Saturday, 30 March 2013

Credit - Gunfight at the O.K. Corralito

"Peace cannot be kept by force; it can only be achieved by understanding." - Albert Einstein 

Looking at the evolution in Cyprus, reminiscent of Argentina's 2001 "Corralito", which eventually led to its default, we thought this week it would be entertaining to use in our title, yet other multi-dimensional references as per last week conversation "The Doubt in the Shadow". 

Our first reference is of course the "Gunfight at the O.K. Corral" which took place on the 26th of October 1881 in Tombstone Arizona, and is generally regarded as the most famous gunfight in the history of the American Old West. Arguably our European Gunfight at the O.K. Corralito, will no doubt be regarded as the most infamous "deposit-levy" fight in "Old Europe's history". The O.K. Corral gunfight represented a time in American history where the frontier was open range for outlaws (tax havens) opposed by law enforcement that was spread thin over vast territories (Europe), leaving some areas unprotected (Cyprus). In similar fashion, the lack of a true European Banking Union from inception of the European project, means, that given the European banking sector's  leverage and thin equity buffers, the depositors can rightly feel unprotected. Yes, we know, on the 29th of June 2012, European leaders expressed their determination to "break the vicious circle between banks and sovereigns". The initial statement focused on the establishment of a "Single Supervisory Mechanism" (SSM) which would pave the way to direct recapitalization of banks by the ESM (European Stability Mechanism). This banking union would not just cover the Eurozone initially but would also be open to the soon to be 28 members of the EU (with Croatia being the next joiner), if they choose to join.

Our second reference is of course, Argentina's 2001 Corralito, which has been recently reenacted in October 2012, limiting ATM withdrawals for Argentinians. The Corralito was the informal name taken by Minister of Economy Domingo Cavallo's economic measures in order to stop bank runs in Argentina. It was not very successful...

Our third reference, is less so evident, but nonetheless, entertaining we think, given the famous Gunfight at O.K. Corral, also gave its name to a mathematical model - The Ok Corral and the Power of the Law (A Curious Poisson-Kernel Formula for a Parabolic Equation) by David Williams and Paul Mcilroy submitted in 1998:
"Two lines of gunmen face each other, there being initially m on one side,n on the other. Each person involved is a hopeless shot, but keeps firing at the enemy until either he himself is killed or there is no one left on the other side. Let μ(mn) be the expected number of survivors. Clearly, we have boundary conditions:
FormulaWe also have the equationFormulaThis is because the probability that the first successful shot is made by the side with m gunmen is m/(m + n). On using the recurrence relation (1.2) together with the boundary condition (1.1), the computer produces Table 1 below, in whichFormula1991 Mathematics Subject Classification 60F05."

In similar fashion each European politician involved in our European Gunfight at the O.K. Corralito is as well a "hopeless shot" but keeps firing (or making blunders that is) until either he himself is killed (or his country's economy) or there is no one left on the other side (we have yet to see an Italian government...). Of course there is an elegant solution to this mathematical model - Solution to the OK Corral model via decoupling of Friedman's urn by J.F.C. Kingman and S.E. Volkov. Just for an illustration, the authors presented the probability that exactly 5 gunmen would survive provided there were initially 20 on both sides. 

We will let you mathematically work out in your own time how many  "hopeless shot European gunmen" will survive this "European O.K. Corralito gunfight" given than they will soon be 28 countries in the European Union, 14 on each side, but, as usual, we ramble again...

While in the last two credit posts we focused our attention on the lack of equity buffers (Dumb Buffers and The Doubt in the Shadow), in this week's conversation we would like to direct our attention to the "unintended consequences" of the Gunfight at the O.K. Corralito given that, in true "Zemblanity" fashion. (Zemblanity being defined as "The inexorable discovery of what we don't want to know"), there will indeed be casualties, and most likely in the peripheral banking space that is, with rising nonperforming loans due to lack of economic growth, thin equity buffers and high loan-to-deposit ratios and soon to happen deposit flights.

Although the intentions of the European Union has been to severe the link between financials and sovereigns with a move towards a European Banking Union, the ban on naked Sovereign CDS imposed on the 1st of November has effectively killed the Itraxx SOVx 5 year index market for good. This market had been trading closely to Itraxx Financial Senior 5 year index in the past (25 European banks and insurance single names CDS). Financial spreads have been as of late on the receiving end of the widening move in cash and CDS markets courtesy of discussions surroundings "bail-in" procedures  from one of the European gunmen (Jeroen Dijsselbloem). 

The EU Recovery and Resolution Directive proposes an orderly introduction of bondholder write-downs, with the bail-in tool set for implementation in 2018 but it looks like our lone gunman is trigger happy and ready to shoot early in the gunfight . Graph below SOVx versus Itraxx Financial Senior 5 year index since March 2011 -  source Bloomberg:
"27 February 2013 - The Markit iTraxx SovX Western Europe index will not roll into Series 9 in March 2013 due to low trading activity as recorded by the DTCC Section IV: Market Risk Transaction Activity data. Series 8 will remain on-the-run." - source Itraxx Markit

While Cyprus replaced Greece has a member of the SOVx index back in 2012, the only remaining series, will remain at 14 for the foreseeable future for lack of liquidity, or lack of market thereof:
Goodbye SOVx CDS market...

Financials have no doubt been the early casualties of the European Gunfight at O.K. Corralito, when one looks at the increasing divergence between the Itraxx Main Europe 5 year CDS (risk gauge for non-financial Investment Grade European Credit)  versus the Itraxx Financials 5 year CDS index - source Bloomberg:
In fact, CDS insuring against default on European financials have risen for 10 days in a row, the longest streak since August 2011, closing on the 28th of March towards the 205 bps, heading for its worst month since November 2011.

Of course in the financials space CDS wise, the Itraxx Financial Subordinated index (indicative of the risk gauge for subordinated debt, in the direct line of fire for bank recapitalization as per the SNS case...) took a pounding as well in this European Gunfight and widening towards 325 bps versus 205 bps for the Itraxx Financial Senior 5 year CDS index. - source Bloomberg:
Back in February in our conversation "House of pain and House of cards" we argued  the following in relation to the SNS case which saw subordinated debt totally wiped-out by the Dutch government:
"If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS."

We were glad to see Matt King from CITI joining our concerns in his note on the 15th of March entitled "Behold the new form of bail-in":
"The CDS trade has the additional advantage that not only are losses at senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out, because of a lack of deliverables. With sub/senior relationships still trading pretty much in line with their long-term averages, this does not seem yet to be priced in (chart below).
Perhaps the SNS auction next week (which is likely to confirm sub recoveries of zero) will be sufficient to give trading a jolt, a result which seems quite likely if there are eventually auctions on Laiki Bank or Bank of Cyprus CDS.5 Conceivably it may take longer: as with many factors in the current outlook, we fear the potential for discontinuities even as the market fails to react today — a sort of “ball in a bowl” phenomenon.6 But even if it takes a while, we think the bailin of bank bondholders on one small island today is ultimately likely to have significance far greater than its size suggests." - source CITI

The recent  "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS.  Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...

Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:
 The spread between both volatility risk gauges has been rising steadily since December, closing towards 8.60 but has yet reached its 2011 record of nearly 15.

Of course the obvious "unintended consequences" of the Gunfight at the O.K. Corralito, should be that depositors will think about spreading their wealth across banks to ensure they are below the 100,000 euros "implicit guaranteed" threshold - Euro deposits table, source Bloomberg:
"A key positive of the restructured solution for Cyprus is the underpinning of the 100,000 euro deposit insurance scheme, explicitly noted in the release. A consequence of the decision to use uninsured deposits along with equity and bond instruments to part-fund the recapitalization of Bank of Cyprus may be depositors spreading money across banks to ensure they don't exceed the threshold at any one lender." - source Bloomberg.

And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.

In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.

We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia

Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.

For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch

As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:

"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.

And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and 
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February

But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.

So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg

It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
Oh well...

The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:

"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.

One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.

On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:

"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.
"The Bank of England warned expected losses from high-risk loan portfolios, including U.K. commercial real estate and euro zone exposure, could exceed existing provisions at major banks by about 30 billion pounds ($45 billion) in the next three years. Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.

What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"

"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.

Stay tuned!

Wednesday, 27 March 2013

Cross-asset credit/volatility in Europe and movements in financial spreads

"Now the reason the enlightened prince and the wise general conquer the enemy whenever they move and their achievements surpass those of ordinary men is foreknowledge." - Sun Tzu 

Following the events in Cyprus and in particular the harsh conversations which followed surrounding bail-in procedures, we have seen an increasing pressure on financial CDS spreads relative to High Yield and relative to Investment Grade Non-financial spreads - chart source Bloomberg:
In blue - Itraxx Financial Senior 5 year CDS index representive of risk perception for European financials.
In red Itraxx Crossover 5 year index representative of high yield risk gauge in Europe.
Both indices have been adjusted for the roll which happens every 6 months.

As pointed out by our good cross-asset friend, in terms of cross-asset credit/volatility, recent historical regressions are perfectly in line between the Itraxx Crossover and the Eurostoxx 50 volatility.
Eurostoxx 50 volatility and Itraxx Crossover spreads are perfectly inline based on 1 year historical data.

One can see in a similar analysis that there is a clear underperformance of European financial spreads based on the Itraxx Financial Senior index versus the Eurostoxx 50 volatility level (1 year at the money):
Itraxx Financial Senior index versus Eurostoxx 50 1 year at the money volatility.

Spread between the Itraxx Financial Senior 5 year CDS index versus the theoretical Itraxx Financial Senior (recalculated via regression with 1 year volatility Eurostoxx 50):
As displayed in the above graph, Itraxx Financial Senior spreads are wide versus Equities volatility.

It seems that Eurostoxx 50 volatility is relatively cheap versus the Itraxx Financial Senior CDS spreads.

"Opportunities multiply as they are seized" - Sun Tzu

Stay tuned!

Saturday, 23 March 2013

Credit - The Doubt in the Shadow‏

"Truth is beautiful, without doubt; but so are lies." - Ralph Waldo Emerson, American poet.

Looking at the deposit-levy fallout in Cyprus and the rising concerns about the sanctity of European deposits as whole, we thought this week that our title analogy should be on two levels.

Our title is first and foremost a veiled reference to the 1943 Alfred Hitchcock movie "Shadow of a Doubt".

Let us explain our "twisted" analogy. In the movie, Charlotte "Charlie" Newton always complained that nothing seemed to be happening in her life until her uncle Charlie Oakley paid her a visit (the European Troika). Charlie Oakley, in the movie is suspected of being a serial killer known as the "Merry Widow Murderer", who seduces, steals from, and murders wealthy widows. At first young Charlie refused to even consider the police's claims that her uncle is the man they are looking for. Her suspicion grows, and her uncle finally spilled the beans and admitted to her that he was the man the police were looking for aka the serial killer. He begged her for help and she resigned herself to keep the horrible scandal secret in order to avoid her family being destroyed (the European Union). Uncle Charlie is delighted in the movie to be off the hook, but, knowing that young Charlie knows all his secrets, he decided to get rid of her. In Hitchcock's movie, Uncle Charlie failed the assassination attempt on his niece and died. But, young Charlie ended up resolved to keep her uncle's crimes secret in the end.

Of course, the first level of our analogy with the deposit-levy and capital control imposed in Cyprus by the European Troika visit is purely fortuitous, but, the second level of this week's title analogy resides in the doubts we have in shadow banking in general, and banks' capital in particular, in continuation of last week's conversation "Dumb Buffers".

We have regularly indicated that, like any good behavioral therapist, we always prefer to focus on the process rather than the content. 

In relation to the Cyprus outrage on the deposit-levy, we think it is entirely "misdirected". What the outrage should be all about is that, as we posited last week, (and in agreement with Bloomberg editors views, Simon Johnson, the MIT professor and Stanford University professor Anat R. Admati), the lack of sufficient equity buffers in banks, means no doubt, that banks are indeed the "serial economic killers" of this world, or "Merry Widow Murderers". As indicated by Ben Moshinsky in his Bloomberg article "Big Banks had $269.2 Billion Basel III Shortfall in Mid-2012":
"The largest global banks would have needed an extra 208.2 billion euros ($269.2 billion) in their core reserves to meet so-called Basel III capital rules had the standards been enforced in June 2012, increasing capital levels by about 166 billion euros from the end of the previous year.
Global banks also had an average leverage ratio of 3.8 percent versus a target of 3 percent ratio for banks’ equity to debt, the Basel Committee on Banking Supervision said today in a statement on its website. The Basel measures are scheduled to be phased in by 2019.“The Committee appreciates the significant efforts
contributed by both banks and national supervisors to this ongoing data collection exercise,” the Basel group said.
Global regulators have clashed with lenders over the severity of the capital and liquidity rules, which were set out in 2010 as part of an overhaul of banking regulation in the wake of the financial crisis that followed the collapse of Lehman Brothers Holdings Inc. The Basel III measures will more than triple the core capital that lenders must hold to at least 7 percent of their assets, weighted for risk.
The biggest lenders in Europe would have needed a combined 112.4 billion euros to reach the core tier one capital target of 7 percent, the European Banking Authority said in a separate statement today.
Both the EU and the U.S. missed a January 2013 deadline to begin phasing in the standards, and have said they will seek to apply them from next year.
The lenders surveyed also needed a combined 2.4 trillion euros to meet another liquidity rule set by the Basel committee, which would force banks to back long-term lending with funds that are unlikely to dry up in a crisis.
Banks can address shortfalls in meeting capital requirements by either boosting their reserves or by reducing their assets weighed for risk. "

And, in similar fashion to Uncle Charlie in Hitchcock's movie, the Charlie Oakleys of this world, namely  banks, have indeed been let off the proverbial hook.

This week we will again focus our attention on the banking sector in particular. 

