Wednesday, 6 June 2012

Credit - Something Wicked This Way Comes

"Capital as such is not evil; it is its wrong use that is evil. Capital in some form or other will always be needed."
Mahatma Gandhi

Following the passing of great American writer Ray Bradbury today, we thought our credit rambling title had to be a reference to ones of Ray Bradbury's book as a form of tribute to one of our favorite writers. The 1962 novel by Ray Bradbury is about a nightmarish traveling carnival that comes to a Midwestern town one October. Looking at the ongoing nightmarish European carnival's, which has returned earlier this year, one has to wonder if indeed something wicked is coming our way. The carnival's leader in the book is the mysterious "Mr. Dark" who bears a tattoo for each person who, lured by the offer to live out his secret fantasies (markets rumors such as using ESM funding to recapitalized peripheral banks). Each person succumbing to these fairy tales has become bound in service to this (European) carnival of "Mr. Dark".
The book by Ray Bradbury "Something Wicked" has an emphasis on the more serious side of the transition from childhood to adulthood, a point we discussed precisely in our conversation "St Elmo's fire" in relation to our "European carnival" traveling from one member to another, like dominos falling, were we argued: "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."

As our good credit friend put it:
"The capital markets have not paid enough attention to various pieces of the global puzzle falling into places, and the true picture is a cause of concern. The overall capital structure of the current financial system is at risk. Financial institutions are in dire need of capital and bailing them out will drag sovereigns (issue of circularity) with them unless policy makers decide to follow a path they have refused so far (following Lehman Brothers bankruptcy). The no-no policy (no loss for bondholders – no loss for shareholders) advocated by Paulson when he was in charge of the Treasury is not valid anymore. Investors will have to take losses if leaders want to save their populations from disaster (Greece is the canary in the coal mine). So shareholders and subordinated debt holders should be wiped out, and senior bonds holders could become the new shareholders if there is not enough capital. How long can leaders still expose their countries to such big risks is unknown, but debt to equity swaps should make the headlines again at some point."
Indeed, it has been a recurring theme of ours in our various conversations, namely that additional pain will have to be inflicted to both bondholders and shareholders. Given the EU proposals for restructuring and managing banks in crisis, something wicked indeed is coming this way, at least towards financial bondholders and shareholders. As ECB President Mario Draghi asked clearly today, the ESM (the permanent EU bailout fund) is not currently set up to be a shareholder in banks:
"Do we want an ESM that is a shareholder in banks?"
So, in this conversation we will review the need for capital which cannot be resolved by liquidity injections alone and the recent Bank Bail-ins proposal. At some point, as our good credit friend put it, losses will have to be taken.
But before we go through this important subject, it is time for a quick credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:
Today had a positive "short covering" tone in the credit space with Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) tightening significantly by 27 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 around 321 bps and so does the Itraxx Financial Senior Index while tighter by 13 bps on the day, a further indication of the existing correlation between financial and sovereign risk.

Itraxx SOVx index versus Itraxx Financial Senior 5 year CDS (senior unsecured financial risk gauge) - source Bloomberg:
We presented the issue of circularity indicated by Martin Sibileau in our conversation "The Daughters of Danaus":
"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."

We also argued at the time:
"As far as the Danaides punishment/Circularity issues goe, 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."

Of course, most Spanish banks are in favor of seeking European funds given neither the banking system nor the government can afford to absorb the losses. As reported by Charles Penty in  Bloomberg in his article "Spain Bankers Backing EU Aid Highlight Doubts on State Finances", according to Santiago Lopez, an analyst at Exane BNP Paribas in a May 29 report:
"Spain’s financial system may still need 45 billion euros in taxpayer money, including 30 billion euros to clean up three previously nationalized banks and 15 billion euros for other lenders."
On top of that, from the same article:
"JPMorgan’s estimate that Spain may need a bailout costing as much as 350 billion euros."

Today's price action in the European Bond Space saw Spanish yields receding towards 6.28%, remaining elevated and a cause for concern in Spain's ability to access funding which it will attempt on the 7th of June for 2016 and 2022 bond auctions. France and Germany saw their yields widen respectively by 8 bps and 12 bps - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) with 5 years Germany Sovereign CDS slightly above 100 bps - source Bloomberg:

Moving on to the subject of capital raising needs, Spanish banks which have suffered rating downgrades (Bankia and Bankinter downgraded to junk by Standard and Poor's on the 25th of May) as well as rising funding costs face a 43 billion euro funding hole according to analysts, warning that they might not be able to roll over covered bonds (secured by pools of prime loans) that mature in the next 18 months according to Bloomberg in their article 'Spanish Banks Face Covered Bond Funding Squeeze" from the 1st of June:
"The seven largest Spanish banks -- Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, Banco De Sabadell SA, Bankinter SA, Banco Popular Espanol SA and Banco Espanol De Credito SA --with a total of 171.4 billion euros ($211.5 billion) in outstanding covered bond debt, have 43 billion euros maturing over the next 18 months, according to data compiled by Bloomberg.
No benchmark-sized public covered bond from a Spanish issuer has been sold for 10 weeks, and further issuance is unlikely in the near-term, according to analysts. Issuance in the first five
months of 2012 is at 36 percent of the total for 2011
, according to figures from Leef Dierks, head of covered bond strategy at Morgan Stanley."

