Tuesday, 8 May 2012

Markets - Credit - The Tempest

"Worm or beetle - drought or tempest - on a farmer's land may fall, Each is loaded full o' ruin, but a mortgage beats 'em all."
Will Carleton - American poet.

Back in March we wondered if in our Credit Space it would be "Plain sailing until a White Squall", and by the end of the month in our conversation relating to Spain "Spanish Denial", we started asking ourselves: "One has to ask oneself if the time has not come to start taking a few chips off the table."

Looking at the recent price action in Europe, with the unnerving news flow following the recent Greek elections in conjunction with troubling news from the Spanish banking giant Bankia (third largest Spanish banking group), our analogy this time around refers to one of Shakespeare's last play "The Tempest", but we ramble again.
Given the acceleration in the news flow from the Spanish banking sector, following a quick credit overview we will focus on the recent Bankia headline and the continuous decline of weaker peripheral banks and the potential outcome. It still very much a game of survival of the fittest (we recently discussed the subject of bank recapitalisations in our conversation "Kneecap Recap").

The Credit Indices Itraxx overview - Source Bloomberg:
Mind the gap...while London markets were closed on Monday, and credit markets fairly muted on Monday, Tuesday was a different story altogether. Itraxx Crossover CDS 5 year index (50 High Yield entities, HY risk gauge) was wider by 22 bps and overall credit indices were wider across the board, Financials Indices taking as well a leading positioning in the widening move with Itraxx Financial Senior 5 year index wider by around 12 bps and Itraxx Financial Subordinate 5 year index wider by 14 bps.

No surprise there given the bad news flow coming from Bankia. As one Index Market Maker commented:
 "In my opinion, the way out for the Spanish bank system is to hurt bond holders further down the capital structure (i.e subordinated bond holders) and the bail-in proposal is supportive of senior bondholders but not for subordinated bond holders."
We have to concur. Of course it the way out! It support our long standing views expressed in our post "Peripheral Banks, Kneecap Recap, Kneecap Recap":
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

It is particularly bound to happen as we wrote it last year given we read on Bloomberg today the following:
"Prime Minister Mariano Rajoy said most Spanish regions, the nation’s “whole financial sector” and most big companies can’t finance themselves on debt markets.
Today the Treasury is practically the only one that finances itself on the markets,” he said in the Senate today.
“That’s why we have to send the message that we will meet the deficit target.” Rajoy declined to answer a question from reporters as he left the Senate on how much public money may be used to overhaul Bankia."

So dear equity friends, "Mind the Gap" - There is a disconnect between the 10 year German Bund, touching new record lows and the Eurostoxx, it appears the divergence between both does not look correct, and warrant caution - source Bloomberg:
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.

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield), new record low dipping below 1.55% versus 5 year Germany Sovereign CDS stable at 85 bps. It's deflation (デフレ) and "Risk-Off". - source Bloomberg:
That Japanese European feeling - 2 year German Notes evolution versus 2 making new lows versus 2 year Japanese Notes - source Bloomberg:

Moving on to the subject of Spain in general and Bankia in particular: "We do expect to see more debt to equity swaps for some weak peripheral banks".
 While discussing the implications of upcoming Moody's downgrade for 114 European banks and Basel III impacts for the European financial sector ("From Hektemoroi to Seisachtheia laws?") we implied: "We think upcoming downgrades means more collateral posting and more haircuts on collateral that can be pledged for funding at the ECB and dwindling "quality assets" therefore even lower German Bund Yields..." and as our Rcube friend mentioned in the same conversation:
"This year, it appears that Spain and/or Italy are going to be the culprits of a third summer of Eurozone distress."

The latest news on Bankia was that the government has forced the removal of Bankia's management and replaced its CEO with an experienced banker (formerly with BBVA). As indicated by Barclays in their Euro area economics morning comment, it is indeed an important move:
"It is also important because Bankia is by far the largest among the problem institutions. The size of its credit portfolio is nearly EUR200bn, of which 22% is to construction and developers (the bank has a net provisioning ratio of c 43% of problem loans in this sector). The Spanish media has also indicated that the government intends to inject public funds into the institution. Some newspapers have indicated that it could be done through the use of CoCos and with the injection of (public) FROB funds for about EUR7-10bn.
In our view the key to a resolution of Bankia (and to the rest of the problem banks) is a comprehensive, prudent and transparent valuation of their assets, including the legacy real estate assets. This asset evaluation process ideally should involve an independent third party. And it should be followed by a public recapitalization plan (with burden sharing by junior bond holders). If this process is managed swiftly and transparently it could help to restore market confidence."