In October 2011, we argued that the markets were long hope and short faith, we also looked at bank recapitalization and in particular professor Anat R. Admati's work. 
On numerous occasions she voiced her opinion on the lack of equity buffer for banks. Specifically she wrote a column in Bloomberg on the 25th of February 2011 on that very subject entitled - "Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati":
"While equity is used extensively to fund productive business, bankers hate to use it. With more equity, banks have to “own” not only the upside but also more of the downside of the risks they take. They have to provide a cushion at their own expense to reduce the risk of default, rather than rely on insurers and eventually taxpayers to protect them and their creditors if things don’t work out.

Fixation with return on equity also contributes to bankers’ love of leverage because higher leverage mechanically increases ROE, whether or not true value is generated. This is because higher leverage increases the risk of equity, and thus its required return. Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity."

Truth is bank debt is indeed a much larger universe than equity, no question there in the capital structure in the banking space:
"However, bank shareholders’ equity represents typically just around 5% of total balance sheet and c. 25% of investable liabilities. Other main investable liabilities include Basel 3 compliant Alternative Tier 1 (eg, including some contingent convertibles (Cocos)), Basel 3 compliant Tier 2 (including some former hybrids), non-Basel 3-qualifying subordinated debt (some former hybrids that counted as Tier 1 or upper/lower Tier 2 (LT2) debt under Basel 2.5), senior unsecured debt and covered bonds. Future resolution legislation could lead to the creation of new classes of ‘bail-inable’ debt." - source Nomura, European Banks - Navigating the liabilities - 30th of November 2012.

Anat Admati concluded her Bloomberg column of 2011 by adding:

"The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas."

In addition to the delays in implementing much needed regulations, banks have been using CDS to lower their capital requirements, as indicated by Jim Brundsen in a Bloomberg article from the 22nd of March entitled - Banks' Use of CDS to Lower Capital Targeted by Basel Regulators:
"Global regulators are planning to crack down on banks that underestimate their capital requirements because of the way they use credit-default swaps and other instruments to lower the amount of risk on their books.
The Basel Committee on Banking Supervision said today that it would seek to stop banks from lowering capital charges by buying instruments such as CDS to insure themselves against losses, while failing to recognize the large liabilities they incur from what they pay for this protection, the group said in a statement on its website.
“The proposed changes are intended to ensure that the costs, and not just the benefits of purchased credit protection are appropriately recognized in regulatory capital,” the Basel, Switzerland-based group of international regulators said in a statement. There exists a “potential for capital arbitrage” as banks can book the benefits of these deals without also booking the associated costs, the group said.
The measure is one of many developed by global regulators to bolster banks’ solvency after the financial crisis. For banks, such credit-protection transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules.
Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry.
Blackstone Group LP, the world’s largest private-equity firm, last year insured Citigroup Inc. against any initial losses on a $1.2 billion pool of shipping loans. The regulatory capital trade, Blackstone’s first, let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, according to two people with knowledge of the transaction." - source Bloomberg

On top of the use of CDS to massage "capital requirements", the 2012 losses from JP Morgan CIO office also shows the inefficiency of the enforcement of the 2010 Dodd-Frank Act derivatives rule given the lack of transparency and clarity of the information received by the CFTC (Commodity and Futures Trading Commission) from the repositories such as the DTCC (Depository Trust and Clearing Corp) as reported by Silla Brush on the 19th of March in Bloomberg - Dodd-Frank Swap Data Fails to Catch JPMorgan Whale, O’Malia Says:
"Swap-trade data the agency has been receiving since the end of last year from repositories including the Depository Trust and Clearing Corp. is inadequate to identify large positions and have overwhelmed government computer systems, O’Malia said in a speech prepared for a Securities Industry and Financial Markets Association conference in Phoenix.
The data “is not usable in its current form,” said O’Malia, 45, one of the agency’s five commissioners. “The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.” JP Morgan, regarded on Wall Street as one of the best- managed banks in the world, lost more than $6.2 billion last year in a derivatives bet on companies’ creditworthiness that reached a net notional value of $157 billion.
Dodd-Frank was enacted in part to give regulators better oversight of the $639 trillion global swaps market after largely unregulated trades help fuel the 2008 credit crisis. The CFTC and Securities and Exchange Commission were granted authority to write rules requiring trade information to be reported to so-called swap data repositories that function as central record keepers." - source Bloomberg

O'Malia also added in the same article:
"“It means that for each category of swap identified by the 70-plus reporting swap dealers, those swaps will be reported in 70-plus different data formats because each swap dealer has its own proprietary data format it uses in its internal systems,” he said. “The permutations of data language are staggering. Doesn’t that sound like a reporting nightmare?” The CFTC’s computer systems are failing to handle the incoming data. “None of our computer programs load this data without crashing,” O’Malia said."

Hence our "doubt in the shadow" reference in our title. Oh well...

One of our recurring themes in our numerous conversations has been around the "accounting tricks" which have been played by banks in relation to capital requirements. The June 2011 Basel 3 monitoring exercise by the EBA showed that large European banks were short of EUR 242 billion of capital to meet CET1 requirements including the G-SIB surcharge (The regulations require a further 1.5% of ‘Additional Tier 1’ plus a further 2.0% of Tier 2, for Global Systemically Important Banks).

Of course reaching the overly ambitious targets for June 2012 have meant credit contraction in peripheral countries such as Portugal where Portuguese banks are still on "IV" (Intravenous therapy) support from the ECB as reported by Anabela Reis in Bloomberg on March 20 - Portuguese Banks Stay Hooked on ECB Feeding Cash:
"ECB lending slipped to 49.51 billion euros ($64 billion) last month, down 0.4 percent from January, the Bank of Portugal said on March 12. While that was the least in a year, ECB money still accounts for a larger proportion of the financial industry’s assets in Portugal than Ireland, the epicenter of the euro region’s worst banking crisis to date. The ECB’s credit line to Portuguese banks in January was 49.7 billion euros, or 9 percent of their total assets, according to central bank data compiled by Bloomberg. Spain relies on the funding for 9.9 percent of its assets, with the figure 6.1 percent in Ireland."
The ECB provided 841 billion euros of emergency funding to periphery banks at the end of January, according to the latest central bank data available. That’s down from a peak of 977 billion euros in August as reported by Bloomberg.

The on-going deleveraging - source Morgan Stanley Research:

European banks are indeed trying to clean up their balance sheets, spreading, no doubt the cost across shareholders (debt-to-equity swaps, or right issues such as the recent one announced by the second largest German bank Commerzbank with its equity share tanking by 17% in the process), bondholders (bond tenders or junior subordinated debt wipe-outs such as SNS) and now even with depositors (Cyprus).

As a reminder, here are a few illustrations of some of these accounting tricks enabling either boosting capital requirements or boosting earnings which we have discussed in the past.

