financial sector due to oversized positions that went badly wrong.
Rules for Bank Capital Still Aren’t Mended Four Years On: View by Bloomberg Editors - 7th of May 2012:
"Bank capital is of paramount importance because it is capable of absorbing losses. If a well-capitalized bank gets into trouble, its shareholders suffer, but depositors, the taxpayers who insure their deposits and the rest of the financial system are protected. Wafer-thin capital -- in other words, huge leverage -- was the main reason the crash propagated as it did.
The new accord proposes that banks maintain equity capital of 4.5 percent of risk-adjusted assets, plus a 2.5 percent added buffer. Equity of 7 percent is an improvement over Basel II, but still far less than needed. Even under the new regime, some supposedly risk-free assets would require little or no capital backing, so equity as a proportion of total assets would be lower. Basel III sets a floor of just 3 percent for equity as a proportion of total assets. A much higher figure -- as high as 20 percent of assets -- is called for."

On a final note, we would like to add that complacency and weak interval of confidence based on flawed assumptions or models can be dangerously deceitful when markets lack direction as demonstrated by Eugene F. Fama and Kenneth R. French, the creators of a model explaining equity returns:
"As the CHART OF THE DAY shows, each component of their three-factor model dropped last year for the first time since 1994. The declines occurred even though the Standard and Poor’s 500 Index was little changed.
Fama, a University of Chicago professor, and French, a professor at Dartmouth College in Hanover, New Hampshire, put together the figures used for the chart. They track return gaps between stocks and Treasury bills, between the shares of smaller and larger companies, and between value and growth stocks.
Although market returns had the biggest swings among the three factors in the past half century, “the volatility of the size and value premiums is nevertheless high,” Fama and French wrote in a paper analyzing the numbers. The research, posted on their blog three days ago, is based on data from the University of Chicago’s Center for Research in Security Prices.
Last year’s total return for all U.S. stocks, weighted by market value, was 0.9 percentage point less than the return on one-month Treasury bills with monthly reinvestment." - source Bloomberg.

"When evil acts in the world it always manages to find instruments who believe that what they do is not evil but honorable." - Max Lerner

Stay tuned!

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