Bankia Stock price evolution - source Bloomberg:
Bankia was formed on December 3, 2010 as a result of the union of seven Spanish financial institutions, with major presence in their areas of influence. The merger of the seven savings banks, known as 'cold fusion', took only four months, with the integration contract being signed on July 30, 2010.
The 3.3 billion euro IPO for Bankia was done in July 2011 with 824.57 millions shares offered at 3.75 euros a piece, now worth less than 2.25 euros, down 37.39% year to date ((Bankia market cap = E4.4bn). Bankia’s auditor, Deloitte, has not signed off on its 2011 accounts, fuelling further doubts about its asset quality.
According to Spanish newspaper "El Confidencial", the government is planning a capital injection of 7 billion euro. Two government sources also said the injection of public money into Bankia would likely take place through convertible shares, also known as Contingent Convertible bonds (or CoCos), but that other options were also being looked at.
As our good credit friend put it:
"According to recent news, the Spanish government intends to nationalize Bankia and to subscribe to Cocos (Contingent Capital) issued by the bank. To my view, this is definitely not the cheapest solution as the government will have to inject money that it is having already issues raising. Politically, this is not a good play while imposing harsh austerity measures with soaring unemployment. A better solution would be to force a conversion of debt to equity (In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company). Doing so will not require 7 to 10 billion funds, but would of course dilute shareholders and destroy bond holders (haircut)."

The FROB (Fondo de Reestructuracion Ordenada Bancaria - Spanish Restructuring Fund) had already dealt last year with a few ailing institutions but so far not in the size of Spanish giant Bankia. The state-funded bailout vehicle FROB has injected nearly €15bn into the banks. It injected last year 2.465 billion euro in NovaCaixa's capital with a discount of around 75 to 85% price to book. Also, CaixaBank's 1Q12 results were hit hard by real estate provisions and the bank was forced to merge with ailing Banca Cívica in 2011.

So far, the Spanish government solution has been consolidation (Savings banks reduced from 45 to 17). The set-up of a bad bank would imply price discovery and coming clean on true asset valuations. This exactly what our good credit friend mentioned in our conversation "Mutiny on the Euro Bounty" in relation to Spanish bank issues and valuations:
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."

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

Of course the decline would have been steeper! Transparency in asset valuations would finally help in discovering the extent of the problems plaguing the Spanish Financial sector. The set-up of a "Bad Bank" in similar fashion to Ireland's NAMA, would indeed force price discovery and true valuations provided a third party assessor is drafted to help in the  set up process as indicated above in Barclays comments.

As indicated by Deutsche Bank in their latest note on Spanish Financials - A new Royal Decree in the making:
"As soon as this coming Friday (surprisingly early), the government could approve a new Royal Decree (RD2) affecting the Spanish financial system. As a reminder, in early February another RD (RD1) was approved, requiring banks to double (by year-end 2012) the provisions for existing real estate risks (E25bn), while moving forward on loss recognition (via a new generic provision requirement for performing RE loans).
When quantifying how much is “enough” is impossible
While we argued in our latest sector piece that RD1 requirements looked
largely sufficient to cover existing real estate (RE) risks, the market seems to lack the patience and the visibility to wait and see whether the new provisioning levels will be sufficient (considering the NPA formation will accelerate); thus, overhang risk (in the form of underlying RE losses) persists in terms of banks’ solvency/P and L. The potential creation of a bad bank could be a positive step to calm down markets. However, at this point, we are skeptical that this may be the silver bullet for which the market is looking; the challenge is the lack of a consensus view when quantifying the size and form of this silver bullet (e.g., what is the “adequate” level of impairments? Will concerns stop at RE or will they extend to SME/mortgage lending?).
What to expect when you are expecting: provisions and bad bank (BB)
On a hypothetical announcement regarding more provisions (PM Mr. Rajoy said in an interview that the “RD2 will go and value RE assets again”), if the government does not want to contradict itself too much in relation to the RD1, the only area where it has some leeway is in the generic provision requirement for still-performing RE loans. We regarded this cushion as useful (though we are not sure whether it is sufficient) to tackle concerns around whether banks were providing an accurate picture of still-performing RE loans (i.e., restructured loans to non-viable clients). With the RD1, the generic provision was equivalent to 7% of still-performing RE loans (E10bn of incremental provisions). The NPA of the RE sector stands at c.50%; we estimate this will move to 70% by 2013. On the BB, there are numerous questions, the most relevant being: (1) the transfer price of the assets (we believe that requiring banks to transfer the assets below the RD1’s markdown levels will mean a low rate of participation by the institutions and a second round of equity raising –
even if some equity is freed up after the transfer – which the system is not in a position to take, except the larger names); and (2) who finances the BB. It could be the financial system (we believe this would not break the negative circular reference seen by the market), the government(probably a good solution depending on the transfer price, though any freeing up of funding will be dependent on whether the BB issues debt, which is exclusively subscribed by the banks), or Europe/IMF (unlikely due to the likely heavy conditionality accompanying the aid)."

