Saturday, 9 March 2013

Credit - The Yield Skeksis

"The ignorant mind, with its infinite afflictions, passions, and evils, is rooted in the three poisons. Greed, anger, and delusion." - Bodhidharma 

While watching the on-going "Yield Famine", with credit investors dipping their toes more and more clearly outside their comfort zone and snapping up CLOs (Collateralized Loan Obligations), providing the necessary fuel for the biggest surge in corporate buyouts since the outset of the financial crisis, we thought our weekly analogy should, no doubt, refer to some of the main antagonists, the Skeksis, from Jim Henson's legendary 1982 fantasy film the Dark Crystal.

In the Dark Crystal, the Skeksis are the corrupt rulers of the planet Thra, having inherited it from their benevolent Urskek predecessors. While they are the embodiment of their knowledgeable predecessors, due to the accelerated decomposition of their bodies, the Skeksis constantly search for ways to prolong their lives at all costs. In similar fashion to the Dark Crystal Skeksis, our Yield Skeksis constantly search for ways to enhance their yield returns.
The primary method of the original Skeksis was to expose themselves to sunlight channeled directly through the Dark Crystal, though the amount of energy replenished to them was greatly dependent on the conjunction of Thra's three suns. In similar fashion, our Yield Skeksis are highly dependent on interest levels set up globally by the Central banks to replenish their level of "energy". 

Another method used by the original Skeksis to prolong their lives at all cost was to drain the lifeforce from other life-forms by exposing them to the reflect beams of the Dark Crystal, with the life-force collected in a liquid form (or coupons for our Yield Skeksis) and drunk only by the Emperor, who regains his youthful appearance. The effect on the drained victims was to turn them into near-mindless husks which the Skeksis use as slaves.

Looking at the incredible surge of Greece ASE equity index since 2012 (up more than 110%), in similar fashion to the end of the Dark Crystal, following the unification of the crystal triggering in effect the merger between the Mystics and the Skeksis, the land is shown rejuvenated and equities rallied:
No doubt, our post from the 4th of March 2012 entitled "Equities, there is life (and value) after default!", indicates the powerful effect of bond restructuring / partial default can have on equities. It looks "crystal clear" to us, but we ramble again...

Of course our reference to the corrupt Skeksis from the Dark Crystal and some European politicians would be purely fortuitous as the saying goes. Although the Skeksis are capable of forming alliances, they are by nature extremely paranoid toward each other. After all the Skeksis were only 10 compared to the 27 members of the European Union:
-The Emperor skekSo (having originally been an energetic ruler who enjoyed lavish festivity and sporting events which he invariably won. As he aged however, he became increasingly paranoid and spiteful).
-The Chamberlain skekSil (skekSil is the most devious, most notably as his intentions are never fully revealed and seemingly contradictory).
-The Scientist skekTek (the other Skeksis fear him out of ignorance of his work. His fascination with anatomy was very great he went as far as amputating his right arm and leg, replacing them with mechanical constructs).
-The Ritual Master (aka High Priest) skekZok (spearheads the various rituals the Skeksis practice such as the "Ceremony of the Sun", and sees their laws as absolute).
-The The Garthim Master (aka General) skekUng (his constant blundering in the capture of the surviving gelflings fails to evoke the desired respect of his subjects).
-The Gourmand skekAyuk
-The Slave Master skekNa
-The Treasurer skekShod (He frequently bribes the other skeksis into temporarily loaning him their personal possessions).
-The Scroll Keeper (aka Historian) skekOk, (also the most dishonest as he constantly rewrites the Skeksis' history to suit his allegiances and propaganda needs).
-The Ornamentalist skekEkt (skekEkt is nonetheless described in The World of the Dark Crystal as an extremely vain and callous character who would gladly cause the death of countless animals for the sake of fabricating one cloak).
but we wander in our thoughts once more.

Similar to the Skeksis from the Dark Crystal, by preventing the ultimate restructuring  in Europe (which will eventually happen), creative destruction cannot happen in true Schumpeter fashion.

Following a quick overview, we would like to focus once again on the broken credit transmission mechanism in Europe in general and in peripheral countries in particular.

The indicator we have been monitoring, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is falling towards 70%, indicative of the on-going "Risk-On" in risk assets. - source Bloomberg:

The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly receding recently following the Italian elections scare, the red line in the graph being Italian 10 year yields - source Bloomberg:

In similar fashion, this divergence between US equities and Europe equities can be seen in the evolution of VIX versus its European counterpart V2X - source Bloomberg:
The short volatility spike in both the VIX and V2X has clearly receded, with V2X receding from 24 towards 17.

We have been monitoring as well the relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
The significant tightening witnessed this week in credit indices, has led the European High Yield risk gauge to recede towards the lowest points of 2010 and 2011, closing around 405 bps. The benchmark of 50 companies mostly speculative-grade ratings has fallen 47.5 bps this week, the biggest fall since January 4th and the lowest level since July 2011, supported by the US jobless rate and nonfarm payrolls number on Friday coming at 236 K.