In relation to Spanish covered bonds, the secondary markets has been on the receiving end as far as Spanish banking woes are concerned as indicated by the same article:
"The issue-weighted average price of 348 Spanish covered bonds stood at 92.15 cents on the euro on May 30. Even the strongest issuers have seen their covered bonds fall in value. Banco Santander SA’s 4.5 percent covered bond maturing in July 2016 has declined to 98.37 cents on the euro from 101.65 in May. The asset-swap spread traded up to 350 basis points over mid- swaps on May 29, a near-one percentage point increase in the month and 47 basis points higher than its previous high on Dec. 2, 2011."
But it isn't only access to the most senior part of the bank capital structure which is proving difficult for Spanish banks. The access to the senior unsecured market is as well proving more and more elusive for Spanish banks:
Still below 2011 levels as indicated by Bloomberg, but another cause for concern:
"Since recovering to above par in March, the mid-yield on senior unsecured debt for Spain's two largest banks has risen steadily. Though still below November highs, sustained elevated yields will drive up the cost of refinancing. Bloomberg data show the two banks have 28.6 billions of euro-denominated senior unsecured debt maturing by 2014."
At the same time EU Banks withdrew 37 billion dollars of Interbank Support from Spanish banks according to Bloomberg:
"EU interbank exposure to Spain's banking system fell $37 billion dollars during 4Q11. Though liquidity fears were temporarily relieved by two ECB LTRO facilities, Bankia's troubles have driven unsecured funding costs higher. Should the withdrawal of interbank capacity continue faster than Spanish banks can deleverage, significant funding problems may return." - source Bloomberg.
Something Wicked the title goes.
If it was only Spanish banks feeling the heat of Interbank lending drying in Q4 2011...

"Global cross-border claims fell $799 billion in 4Q11, 80% driven by a drop in interbank lending. Within this, euro zone cross-border claims fell $364 billion as institutions retrenched and shrank balance sheets. Absent further stimulus or a crisis solution, this draining of interbank support may become problematic as the ECB liquidity programs expire." - source Bloomberg

As the BIS put it in their Quarterly June 2012 report:
"Three features characterise the sharp decline in cross-border claims on banks in the fourth quarter. First and foremost, internationally active banks reduced their cross-border lending to banks in the euro area. Second, they also reduced cross-border interbank lending in several other developed countries, albeit by a lesser amount. Third, they cut interbank loans much more than other instruments.
Cross-border claims on banks located in the euro area fell by $364 billion (5.9%), which is equivalent to 57% of the decline in global cross-border interbank lending during the quarter. It was the largest contraction in crossborder claims on euro area banks, in both absolute and relative terms, since the fourth quarter of 2008. Cross-border lending to banks located on the euro area periphery continued to fall significantly. Lending to banks in Italy and Spain shrank, by $57 billion (9.8%) and $46 billion (8.7%), respectively, while claims on banks in Greece, Ireland and Portugal also contracted sharply.
Nonetheless, exposures to these five countries accounted for only 39% of the reduction in cross-border interbank lending to the euro area. BIS reporters also reduced their cross-border claims on banks in Germany ($104 billion or 8.7%) and France ($55 billion or 4.2%)."

In this elevated financial risk environment as indicated by the high level of Itraxx Financial Senior 5 year CDS, no wonder some European banks are on a quest of securing funding as indicated by Fabio Benedetti-Valentini in Bloomberg on the 25th of May "SocGen Search for Crisis Funding Takes Bank to German Car Buyers":
"Societe Generale SA’s quest for funding is prompting the bank, France’s second-largest, to mine
sources not tapped before: German car loans and Dim Sum debt. Seeking shelter from Europe’s resurgent sovereign debt crisis, Societe Generale and France’s three other large, listed banks -- BNP Paribas SA, Credit Agricole SA and Natixis SA --are seeking new ways of financing their balance sheets."

Lessons learned from 2011? Maybe. From the same article:
"Burned by last year’s liquidity crunch, Societe Generale, BNP Paribas and Credit Agricole are shrinking balance sheets in most overseas markets and cutting sovereign-debt holdings. The four Paris-based banks bolstered assets in France by 11 percent last year to 3.72 trillion euros ($4.67 trillion) while cutting commitments in other European countries by about 7 percent, according to the lenders’ data compiled by Bloomberg. BNP Paribas in 2011 cut assets even in Belgium and Italy, its largest retail-banking markets outside France, by 1.6 percent and 3.8 percent respectively, its annual report shows. Societe Generale boosted French assets by 15 percent and got most of its new debt placed with investors in northern Europe."

In relation to their respective funding needs:
"To protect against a refinancing drought, France’s three largest banks have completed about three quarters of their 2012 plans to issue at least 42 billion euros of debt with maturities over one year. Societe Generale went so far as to securitize 700 million euros of German car loans from a unit representing less than 0.5 percent of its balance sheet." - source Bloomberg.