Liability management:
Banks may have an incentive to buy back non-compliant Basel 2.5 hybrids that do not qualify as regulatory capital under Basel 3. To the extent that such "liability management exercises" can result in debt being repurchased at a discount to par (well below a cash price of 100), banks are able to generate common equity Tier 1 (CET1) gains. On that subject see our October 2011 conversation "Subordinated debt-love me tender?".
Recently Spanish banking giant Santander has been trying to get junior bondholders to contribute to the balance sheet clean-up of its liability structure but not encountering the same level of success it had in 2012. We illustrated the game played by Santander in our August 2012 conversation "Banker's algorithm":
"Credit wise, while in our last conversation "Desperado" on the 21st of August  we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000." - source Macronomics
While bond tenders for Santander were so "2012ish", it ain't so much in 2013 given that the acceptance level of the recent proposed "hair cut" on the main GBP/Eur part of the bond tender offer was only 7% in aggregate with sterling bond holders more eager to get the "shaving" treatment with 30% accepting the proposed terms according to CreditSights in their recent Euro Financial Movers report from the 17th of March 2013 - The Week Before Cyprus.

Goodwill write-downs and the beauty of tax credits:
Back in 2012 we indicated that BBVA took a Goodwill impairment charge of 1.5 billion euros in January 2012, which according to CreditSights counter-intuitively helps improved its regulatory capital by generating an immediate tax credit:
"The 400 million Euros tax credit is offset against current taxation and relates to a gross goodwill impairment charge of about 1.5 billion euros rather than 1.1 billion euros, because of rounding differences. 400 million euros equates to an increase in retained earnings flowing into Core Tier One versus the retained earnings that would have been achieved without the goodwill impairment of the tax credit. This is because the gross impairment of 1.5 billion euros does not affect Core Tier 1, since all outstanding goodwill is already discounted in the regulatory number, even though in accounting terms, shareholders'equity will be negatively affected on the balance sheet. The benefit in ratio terms is 14-15 bps worth of Core Tier 1(which stood at euros 25,979 million at 30 September under the EBA Criteria).
Our understanding is that BBVA will be able to offset this against tax payable for the whole of 2011. Although a tax charge is accrued quarterly in the P&L, it is actually paid on an annual basis, so the lack of sufficient pre-tax earnings in the fourth quarter alone should not prevent the group from offsetting the 400 millions euros against the tax that will be payable on the full-year 2011 earnings."

While it was a Spanish trick in 2012, in 2013 it is an interesting Italian trick. Unicredit in its 4Q12 earnings statement reported losses at -€553m vs. -€173m company's gathered consensus it could have been much worse:
"Goodwill tax redemption (DTAs) saves the day:
The results were marked by a very high credit loss charge at €4.6bn which was however partly offset by c. €2bn goodwill tax redemption. Lower yoy costs were a positive but management guided to a flattish 12-13 cost line. In 4Q12 revenues dropped a significant 6% yoy and qoq (NII >€200m lower qoq)" - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013

So, no earnings mean no Goodwill impairment impact on earnings and a "convenient tax credit" in conjunction with an improved regulatory capital:

"Losses at -€553m were worse than expectations but capital impact was contained with a B3 fully phased common equity at 9.2% (9.3% in 3Q12) while B2.5 core tier I was slightly higher. UCG was able to offset a high credit charge at -€4.6bn with DTA generated by the goodwill tax redemption (€2bn = €3.9bn – €1.9bn substitute tax).
Capital position:
Basel 2.5 core Tier 1 improved to 10.84% despite a negative earnings impact (-17bps) thanks to lower RWA (+24bps) and other actions at 10bps. The bank stated to be at 9.2% fully-phased Basle 3 lower than in 3Q12 (9.3%) probably on account of higher DTA deductions. " - source Bank of America Merrill Lynch - Alberto Cordara - The Cost of deleveraging - 18th of March 2013
For more on goodwill, see our post from November 2011 - Goodwill Hunting Redux.

Earnings boosting techniques - FAS 159:
In July 2010 we commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"
"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

And  we wrote more on the subject in October 2011 - For whom the vol tolls and the return of FAS 159.
Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
"To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses." - Credit Agricole Securities USA analyst Michael Mayo
Any similarities to today's situation are of course purely fortuitous. As a reminder from David Hendler, Senior Analyst from CreditSights did sum it up nicely in the same Bloomberg article around FAS 159:

"When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much." 
Of course the on-going discussions surrounding the most recent tool in liability management being deposits, the risk of letting the genie out of the bottle is raising fears of contagion across Portugal and Spain as indicated by Bloomberg:

"A controversial bank-deposit levy to raise 5.8 billion euros ($7.5 billion) of a 10 billion euro Cypriot rescue package raised fears of bank runs across Southern euro zone nations. While the proposed 6.75% levy on deposits of 100,000 euros or less may be amended to shift a greater burden to larger accounts, it could still prompt deposit runs in Portugal or Spain. That would drive CDS levels higher, raising funding costs for both sovereigns and banks." -source Bloomberg.

A total of 378 billion euros was pulled from banks in so-called peripheral countries -- Ireland, Spain, Portugal, Greece and Italy -- in the 13 months through August, according to data compiled by Bloomberg. 

But the Cyprus situation is not unique: 
"In 2011, Denmark became the first EU nation to bail-in bank depositors when it forced some Amagerbanken A/S savers and senior creditors to share losses. While the move affected only depositors holding more than the EU insurance limit, it left its mark on Danish banks by increasing borrowing costs.Outside the EU, Iceland decided to pay domestic depositors only after the country allowed its banks to fail, leaving out about $5 billion of deposits collected in the U.K. and the Netherlands. The British and Dutch governments made depositors in those countries whole and demanded payment from Iceland.
The almost blanket protection of depositors has been one reason withdrawals from banks in the periphery haven’t soared. Another is higher interest rates paid on deposits. Lenders in those countries and Cyprus are paying customers 3 percent to 5 percent interest on savings, compared with about 1 percent by German banks and 0.5 percent in Belgium, according to ECB data." - source Bloomberg - EU Getting Closer to Bank Union Fails to Help Cyprus Crisis.

Talking about regulations and banks, being "serial economic killers" in true Charlie Oakley fashion, although Denmark was the first EU nation to imposed bail-in, the lack of equity buffers in banks are indeed a serious threat even for Denmark given Danish borrowers are starting to struggle on their interest-only mortgages with a deepening property slump as reported by Frances Schwartzkopff on the 19th of March in Bloomberg - Denmark Races to Prevent Foreclosures as Home Prices Sink:
"The Association of Danish Mortgage Banks and the Mortgage Bankers’ Federation are due to start talks with Business Minister Annette Vilhelmsen to decide how to treat borrowers who won’t be able to afford the interest-only loans they took out a decade ago once amortization requirements kick in this year.
Borrowers are also struggling as a deepening property slump drives house prices down to 2005 levels.
Eighty percent of homeowners under 35 years of age are under water. That’s a lot,” Curt Liliegreen, head of the Center for Housing Economics in Copenhagen, said yesterday in a telephone interview. “This is a problem that threatens the Danish economy.”
Denmark’s housing crisis, which started when the nation’s property bubble burst in 2008, is showing signs of deepening. Prices sank 2.8 percent last quarter from a year earlier, the two mortgage groups said yesterday. More than 100,000 households will need to have special terms negotiated if they are to meet their loan obligations, according to a February study by the University of Southern Denmark." - source Bloomberg.