But when it comes to the 7.7% unemployment level touched in the US. As far as we are concerned, unless we start seeing both a rise in velocity M2 and the US labor participation rate, we will remain skeptical about the much vaunted US recovery underway - source Bloomberg:
So, you might have 7.7% unemployment level but the US labor participation rate is still trending down and is now at 63.5%, a 32 year low and velocity remains muted. As we argued in our conversation "Zemblanity":
"Does the end (lowering unemployment levels) justify the means (increasing M) or do the means justify the end (deflationary bust)?"

So can someone please demonstrate to us how "this time it is going to be different" in terms of outcome for the US labor market given the "paradox of thrift" with bank reserves sitting idle at the Fed like we indicated in our previous conversation, with a broken transmission to the US economy, and questions surrounding fiscal stimulus which could potentially alleviate the situation (tax breaks for small companies anyone...)?"

Moving back to our Yield Skeksis analogy and relating to "Pareto Efficiency" in a Pareto efficient economic allocation, no one can be made better off without making at least one individual worse off, it is that simple, and the losers today being unfortunately the younger generation in "developed" countries, leading to high unemployment in Europe and lower growth.

We have highlighted the deflationary forces at play in Europe in our shipping conversations, the lack of credit and the broken credit transmission channel have led to poor growth prospects in conjunction with a significant rise in bankruptcies in Europe leading to a continuous rise in unemployment levels. The recovery in exports and shipping which could bring some improving growth prospects for Europe is clearly hindered by unemployment levels - source Bloomberg:
"Unemployment within the euro zone is expected to increase to 11.95% in 2013 from 11.7% in 2012, and to improve slightly to 10.8% by 2015. Lower unemployment is crucial for expanding global demand for goods, keeping capacity loose and rates depressed. The recovery in the shipping industry will not be fully realized without improving unemployment trends."  - source Bloomberg.

But if you think that in this game of survival of the fittest, the prolonged impact has only impacted the greed of  "Yield Skeksis" in a true Pareto efficient way, the QE induced rise in Bunker fuel prices has as well killed off the "velocity" of ships forcing them in essence to adjust their supply chain to survive:
"Slow steaming, or moving slower to conserve fuel, has affected 90% of shippers' supply chains and 85% of them had to make changes to their operations, according to a survey by Centrx and St. Joseph's University. Given the longer transit times, shippers are increasing inventory levels and moving to multiple carriers to gain access to additional departure times." - source Bloomberg.

Courtesy of ZIRP, our Yield Skeksis have seen:
-Falling Yields (in the Dark Crystal movie, originally, Gelflings were most ideal in essence extraction until they were exterminated and Podlings were used in their place, their lifeforce having a temporary effect on the drinker)
-Falling labor participation rate
-Falling velocity

In relation to the European government bond picture, this week Spanish 10 year yields closed around 4.85% and Italian 10 year yields around 4.57% whereas German government yields closed around 1.50% levels - source Bloomberg:

But even the excess liquidity which have been provided to financial institutions via LTRO 1 and LTRO cannot prevent the return at some point of sovereign risk - source Bloomberg:
"Excess euro-zone bank liquidity, defined as ECB current and deposit accounts less reserve requirements and marginal lending, drove falling yields and improved bank liquidity from late 2011. Current concerns on Italian political instability and delivery on austerity targets demonstrate that while retained LTRO funds continue to ensure adequate liquidity, bond yields and bank funding costs may rise again. Excess liquidity in the euro-area banking system fell below 400 billion euros for the first time since December 2011, when the first ECB long-term refinancing operation (LTRO) was announced and disbursed. Collectively, 224.7 billion euros of LTRO I and II have been repaid since the end of January. If excess liquidity falls further, scrutiny will likely fall on Euribor, EONIA and other liquidity-cost indicators. - source Bloomberg

Moving on to the subject of the broken credit transmission mechanism in Europe in general and in peripheral countries in particular, we have long argued that LTRO liquidity injections amounted to "Money for Nothing". 

Only 61 billion of Euros came back to the ECB relating to the second tranche of the LTRO, indicative on the  cautious stance of financial institutions in peripheral countries, which had been the biggest beneficiary. This is not really a surprise given that Italian banks for instance are seeing a steady rise in bad loans as the political gridlock is staving growth in the process. This is clearly indicated by Sonia Sirletti and Fabio Benedetti-Valentini in their Bloomberg article from the 7th of March entitled - Italian Banks' Bad Loans Seen Rising as Gridlock Hampers Growth:
"Italian corporate and household non-performing loans rose to a record in December, reaching 125 billion euros, according to data from the Italian Banking Association. Banks’ gross non-performing loans as a proportion of total lending increased to 6.3 percent from 5.4 percent a year earlier. France’s BNP Paribas SA, which owns a retail bank and consumer credit unit in Italy, and Credit Agricole SA reported higher bad-loan provisions from their Italian branch networks in the fourth quarter. 
Italy’s central bank has increased inspections and is urging banks to take more provisions. “In periods of market tension, the intensity of supervision cannot be relaxed,” Governor Ignazio Visco said in a speech on Feb. 9. “The Bank of Italy review of the top 25 banks likely means an increase in non-performing loans coverage” in the fourth quarter, Francesca Tondi, an analyst at Morgan Stanley, wrote in a report March 6. “We think 2013 accounts will also be affected by still-growing NPLs and the need for more coverage. 