So in effect, European banks while scaling back from dollar-funded businesses such as aircraft financing, are trying to find ways to diversify their sources of long-term funding such as private placements, Dim-Sum bonds (Societe Generale sold 500 million renminbi bonds to fund its Chinese operations), and securitizing German car loans (Societe Generale at its BDK unit, representing 8% of its medium and long term issuance between January and April 23rd).
funds as the region’s deepening debt crisis makes unsecured debt
sales scarcer and more expensive.

As far as the LTROs effects are concerned and investments funds strategy, as indicated in a recent note by CreditSights entitled "Eurozone Investment Funds Use LTROs to Exit Euro" from the 4th of June, they indicated the following in relation to banks' bonds take up:
"Eurozone investment funds increased their allocation to bonds by 69 billion euros in the first quarter; the largest net purchase of bonds since the third quarter 2010.
However the vast majority of that net allocation to bonds, 57 billion euro, was to emerging markets. Indeed the allocation was the largest by investment funds on record.
Investment funds also increased their allocation to banks’ bonds by the largest amount since the third quarter 2009. But that was entirely an allocation to two-year-and-shorter dated bank bonds. Funds reduced their holdings of longer-dated bank debt by 2 billion euro."

In relation to the subject of Banks Bail-in legislation, senior unsecured creditors will indeed be facing the music to cover costs from failing banks under the European plans unveiled today, meaning an end to the era of bank bailouts, in an attempt to move towards a more unified financial supervision. Under the plan, national governments would impose annual levies to set up enough cash for a resolution fund available to a failing financial institution. As of the 1st of January 2018, outstanding senior unsecured liabilities of European Banks will be "bail-in-able", excluding short-term debt (less than 1 month).
The "unintended consequences" of such a plan have been discussed in our conversation "From Hektemoroi to Seisachtheia laws?" as indicated by Nomura:
"the sooner a bank can increase its long-term debt issuance, raise its term deposit funding, or unwind its balance sheet before its competitors do the same, the cheaper its funding costs will be and the less pressure it will face to reduce its balance sheet. In this respect, the current effective subordination of unsecured creditors of eurozone banks due to the balance sheet encumbrance issue allied to a general aversion of creditors to increase exposure to banks is particularly worrisome as this impedes the ability of banks to obtain term-funding."

Yes, "Something Wicked This Way Comes" and as CreditSights put it in their note relating to the European Bank Bail-in - "D-Day for European Bank Bail-ins":
"Bail-in allows the authorities to write down some liabilities to allow the bank to remain in business. Our view is that normal insolvency proceedings are not an effective way of dealing with failing banks and preventing systemic crises, and that a resolution regime is therefore a sensible alternative. We also agree that if governments are determined that public funds should not be used to finance bank rescues, then either banks will have to have significantly higher equity and subordinated debt, or senior creditors will potentially have to be subject to write-down or conversion into equity.

However we think regulators and politicians are in denial about the consequences for banks'funding models. This will push banks towards deposits and covered bonds as principal funding instruments, which seems to alarm some regulators. Senior unsecured debt will be more expensive - some investors will inevitably view it as contingent capital - and the universe of investors will shrink. The Commission's own impact assessment reckons that the total funding cost of banks in the EU would increase on average by a range of 5 to 15 bp, reflecting an estimated average increase in yields on bail-in-able instruments of 87 bp. We suspect this significantly underestimates the likely costs and is one reason we recently revised our recommendations on European banks to Underweight."

So, thank you "Mr Dark" for the "Bail-in" invitation to your nightmarish European carnival. But, you won't be wearing another tattoo because we will not be lured in believing in yet another "secret fantasy". In our conversation "From Hektemoroi to Seisachtheia laws?" we once again voiced our concerns Mr Dark:
"We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP."

Deposit guarantee funds preference is more negative for bondholders. The resulting structural subordination means they will rank pari-passu (classes of bonds or shares having equal rights of payment or level of seniority) with unsecured claims and it could soon be a factor for UK banks if the government follows the ICB’s recommendations...

On a final note we leave you with a Bloomberg chart, showing that Indetex SA, owner of Zara clothing chain has overtaken Banco Santander SA as Spain's second-biggest company by market value as surging profit attracts investors growing wary of banks:
"The CHART OF THE DAY shows the market capitalization of Arteixo, northern Spain-based Inditex, and that of Santander. The world’s largest clothing retailer has almost trebled since the fourth quarter of 2008 to 42.1 billion euros ($53 billion), while Spain’s biggest bank has fallen more than 50 percent since 2010 to 41.6 billion euros. Telefonica SA, Spain’s biggest phone company, is the largest stock on the IBEX 35 index, with a value of 48.4 billion euros." - source Bloomberg, 21st of May.

“Really knowing is good. Not knowing, or refusing to know, is bad, or amoral, at least. You can't act if you don't know. Acting without knowing takes you right off the cliff.” 
  ― Ray Bradbury,  Something Wicked This Way Comes

Stay tuned!

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