We have argued in a 2011 conversation that the policy of achieving a high home ownership rate is the biggest threat to an economy:
"The issue with enticing a high home ownership rate is the level of household debt it generates. It can be argued that the most toxic of all bubbles is a housing/property bubble. They also always generate a financial crisis when they burst due to the leverage at play. How the risk can be mitigated? By forcing players to have more skin in the game.
Recently Sweden passed a law limitating the maximum Loan to Value (LTV) to 85%. In effect, Swedish people will need to put down a minimum of 15% of deposits to borrow 85% of the remainder."

More recently the prudent Swedish Central bank has entered into a direct confrontation with the Swedish bank regulators over macro-prudential supervision as indicated in a Bloomberg article on the 22nd - Swedish Banks Find Ally in FSA Warning Against Risk-Weight Race
"Sweden’s financial watchdog cautioned against a central bank proposal to consider raising risk weights from levels announced less than half a year ago.
Riksbank Governor Stefan Ingves said earlier this week Sweden should consider increasing risk weights on mortgage assets to more than the 15 percent proposed by the regulator in November. The Financial Supervisory Authority’s target, which is three times existing levels, is due to become effective later this year.“We don’t today see any reason to immediately touch these,” Martin Andersson, director-general at the FSA, said in an interview in Stockholm. “To make lots of changes and then make changes to the changes before anyone has had a chance to evaluate them and before we’ve even had time to implement these I think is to run a bit too fast.” The watchdog, which has argued against proposals to hand over macro-prudential supervision to the central bank, has defended stricter bank capital standards than those set elsewhere as Sweden tries to shield taxpayers from the risk of losses. The biggest Swedish banks, whose combined assets are four times the size of the economy, must set aside at least 12 percent core Tier 1 capital of their risk-weighted assets by 2015.
The FSA in 2010 reacted to signs of excessive credit growth by imposing an 85 percent cap on loan-to-value ratios. The regulator has also warned it is ready to do more should the need arise. Measures to date have started to work and credit growth slowed to 4.5 percent in January, compared with a peak of 13.2 percent in March 2006. " - source Bloomberg

In our 2011 conversation relating to housing we also said:
"One could argue, that home ownership should not be recklessly encouraged by politicians as it does appear to be a "Weapon of Economic Destruction" (WED). If people are struggling to raise large deposits required to secure a mortage, should the government encourage them to leverage too far in the first place? The recent credit bubble burst in the US and the subprime debacle, highlights the dangerous results in the incestual relationship between politicians and banks, and the promotion of the "American Dream" at all cost."

The housing bubble in Europe - source Nomura - EU Banks Macro Hedging, March 11th 2013

In relation to Sweden's housing market, and the previously quoted Bloomberg article:
"Though the real estate market has cooled in the past two  years, property prices have soared about 25 percent since 2006. That has fanned speculation the market may be overstretched, making households vulnerable to interest rate increases. Ingves signaled last month his bank may start raising rates next year. Swedish home prices could fall by as much as 10 percent in the next 18 to 24 months, Jens Hallen, director for financial institutions at Fitch Ratings, said last month.
Ingves has also discussed introducing other measures to cool the housing market, including requiring borrowers to amortize their mortgages. A March report by the FSA showed that the average Swedish household needs 140 years to pay down its home loan." - source Bloomberg

Lessons learned?
Quite frankly no, when one looks at the latest proposal from the United Kingdom Chancellor of the Exchequer George Osborne as reported by Bloomberg on the 21st of March - Cameron Unsettled by Housing in Austerity Offers Aid: Mortgages:
"Osborne yesterday pledged 3.5 billion pounds ($5.3 billion) to help buyers of new homes with loans of as much as 20 percent of the property’s value, broadening an existing program beyond first-time purchasers. He also announced a plan to guarantee as much as 130 billion pounds of new mortgages to fuel demand from purchasers with limited cash for a deposit."

From the same Bloomberg article:
"Osborne’s Help to Buy program will provide potential buyers equity loans for newly built homes worth up to 600,000 pounds starting in April. The program lasts three years. It also offers guarantees to support 130 billion pounds of mortgages for existing and newly built homes. Under the program, which starts in 2014 and runs for three years, lenders can buy a state guarantee that compensates part of their losses in the event of foreclosure, and the government will charge a fee for the assurance."

This is pure madness and will end up in tears. 

We completely agree with a recent Gavekal note on this subject from Anatole Kaletsky: 
"This is akin to creating a British equivalent to Fannie Mae mortgages to offer equivalent sub-prime loans. The government whose excessive prudence has discouraged banks from offering mortgages worth more than 75% of a home’s value, will now guarantee borrowers who have a 5% deposit the additional 20% loans they need to qualify. In doing this, the Treasury will expose itself to any falls in house prices beyond 5%—and this exposure will not be included in national debt statistics. In short, Britain will imitate the off-balance sheet financing of Fannie Mae that helped to trigger the 2008 crisis, and will use this mechanism to “support £130 billion of high loan-to-value mortgages over three years”that are much more leveraged than Fannie Mae’s “conforming” loans. (In relation to GDP, the US equivalent of £130bn would be roughly $1.5 trillion)." - source Gavekal.

On a final note and in relation to our recent computational analogy "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary - source Bloomberg:
"German lenders could be the beneficiaries of renewed peripheral Europe depositor-outflow fears after the Cypriot bailout, as savers seek a haven in the euro zone's strongest economy. German banks have been awash with deposits since the onset of the sovereign debt crisis, with inflows from retail and corporate clients accelerating in the aftermath of the political gridlock following Greek elections in mid-2012." - source Bloomberg

"Doubt grows with knowledge." - Johann Wolfgang von Goethe 

Stay tuned!

Thursday, 21 March 2013

Have Emerging Equities been the victims of currency wars?

"Truth is confirmed by inspection and delay; falsehood by haste and uncertainty."

Many pundits are starting to make comments on the relative underperformance of Emerging Markets equities with weakening inflows as reported by Bank of America Merrill Lynch, in their recent Flow Show from the 14th of March entitled - Equities on course for $400bn inflows this year:

"Record inflows of $2.0bn to Japan equity funds as investors continue to pile into the reflation trade. $0.5bn outflows from EM equity funds; investor sentiment toward EM starting to fade (Chart 2) after underperforming developed markets by 770bps since Dec'12"

When one looks at the relative performance of the MSCI World versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) have underperformed developed markets (MXWO) by 10% and the SPX by 14% YTD.  - source Bloomberg:
The ratio between both continues falling and is now at 0.7156, lower than in 2012.

As indicated by Stefan Wagstyl in the Financial Times, on the 20th of March 2013 - Emerging Markets lag behind:
"While world equity markets have generally had a good run in the first quarter of 2013, there is one conspicuous laggard – emerging markets. Developed market bourses are up 6.6 per cent on the three months but their emerging market cousins are down 3 per cent – and that is despite the sustained strength in emerging market bonds and money markets in emerging economies. Admittedly, a few emerging market bourses have done well, with Thailand climbing 11 per cent in local currency terms and Dubai 17 per cent. But Japan easily beats them with a 20 per cent gain and the huge US stock market is up 9 per cent. This is not what was supposed to happen – in the long term, emerging markets should see faster growth in economic output and in stock market capitalisation. So what is going on?" - source Financial Times.

