Monday, 12 September 2011

Markets update - Credit - Crash Test for Dummies

I had previously extended an invite for next post title, given one of the reader had already used my previous analogy relating to the "Chandrasekhar limit", but I have not received a suggestion yet. I felt the urge of posting an update after another eventful session today.

All credit indices went through the roof, once again:
Itraxx Crossover 5 year index (European High Yield - 40 companies in the index):
Risk of contagion is truly on, and Greece is drifting wider still, with two years notes yielding more than 60%.
For Greece, we already know the score with the central government's budget gap hitting 22% in the first eight months. The Greek goverment is now expecting the economy to contract by more than 5% in 2011, more than the 3.8% forecast by the European commission.

Here is the picture for Greece today:
Greek Yield one 1 year government bond - 117% yield:

Greek 2 year bonds yielding 63.4%:

Greek 10 year bonds, 21.87% yield:

Greece's fate is signed, sealed and delivered.

What caught my attention today was Italy's auction on T-bills with yields hitting a new three year record at above 4.153% from 2.959% a month ago. Contagion is still on.

And liquidity indicators were still worsening today,

But the deterioration seems to be accelerating still as the Euro-USD Basis swap 3 months indicator is telling us:

Banks have now 181 billions euros of deposits parked at the ECB, up from 152 billions when I wrote "Markets update - Credit - Crossing An Event Horizon" on the 5th of September:

So yes, flight to quality it is, and flight to quality we have. Correlation between 10 year Swedish government bonds and 10 year German government bonds is 1:

And financials, both in the equity space and in the credit space, took the brunt of the sell-off / widening today:
Itraxx Financial Senior 5 year index flying through 300 bps:

Itraxx Financial Subordinated 5 year index, widening faster:
This movement in credit indices was summarised by a dealer today as following. We had capitulation in the Financial Subordinate space and in relation to Financial Senior, the widening was strong but not sustained by flows. Size for hybrid Tier 1 trades was around 1 million euros, with significant downwards movement, 10 points down. In relation to High Yield volumes, they are very light. Whereas CDS so far had been leading the widening move, in last couple of days, cash has been underperforming CDS today.

In relation to bank capital structure, it is important at this juncture to go through the architecture, from the most senior to least subordinated bank debt.
Covered bonds backed by prime pool of loans are deemed senior to Senior debt.
Below senior debt, you have subordinated debt:
Lower tier 2 (LT2), Upper tier 2 (UT2), Tier 1 debt and finally equity (preferred shares).

And we know by now that European and UK banks face more funding pressures than US banks:

Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deffered in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds.

A typical LT2 Structure is as follows:
10 years, non-callable for 5 years (10-NC5)
-Final maturity is hard, meaning no get out clauses.
-No coupon deferral. A coupon deferral would constitute a credit event and therefore trigger a credit event and the relating CDS.
-Ratings: 1 notch below senior debt (Moody's / S&P).
-More standardised structure than Tier 1 or UT2. Given regulatory capital treatment decreases as it moves towards maturity (as it gets closer to 5 years to maturity) so many deals structured have had callable features, meaning the issuer can decide to call the bond.

Why am I going through these details relating to Bank Capital structure? Simply because mister Market "sometimes" has a short memory span. On the 17th of December 2008, Deutsche Bank decided to skip the call option on a 1 billion euro LT2 bond. Not so good for their reputational risk at the time.

In 2009, the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt.

The big issue today is that we know from previous credit posts that they cannot at the moment issue term debt given current market dislocation and the only bonds which, so far have been issued, have been the most senior ones, namely covered bonds backed by pools of prime loans but by only for top issuers.

If a financial entity is able to buy back its LT2 debt below par, it generates earnings (the beauty of FAS 159, on that subject see my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.") and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder).

But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure...

Survival of the fittest.

And is this fully priced in the subordinate space? I don't think so, given borrowers are expected generally to repay subordinated bondholders at the first opportunity and the bonds are valued on that basis.

So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging.

And my good credit friend agrees on the above, I am not alone:
"Do not forget that in 2008, when funding became an issue (and it is becoming an issue right now) Deutsche Bank decided not to call a LT2 bond at its call date, and all participants suddenly woke up to the reality that subordinated bonds could not be called.

Needless to say that it could and …… should happen again."

And given UK banks have just been given the ICB slap, recommending on ring-fencing retail banking and increasing loss absorbency, meaning lower ratings (downgrades), lower profitability and higher funding costs, this might bring some solace to their French counterparts (Moody's fear of downgrades), which recently have been at the receiving end of the cricket/baseball bat, you can expect additional widening unfortunately.
[Graph Name]

Until next time, I give you Bloomberg Chart of the Day, pointing towards additional pressure on the Euro:

Stay tuned!


  1. Great post, enjoy your blog - found it a few days ago, already favorited it.
    Question on the debts you mention backing CDSs.
    BNPP for example has a SNR and a SUB cds that are offered and quite liquid.. In each case then, would the CDS be on a different bond of BNPP?
    Also, " all participants suddenly woke up to the reality that subordinated bonds could not be called."
    Can you briefly go over why not calling a convertible (im assuming? since embedded call inside) is considered bad? Why not let it run out till maturity, pull to par effect.

  2. "In each case then, would the CDS be on a different bond of BNPP?"

    Hi coolstorybro, in each case, yes the CDS is on a different bond. A senior bond for the CDS Senior single name and a subordinated bond for the single name subordinated CDS (often a LT2 bond).
    In relation to convertible bonds, it isn't really my specialty. I am more familiar with investment grade. Given a callable bond is priced assuming the next call date. It is of common practice in the market place that the issuer calls the bond at the date of call. When Deutsche Bank did not call the bond in December 2008, they suffered reputational risk, as some counterparties placed Deutsche Bank in the sin bin for a couple of weeks/months.



  3. Thanks Martin, look fwd to future posts.


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