Sovereign Debt:
UniCredit shares as much as doubled in Milan trading, and Intesa surged as much as 73 percent, after European Central Bank President Mario Draghi’s July pledge to do “whatever it takes” to defend the euro. Those gains began to erode over the past month as Italian government borrowing costs increased in the run-up to the elections. “Any renewed rise in funding costs would be the equivalent of a tightening in monetary conditions, with the potential to slow the economy,” Credit Suisse Group AG analysts including Yiagos Alexopoulos and Christel Aranda-Hassel said in a note last week. Italian banks tied their fortunes more closely to the financial strength of the state in 2012, increasing holdings of the country’s sovereign debt by 58 percent to 331 billion euros. Italy has 2 trillion euros of debt, more as a share of its economy than any developed nation other than Greece and Japan.” - source Bloomberg

This provision pressure on Italian banks can already be seen in the growing spread difference between German, and Italian Corporate loans with costs widening - source Bloomberg:
"The cost of accessing a corporate loan in Italy is nearly 1.5% higher than the equivalent in Germany. In mid-2011, Italian new loans were priced more cheaply than Germany's and since 3Q12, new corporate lending in Italy has cost more than in Spain. Coupled with lower repayment of LTROs by Italian banks than witnessed in Spain and political turmoil, the outlook for credit costs and supply in Italy is deteriorating." - source Bloomberg.

But it is not only Italy which is stricken by this broken credit mechanism transmission to the real economy. Spain has well is facing similar issues of significant rising corporate loan costs - source Bloomberg:
"The cost of a new corporate loan in Spain of more than 1 million euros for a duration of one to five years reached a four-year high in January, underlining how supply and cost of credit to Spain's corporates remains a source of concern. While IMF analysis suggests significant progress has been made on reform, and anecdotal evidence suggests that the domestic deposit war may soon come to an end, supply of credit remains poor." - source Bloomberg

According to Bloomberg, Rates on consumer credit loans up to one year in duration fell 0.8% in Spain and 0.4% in Italy during December but not enough to offset the pressure coming from rising nonperforming loans.

As we posited in January 2013 in our conversation "Cool Hand", the Bank of Spain has been revisiting the introduction of caps to time deposit rates in order to reduce the deposit war which started in 2012. While there is no doubt, early signs, of some sort of ceasefire, as indicated by Bloomberg. The lower than anticipated refund of the LTRO in conjunctions with rising nonperforming loans, might not be enough to increase credit access to the real economy - source Bloomberg:

"Interest rates on new spanish household deposits, with less than one year maturity, fell more than 50 bps to 2.43% in January, the biggest absolute drop for four years. Following five straight months of growth in deposits with an agreed maturity, this hints at improving liquidity and banking conditions following many months of bank restructuring and reform." - source Bloomberg.

The fall to 2.43% is the biggest monthly decline since Bank of Spain records began in 2003.

Truth is when it comes to the deleveraging process for European financial institutions, much more is needed when one looks at the level of Loans to Deposits as indicated by Morgan Stanley in their note from the 1st of March on European Banks:

Credit wised, the Loan-to-bond refinancing, or disintermediation, is another growth driver in European High Yield markets as European banks tighten lending conditions. According to Bloomberg, analysis shows 50% of funding in Europe from loans vs 40% in U.S. so while banks are in retrenching mode, companies are switching to the bond market rather that asking banks for loans with the stringent covenants normally attached to bank loans:

After all our the greed of our "Yield Skeksis" knows no bound and if ones looks at CLO demand for AAA  rated portions, one could see that the average spread on institutional loans was 377.6 basis points last month, down from 515 at the end of June 2012, as reported by Bloomberg and according to S&P Capital IQ Leveraged Commentary and Data.

Back in 2007 the tightest level was 243.3 basis points. On top of that and according to Bloomberg, borrowers obtained more than $88 billion in loans last month from non-bank lenders, exceeding the pre-crisis peak of $55 billion in April 2007 and more than tripling the $26.7 billion received in January, according to JPMorgan Chase & Co. More than 80 percent of the loans made this year were used to reduce borrowing costs or extend maturities.
On top of that ZIRP engineered by the Fed has managed to raise the level of corporate takeovers to 86.6 billion dollars in the US in February, the busiest month since July 2008 according to data compiled by Bloomberg.

Given the appetite of our Yield Skeksis it remains to be seen how low spread can go in order for them to replenish their level of "energy", but that's another credit bubble story, we think.

"It is greed to do all the talking but not to want to listen at all." - Democritus

Stay tuned!

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