Indeed, what is going on, we wonder? Could it be the impact from currency wars and Japan being one of the culprits?

Back in February we discussed the recent surge in the Brazilian real versus the US dollar marking somewhat the return of the Japanese Double-Decker" funds. But, today the Brazilian Real weakened to 2 per dollar for the first time since January! - source Bloomberg:
As indicated today in the Bloomberg article written by Gabrielle Coppola and Josue Leonel - Brazil Real Weakens to 2 Per Dollar for First Time Since January:
"The level of 2 per dollar was last crossed in January, when the central bank intervened to strengthen the currency as inflation accelerated. Brazil had foreign currency outflows of $990 million in the week through March 15, the central bank reported yesterday. The currency has lost 1.8 percent in five days, the worst performance among major currencies tracked by Bloomberg, The real has pared its gain this year to 2.9 percent.
The central bank has swung between selling currency swaps to prevent the real from falling too quickly and offering reverse currency swaps to protect exporters by preventing excessive gains. The real closed at a 10-month high of 1.9442 per dollar on March 8 before the central bank intervened on March 11 to weaken it." - source Bloomberg.

Japan's performance easily comes on top of Emerging Markets with a 20% gain while the US stock market is up 9% so far.

It appears to us that the "rise of the Kagemusha" we mused about couple of days ago, could indeed be the culprit for Emerging Market equities woes - reverse Itraxx Japan (credit risk perception has been receding), USD/JPY and Nikkei index, bottom graph Nikkei volatility - source Bloomberg:

Is valuation a concern for Emerging Markets equities?
As indicated by BNP Paribas 2013 Global Equity and Derivative Strategy outlook published on the 21st of March not really:

Emerging Equities have indeed been the victims of currency wars and "Abenomics:

"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

"The decline of the JPY is negative for emerging markets, obviously more for those in Asia, putting pressure on emerging company market shares for exported goods and leading to cuts in investments in Asian countries by Japanese companies." - source BNP Paribas

One thing for sure, Mario Draghi, our "Generous Gambler" and his "whatever it takes". is not alone anymore Kuroda, who officially started yesterday at the Bank of Japan, has pledged as well to do "whatever it takes" to end deflation.

On a final note, looking at the recent appetite in the UK for the construction sector (with the latest guarantee for mortgage borrowers), France (latest construction plans) and Japan's numerous public spending plans over the years, we thought this chart from BNP Paribas from their Back To the Future note on Japan from the 18th of February would entertain you, as it displays the contribution of public spending to nominal growth in Japan over the years from 1981 onwards:

If Mr Kuroda is indeed serious about "reflating" in this on-going currency wars, the "rise of the Kagemusha", no doubt, represents a serious headwind for some Emerging Markets in general and their equities in particular.

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time."

Stay tuned!

Saturday, 16 March 2013

Credit - Dumb buffers

"When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed."
- Benoit Mandelbrot 

A buffer is a part of the buffers-and-chain coupling system used on the railway systems of many countries, among them most of those in Europe, for attaching railway vehicles to one another. Buffers in the very earliest days of railways were rigid (dumb buffers). 
Cross section of volute spring buffer

You might wonder where we might be going with this week's railway analogy, but, looking at the recent senate hearings following last year JP Morgan's 6 billion dollar losses, discussions surrounding banks and equity capital have resurfaced as of late. Arguably one of the most pertinent read we have come across was from Bloomberg's editors - JPMorgan’s $6 Billion Loss Shouldn’t Be a National Matter:
"To make the whole system more resilient, banks need to get a larger share of their funding in the form of equity from shareholders, as opposed to loans from depositors and other creditors. We have advocated $1 in equity for each $5 in assets, a level that would absorb a 20 percent drop in the value of a bank’s investments, compared with JPMorgan’s 3.1 percent. The latest global banking rules require only $1 in equity for each $33 in assets, and use a lenient approach for measuring the ratio.
Higher equity requirements reduce taxpayer support to banks in a different way, by making them less likely to require bailouts. The added discipline would also put natural pressure on banks to shrink: Once shareholders fully realized how poorly the largest banks perform in the absence of subsidies, they would have more incentive to demand that they be broken up into smaller, more profitable units." - source Bloomberg

Dumb buffers were the source of many staff accidents and damaged loads and vehicles. The Board of Trade required all new construction in England and Wales from 1889 to have spring buffers, but in Scotland the railway companies continued to accept new wagons with dumb buffers until 1 October 1903. From 31 December 1913 all dumb buffered vehicles were banned from the main line, but the Scottish owners gained an extension to 1915. In fact, the disruption of the Great War meant that dumb buffers persisted in Scotland until at least 1920-21. 

One can argue that the latest global banking rules requiring only $1 in equity for each $33 in assets is akin to the famous dumb buffers that plagued Scottish railways for an extended period of time, which might be leading to many "derailments" for banks in particular and for the economy in general as witnessed with the financial crisis of 2008:

Similar to Bloomberg editors and Simon Johnson, MIT professor and former chief economist at the IMF, we have long advocated larger equity buffers for banks in order to reduce the systemic risk banks pose to the real economy as a whole. Back in October 2011, in relation to discussions surrounding Capital Regulation, contrary to many beliefs, we argued as well that Bank Equity is not expensive. It is a myth. A study realized by Stanford University by Anat R. Admati is a must read. a summary of the presentation made to the Bank of England by the co-author is available here:
"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

A summary of a presentation to the Bank of England is available below which highlights Professor's Admati's key findings.

Some countries such as Denmark have started asking for higher extra capital. For instance, Denmark's systematically important financial institutions will have to hold 2.5% to 5% of extra capital as recommended by Denmark's Sifi committee. Its recommendations will have to be passed into law by the Danish parliament.

While the European Union us trying to press ahead with global banks standards by March 22nd, if the measures are not in place by month end, it would mean additional delays in implementing the January 2014 target for Basel III accord, which could potentially shorten the transition period and put some additional strain on lenders to adjust by the start of 2014 or delay the implementation until January 2015.

In this week conversation, we would like to focus our attention to this very important subject of bank regulation and capital adequacy, given both the European Union and the US have struggled to agree on legislation to apply the international standards on capital, known as Basel III, which were published in 2010 in conjunction with the Dodd-Frank act, following the demise of Lehman Brothers Holdings Inc.