As a reminder, BBVA and Santander need to provide around 2.3 billion euro each in 2012 under the RDL, and neither charged a meaningful portion of this in the first quarter (zero for Santander, and €174 mln for BBVA) so far in 2012. Caixabank has already met its 2012 RDL requirement of 2.4 billion euro in the first quarter.

Without credit growth resuming, the ambitious target deficits will not be met in Spain. The conditions for growth needs credit growth to resume, as shown by the recent credit growth in the US (see our conversation - "Growth divergence between US and Europe? It's the credit conditions stupid..."). Spain has to go through resolving the Spanish banking encumbered balance sheets.

This is clearly indicated in a recent note by Cheuvreux - Spain, too much already but still not enough:
"Banks still have a lot of bad assets to deal with, in part thanks to regulatory forbearance. The official stance of the new government in this respect is very straightforward. Its aim is to clean up some of the excessive leverage through new impairments. Supposedly, the cleaner balance sheets and lower leverage following this action would allow loans to flow to where there is demand. A clear strategy does not necessarily make it a good one. And some banks are even vocal about what's next (both Santander and CaixaBank have publicly stated that private loans will have to fall by around EUR300bn-400bn over the next few years).
We believe the private sector deleveraging poses significant challenges for the Spanish economy going forward. Going back to the surplus/deficit per sector, a private deleveraging process would need to be countered by higher public spending to compensate for the fall in GDP. This was the case in Japan in the early 90s but it is not plausible for Spain within the current EU configuration, where fiscal austerity is king. In this regard, note that the Spanish government has undertaken to reduce the budget deficit from around 8.2% in 2011 to 5.3% and 3% in 2012 and 2013, respectively (gaps of around EUR40bn and EUR55bn, respectively).
More importantly, it is unclear whether corporates are willing to borrow given:
1) high levels of debt and B/S deterioration as the price of assets fall; and 2) many companies, particularly in the property sector, are unable not only to borrow more but to even pay back their existing debt. Consequently, a number of corporates are moving into debt reduction mode as opposed to maximising profitability. This is not helped by the ongoing credit crunch, as shown by higher lending spreads. See charts below."
Spain: Spreads in New Loans (%) - source Cheuvreux - Bank of Japan:

Spain: Lending Growth - source Cheuvreux:
LTRO was good news but will not promote lending growth - Cheuvreux (hence our "Money for Nothing" argument...):
"In a perfect world, the availability of an affordable (1% cost) source of medium-term (three years) funding would certainly promote lending to the private sector. There is sufficient empirical evidence to suggest, however, that neither low rates nor QE programmes foster lending to the private sector in highly leveraged economies. This has certainly been the case in Japan, the US and the UK where an enlarged monetary base did not lead to an increase in lending demand."

While the restructuring of the banking sector is a pre-condition in resuming enough credit growth to sustain economic growth, Cheuvreux estimates that the banking sector restructuring will take out 50 billion euro from taxed earnings and has clearly negative views for growth in Spain in 2011, forecasting a -2.4% print and -0.9% in 2013:
"True realism consists in revealing the surprising things which habit keeps covered and prevents us from seeing."
Jean Cocteau

Stay tuned!

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