Markets update - Credit - The Italian Peregrine soliton

"In mathematics and physics, a soliton is a self-reinforcing solitary wave (a wave packet or pulse) that maintains its shape while it travels at constant speed." - source Wikipedia

"A single, consensus definition of a soliton:

1. They are of permanent form;
2. They are localised within a region;
3. They can interact with other solitons, and emerge from the collision unchanged, except for a phase shift." - source Wikipedia

Another interesting day in the ongoing European crisis.

It is of no surprise with liquidity dwindling as we move towards year end to see a lot more ongoing volatility, definitely not helping. It seems Six Sigma standard deviation is not the norm anymore, it is higher still. So another long post, focusing on our Italian Peregrine soliton, liquidity issues affecting bid-offer prices and touching on fine-tuning risk weighting assets for banks to shore up Core Tier 1 capital.

Italy took centre stage today with some epic price movements:

Italian 2 years:  --- 6.37 yesterday ---- 7.13 today ---- +75 bps

Italian 5 years:  --- 6.87 yesterday ---- 7.62 today ---- +75 bps

Italian 10 years: --- 6.77 yesterday ---- 7.38 today ---- +61 bps


Time for a market overview.

The Bond Picture - Source Bloomberg:

Italy reaching "Terminal velocity"? The move today was epic to say the least.

Here is the intraday picture for 10 year Italian Government bond yield move- Source Bloomberg:

The CDS picture, Italy and Spain 5 year Sovereign CDS drifting apart - Source Bloomberg:

New record, 140 bps apart.

In the process, CDS wise, everything Italian widened - Source CMA:


Banks as well as Italy and Italian Companies - Source CMA:


Triggering in the process, flight to quality, Germany 10 year Government bond trending back to record lows - Source Bloomberg:

There is an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, while it had been moving in lockstep until recently, it appears the divergence between both does not look correct, so mind the gap - Source Bloomberg:

Volatility rising in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

France as well was not spared either with today's price action, given its exposure to Italy, with the 10 year Government bond spread level with Germany reaching another record in the process, coming close to 150 bps - Source Bloomberg.

OAT and EFSF Bonds widening versus German 10 year Government Bond yield - Source Bloomberg:

At this stage we know that EFSF will not be enough to deal with ongoing contagion to Italy.

The liquidity picture, not improving, new reserve period starting at the ECB hence the drop in the deposit levels at the ECB - Source Bloomberg:

In relation to liquidity dwindling as we move steadily towards year end, and dealers not particular eager to add risk towards year end, bid-offer spread are rising, but in relation to Italian debt, they have been soaring according to Bloomberg Chart of the Day relating to 2 year Italian Bonds bid-offer spreads:

By Matthew Brown - November 9 - Bloomberg:

"The gap between prices at which traders buy and sell Italian bonds has soared this week as market makers became less willing to deal in the nation’s debt, sapping liquidity from Europe’s largest bond market.
The CHART OF THE DAY shows the so-called bid-ask spread on Italian two year notes. The gap widened to 44 basis points today, the most since January, and up from 4 in March. Italian two-year yields climbed 98 basis points to a euro-era record 7.36 percent today, while 10-year yields climbed above 7 percent, the level that presaged Greece, Ireland and Portugal requesting international bailouts."

In recent post we have been discussing how banks will need to tackle revamped regulation needing them to beef up their core Tier 1 capital, as required by the European Banking Association.
We have already touched on the subject of DVA, bond tenders, debt to equity swap, upcoming deleveraging and of course reduction of appetite for risk with the reduction of the size of the trading book via attrition of Risk-Weighted-Assets.
As indicated by Bloomberg today by Liam Vaughan in his article "Financial Alchemy Foils Capital Rule as EU Banks Redefine Risk". It is worth mentioning the creativity of banks in dealing with capital rules imposed by regulators. When rules doesn't work your way, it is time to adapt:

"Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.
Banco Santander SA, Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA, the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.
Regulators in Europe, seeking to stem the region’s sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk weighted assets by the end of June."

And from the same article, an interesting comment from Adrian Blundell-Wignall deputy director of the Organization for Economic Cooperation and Development’sfinancial and enterprise affairs division in Paris:
"By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the game-keeper”.

Yes, every bank uses their own models for calculating their RWA (Risk-Weighted-Assets) which are submitted once a year to national regulators according to the article.

Also from the same article:

"Sheila Bair, who stepped down as chairman of the Federal Deposit Insurance Corp. in June, has called Europe’s adoption of risk-weighting “naive.” The Washington-based regulator guarantees most consumers’ deposits in U.S. banks. “It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses,” Bair wrote in Fortune magazine on Nov. 2. “Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.
Some regulators, including Bair, have pushed for a leverage ratio that would require lenders to hold a fixed amount of capital against total assets.
One reason there’s a difference between risk-weighted assets and total assets is that some securities, such as certain sovereign bonds, carry a zero risk-weighting, requiring banks to hold no capital.

‘Gaming the System’

“A basic leverage ratio would be rougher, but it takes away the risk of gaming the system,” said Stephany Griffith-Jones, an economist and lecturer in financial markets at Columbia University in New York. “We need to move away from outsourcing regulation of the banks to the banks.” European bank stocks have tumbled 31 percent this year, valuing firms at 62 percent of tangible book value."

And the article to conclude quoting Mark Harrison, a Barclays
analyst, who is based in London:

“Gaming RWAs isn’t helpful, particularly if the objective is to convince the market to invest in banks again,” Harrison said. “The risk is that it’s counterproductive, because there
is even less faith in what the banks are telling you.”

Raising capital for Banks is therefore going to be an interesting exercise indeed in the coming months.

"Running a casino is like robbing a bank with no cops around." Ace Rothstein (Robert de Niro) in the movie Casino by Martin Scorsese

"Running an investment bank is like robbing a casino with no gaming regulators around."
Martin, Macronomics.

Stay Tuned!