So far, the Basel rules negotiations also have been stalled on how much additional capital should be required for systemically important financial institutions as reported by Rebecca Christie and Caroline Connan in their Bloomberg article from the 26th of February entitled - Barnier Says EU Needs Basel Deal to Lift Uncertainty for Banks:
"Lawmakers are pushing the EU to include in the capital rules a requirement for country-by-country reports on profits, losses and taxes, according to the document. Nations have been reluctant to expand the scope of the capital rules, preferring to tackle the topic in separate accounting legislation.
The Basel Committee on Banking Supervision brings together banking regulators from 27 nations including to the U.S., U.K., and China to coordinate their prudential rule-making.
The Basel III measures, which must be written into national laws, would more than triple the core capital lenders must hold and set standards for how lenders should manage risks. Representatives of Karas and the Irish presidency in Brussels declined to comment on the paper." - source Bloomberg.

On top of that, regulators from the Basel Group have clearly put Bank's debt addiction on scrutiny this year as reported by Ben Moshinsky and Jim Brunsden in Bloomberg on the 12 th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:
"Regulators are preparing to fight lenders over the details of the so-called leverage ratio as they seek to toughen rules on the minimum amount of capital they must use to back their investments. The Basel group, which brings together supervisors from 27 nations, will meet in the Swiss city tomorrow, according to the people, who asked not to be identified because the meetings are confidential.
 Concerns over how banks calculate reserves has led U.K. bank regulator Adair Turner and U.S. Federal Deposit Insurance Corp. board member Jeremiah Norton to call for tougher leverage ratios. Global supervisors in 2010 included a draft leverage ratio in an overhaul of rules, known as Basel III, drawn up in response to the financial crisis that followed the collapse of Lehman Brothers Holdings Inc.
“Early on, banks did not see it as such a big danger, or as a priority for lobbying, because it looked less likely to be implemented in the EU than other parts of Basel III,” Philippe Lamberts, the lawmaker leading the work on the Basel III rules for the European Parliament’s Green group, said in a telephone interview.
Leverage ratios force banks to hold capital equivalent to a percentage of the value of their assets. Such measures are simpler than standard capital requirements as they don’t give banks any scope to take into account the riskiness of their investments when calculating the reserves they must hold." - source Bloomberg

Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:
"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

For instance, since 2009, banks have indeed been very creative in the methodology used to beef up their Core Tier 1 ratio using a new generation of Hybrids securities called CoCo (Contingent Convertible Capital). CoCos, convert to equity or are written off once an issuer’s capital ratios fall below a preset level. This market for these new securities, already amounts to +10 billion dollars. This contingent convertible security pays a higher coupon and automatically convert into equities or suffer a full or partial write-down when the bank's capital ratio falls below a pre-defined trigger. 

The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing
bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.
The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment.

The benefits of such transactions for the issuer of CoCo notes is that not only it enables the issuer to maintain a particular minimum capital level, it also pleases the regulator and allows issuers which have been previously bailed out in Europe, to continue repayment of the aid received. For instance, KBC bank issued in January 1 billion dollar worth of CoCos, allowing them to continue the repayment schedule on time and, following a stress test, the National Bank of Belgium had required an additional 2 billion euros of Core Tier 1 capital to be raised. KBC completed in December 2012 a 1.25 billion euro equity offering and 750 million euros worth of CoCos.
While Europe is falling behind in relation to the implementation of Basel III, Switzerland has started implementing it as of January 2013 as indicated in a recent note by BNP Paribas on KBC's specific CoCo from January 2013:
"It is worth pointing out that due to the implementation of Basel 3 in Switzerland starting January 2013 as planned (as opposed to the delay in Basel 3 implementation in Europe, due to delay in completion of CRD4), the relevant ratio in ascertaining the likelihood of trigger is now the Core Equity Tier 1, rather than Core Tier 1 as it was under Basel 2.5. While this comes as no surprise and should have been fully expected it does make quite a bit of difference. For instance, at its Q3 12 UBS reported Basel 2.5 Core Tier 1 ratio of 18.1%, whereas the pro-forma phased in Basel 3 CET1 ratio was 13.6%." - source BNP Paribas

The fixation bankers have with equity buffers mean that they prefer issuing hybrids securities such as CoCos rather than equity in order to maintain their leverage and generate ROE. As indicated by Dr Jochen Felsenheimer, in case of trouble, the insurer is the taxpayer. CoCos are deemed to be "capital" and automatically improve the capital ratios, pleasing regulators in the process, and avoiding an automatic dilution of existing shareholders via capital increases through right issues. They are not equivalent to "equity", they are debt instruments, paying no doubt, a higher coupon, given the risk taken by the low subordination and risk of capital wipe-out faced by the bondholders.

As a reminder, under the draft Basel III plan in 2010, banks would have to hold so-called Tier 1 capital equivalent to 3 percent of their assets, so capping a lender’s debt at no more than 33 times those reserves, which, we think is way too low.

Last week events surrounding German Bank Commerzbank's capital increase is a reminder of not only the lack of sufficient equity buffer in the banking space but is also indicative of the material impact internal models of RWA (Risks Weighted Assets) can have to boost capital ratios as highlighted again in Bloomberg's article from the 12th of March Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:
"The temptation for banks to boost their reserves through changes to risk calculations, rather than real steps to raise capital, could be countered by a strong leverage ratio, said Lamberts, the European lawmaker. One example of this is how German lender Commerzbank AG sought to meet EU capital rules in part by adjusting its risk calculations, rather than simply raising fresh reserves, Lamberts said.
“Details that are coming to light about how banks misuse their internal models, for example when Commerzbank said it would make up half of a capital shortfall through changes to its models, show the need for this kind of rule,” he said.
Commerzbank was one of more than 60 lenders told by the European Banking Authority to hold capital equivalent to 9 percent of its risk-weighted assets." - source Bloomberg

On March 2013, Commerzbank AG, Germany's second largest bank announced it would sell 2.5 billion euros of shares to repay the government and insurer Allianz SE. Commerzbank received a 18.2 billion euros bailout in 2009 and the German government had owned 25% of the bank prior to the announcement.

Of course the 15% dilution announcement led to the share sliding 14% in Frankfurt on the 13th of March - source Bloomberg:
 The share declined 14% valuing the bank at around 7 billion euros.

Commerzbank's shares, the intraday proverbial "sucker punch" - source Bloomberg:
This news made us chuckle given that the CEO Martin Blessing, will be using the capital raised to repay 1.6 billion euros owned to the government and 750 million euros to German insurer Allianz, as well as increasing its Core Tier 1 capital to 8.6% under full Basel III capital from 7.6%. 

Why did we chuckle, you might ask? Well, because Commerzbank's largest shareholder SoFFin (Special Financial Market Stabilization Fund), converted already its silent participation in June 2012 to approximately 58.85 million Commerzbank shares,  increasing in effect the capital of Commerzbank to maintain its equity interest ratio in Commerzbank to 25% plus one share. With the 15% dilution, this participation will be now diluted to 20%, meaning in effect a loss for the German taxpayers.
Oh well...

But this painful adjustment for Commerzbank will not be the last one, given we have already established the link between credit and shipping and in particular the exposure of German's second largest bank to shipping woes back in August 2012:
"Commerzbank – the world’s second-biggest provider of ship finance, and reluctant owner of a flotilla of foreclosed ships – said it is shutting down its €20bn (£15.7bn) ship funding operations entirely to “minimise risk and capital lock-up” under tougher EU banking rules."

In April in 2011, in our conversation "Shipping is a leading credit indicator", we indicated:
"Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II." - source Bloomberg.

One can wonder what will be the recovery value for its maritime-loan portfolio looking at the boom and bust which occurred in the shipping space - source Bloomberg:
"The marine shipping industry is highly cyclical and susceptible to periods of boom and bust. Cycles are driven by overbuilding during times of growth to take advantage of strong markets. Shipping companies do not have enough lead time to alter orders when economic activity begins to slow, which has a significant effect on freight rates." - source Bloomberg.

Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book:
"Prices of seaborne vessels have crashed since peaking in 4Q08 and have been steadily declining since 4Q09, as excess capacity slowed the new build backlog, along with cheaper builds in China and tight credit markets. Chinese shipbuilders have been using price in attempt to win market share. Price pressure has come on less sophisticated dry-bulk ships relative to LNG tankers." - source Bloomberg

On the subject of banks capital shortfalls and the need to deleverage, and RWAs in particular, Nomura's note from the 11th of March 2013 entitled EU banks - Reconciling weak macro with momentum made some interesting points:

"To illustrate the point on headline capital ratios, the last published EBA Basel 3 monitoring exercise showed that at end-2011, European banks required EUR 225bn of equity capital to meet the minimum CET1 requirement of 7.0% of RWAs (inclusive of GSIB buffers where required). The report implied that the risk-weighted capital ratio rather than the unweighted leverage ratio was more of a bind on banks’ capital needs (given that the bar for unweighted leverage at 3.0% is set rather low, in our view). While we do not expect an official update on the 2012 capital position before September 2013, the EBA did separately disclose that as a result of capital raised for the 2012 stress test as well as other capital measures, European banks increased their capital positions by more than EUR 200bn in 1H 2012 (mostly through measures that directly increase capital rather than reduced assets). Based on the 2011 run-rate of net profit, in 2H 2012 around another EUR 40bn could have been added to banks’ capital bases.
Given that some banks will choose to build additional capital buffers, we do not expect the next monitoring exercise to show zero capital shortfall at end-2012 (several of the large often wholesale banks such as Deutsche Bank still had a gap at end-2012). However, we expect the reported capital shortfall to be substantially reduced for end-2012.
We are aware in 2013 that regulators are looking to improve harmonisation of the measurement of RWAs, moving away from internal models. In some cases, the banks have been well prepared (such as in Sweden) while in others it will delay the timeline to full Basel 3 compliance (such as in the UK). In general, we find that it is the wholesale banks with the lowest RWA/total asset ratios that might have the most need for additional capital actions or balance sheet shrinkage to meet regulatory goals. 
However, our main concerns for the banks are less about the measurement of RWAs and more about the fact that in some economies (such as Spain), the historical cost carrying value of banks’ assets is too high compared with their market value considering the fall in real estate prices in those economies. These unrecognised bad assets (along with deteriorating GDP and rising unemployment) require banks to divert profits to loan loss reserves rather than new lending." - source Nomura.

Moving back to our discussion around bank regulation and capital adequacy, we need to ask ourselves what have been accomplished since the demise of Lehman in 2008? Not enough, as indicated by the Bloomberg editors on the 10th of March in their article - Getting the Banks Around the World to Play by the Same Rules:
"Since that 2008 pact, progress has been made on the road to convergence. One example: Starting on March 11, Wall Street’s largest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., must process derivatives trades through clearinghouses, an accomplishment of the 2010 Dodd-Frank financial reform law, itself part of the U.S.’s commitment to convergence. By holding collateral and standing between buyers and sellers, clearinghouses can prevent one participant’s default from infecting all the others. In another step forward, the EU decided in December to create a single bank regulator. 

In Reverse 
But the dream of convergence remains, well, a dream. Conflicting national and regional laws, regulations and accounting standards have blocked the world from getting on the same page on financial reform. This, in turn, has jeopardized the ability of regulators to work across borders to address the next crisis. Shutting down a large failing bank that, say, loses all its capital because of a trading strategy gone haywire isn’t possible without universal rules for resolving sick banks. Moreover, financial companies will be able to take advantage of regulatory arbitrage -- shifting operations to countries with the loosest rules.

What happened? Let’s take a tour.
 In the U.S., regulators have been lobbied to a standstill. They have yet to name a single nonbank financial company or industry as systemically risky, despite the immense size and vital roles played by money-market funds, hedge funds, insurers and nonbank lenders. 
The Commodity Futures Trading Commission is backing away from some of its early positions on derivatives, moves that could have broken the big-bank stranglehold over the swaps business. The agency looks likely to revoke a proposal that would have required large investors to solicit quotes from at least five dealers, as a way to promote pre-trade price transparency. 
Regulatory agencies have also stalled over the Volcker rule, named after former Federal Reserve Chairman Paul A. Volcker. The measure is supposed to limit speculative trading by federally insured banks. For more than a year, five agencies have been debating with large banks and among themselves about where to draw the line between trading and making markets for clients, which the law exempts from the Volcker rule. On Capitol Hill, meanwhile, lawmakers from both parties and both chambers want to repeal parts of Dodd-Frank, including the requirement that banks move derivatives trading to separate affiliates with their own capital. 

Nasty Split
In Europe, the situation is no more auspicious. A nasty split has opened between the Continent and the U.K. The European Parliament and national governments have moved in recent weeks to tax financial transactions and cap bankers’ bonuses. This has (rightly) rubbed the British the wrong way, as their model of finance -- the Anglo-Saxon model -- is less regulated, more centered on trading and pays bigger bonuses than its counterparts in, say, France or Germany. 
Another rift is between Europe and the U.S. -- this one over capital requirements. New rules being written in Basel, Switzerland, have been watered down after much bickering. The level is now set at 7 percent of risk-weighted assets, up from 2 percent. Still, it falls short of the 10 percent initially sought by the U.S., and way short of the 20 percent of total assets that some economists and academics recommend. France and Germany led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors, Bloomberg News has reported. Not only is the global financial system no safer now than it was in 2008, it’s also clear that the project of convergence is badly stalled. Is the world really prepared to let the great convergence turn into the great divergence?" - source Bloomberg.

On a final note the principal reason for banks to hold a larger equity buffer is to be able to face risks such  as real estate bubbles. For instance both Credit Suisse and UBS have been asked to hold more capital to that effect as reported by Bloomberg:
"The 1.2 swiss-franc-to-euro cap and low interest rates have prevented the Swiss National Bank from tightening monetary policy to avert soaring real estate prices. To mitigate the risk of a property bubble, the authorities plan to curb lending growth by requiring banks to hold an extra 1% of capital on residential mortgages, starting 4Q13. UBS and Credit Suisse had 252 billion francs of mortgages outstanding at end-November." - source Bloomberg.

"What we define as a bubble is any kind of debt-fueled asset inflation where the cash flow generated by the asset itself - a rental property, office building, condo - does not cover the debt incurred to buy the asset. So you depend on a greater fool, if you will, to come in and buy at a higher price." - James Chanos 

Stay tuned!

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