Tuesday, 15 November 2011

Markets update - Credit - Mind the Gap...

"There is a time to take counsel of your fears, and there is a time to never listen to any fear."
George S. Patton

Following our previous post relating to the "Italian Peregrine Soliton", it was interesting to read about Grant Williams comparable analogy relating to the freak wave that sank the Big Fitz in John Mauldin's latest Outside the Box, with our Italian "rogue wave-soliton".
In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis
In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia.

But I ramble once again, and given poor liquidity, and recent price action it is time for another credit overview. In the process we will review the unfolding scenarios we have been discussing in recent months, namely liquidity issues leading to a financial crisis, contagion to Emerging Markets (Eastern Europe in the front line), bond tenders and more. So, yet another long conversation.

The Credit Indices Itraxx overview - Source Bloomberg:
We still have high volatility, with Itraxx Credit Indices experiencing big price movements, in an environment where liquidity is definitely dwindling.
A market maker in fact commented on today's price action:
"One of the worst days of the year in terms of flow biz if it can be considered that anymore. A difficult environment to trade with clients mostly on the sidelines watching the Hollywood horror flick become a reality as SOV cash got decimated, particularly in the front end. Underperformers today the Italian/French/Iberian names which closely followed the Sovs. Even names like RBS & Lloyds SUB which are considered the "hairier" of the UK names failed to widen as much."
European Financials wider:
[Graph Name]
Italian Financials 5 year CDS were wider by around 70 bps on the day with Senior Financials CDS trading from 495 bps up to 760, depending on the Italian bank.
Spanish Financials 5 year Senior CDS were wider as well (BBVA +90 bps, Santander +80 bps).
French Senior Financial 5 year CDS also took a severe beating with Credit Agricole wider by 55 bps to around 570 bps, Societe Generale wider by 30 bps to around 370 on the 5 year Senior 5 year point and BNP Paribas wider by 55 bps to around 300 bps on 5 year Senior.

The issue of circularity for financial spreads and correlation with sovereign spreads is alive and well:
Daily Focus Graph

In relation to the bond picture, contagion has been spreading to core Europe with France drifting wider still - source Bloomberg:

And, if we only look at core Europe, it seems Austria is effectively now drifting in tandem with France towards 4% yield with core Europe now only made of Netherlands, Finland and Germany - source Bloomberg:
We previously discussed Austria's banking issues relating to Eastern Europe exposure, namely Hungary in our previous post "Long hope - Short faith" and why I was closely monitoring the situation.
On the 11th of October I indicated:
"I am expecting Austria's sovereign CDS to trade wider than France at some point, given the exposure of Austria's banking sector to Eastern Europe and in particular Hungary where a new law has been passed allowing foreign currency mortgages borrowers in Hungary to repay their loans at a fixed exchange rate with large discounts to current FX market rates, which will trigger losses to Austrian Banks."
In relation to the Hungarian situation we discussed a month ago:
"Under the new legislation borrowers can repay their mortgage in a single instalment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg:

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we indicated that "European banks’ lending to Hungary amounted to more than 70 percent of that country’s GDP, according to estimates by Barclays Capital based on BIS data. Lending to Poland reached 40 percent of GDP, and that to Brazil and Mexico was equal to about 20 percent of their economies." Following up on our Austrian conversation, it is interesting to see it followed up by Eric Frey from the Financial Times - "Austria moves to defend top rating" as well as by Geoffrey T. Smith from the Wall Street Journal - "Austria Has a Déjà Vu Moment":
"Austrian banks’ foreign assets at the end of 2010 were 137% of domestic GDP, according to Raiffeisen Zentralbank.

Data published in the European Banking Authority’s stress tests showed a combined exposure of around €210 billion to central and Eastern Europe, although that excludes loans made to the region through Unicredit SpA’s local subsidiary, Bank Austria.

Those assets have generated stellar growth over the last 15 years for the banks, but a small domestic economy can hardly underwrite them if things turn sour.

By contrast, the Bank for International Settlements suggests that Austria’s exposure to the five most indebted countries of the euro zone is relatively modest, with even Italy accounting for no more than €18 billion.

As a result, the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

In relation to the deleveraging risks for Emerging Markets coming from European banks we discussed on the 2nd of November, Morgan Stanley in a report published on the 13th of November entitled "What Are the Risks of €1.5-2.5tr Deleveraging?" had to say the following:
"Contagion to EM is a key risk, although our concerns centre on CEE/SEE rather than Asia. 12 of the 16 major European banks in CEE (~78% of these banking assets) either had a capital shortfall in the recent 9% test or are TARP recipients. We expect the greatest strain in SEE. In contrast, while we see growing risks to global trade finance – French banks looking to reduce dollar dependency represent 25% of outstandings – our assessment is that in a more orderly scenario this will be passed to local banks or globals (HSBC, STAN, C, JPM) although clear risks if disorderly."
The Morgan Stanley report was also quoted in relation to the heightened possibility of a Credit Crunch in Europe by Lisa Pollack in ft.com/Alphaville in "It’s a capital ratio of two halves" who has been following up on our post "Leda and the Greek Swan" (published by Pragmatic Capitalism courtesy of Cullen Roche) in relation to the impact of deleveraging.

The truth is that the liquidity picture is not improving, it is sliding still - source Bloomberg:
We have discussed at length upcoming term funding issues (in our post "Complacency"), and why liquidity issues always trigger financial crisis.

Morgan Stanley in their report commented:
"Bank funding roll is considerable – €1.7tr of debt due to refi for the major banks in the next three years. We think a step change in the pricing and availability of senior unsecured debt as well as dollar funding challenge many businesses. Whilst intense ECB support has helped, lack of a temporary bank debt guarantee plan is unfortunate, we feel.

Funding is no small issue. European banks lost $100bn of CP over the summer alone – making some major European banks more dependent on the ECB for funding. Given the dollar is the functional currency of global trade, this will impact European banks’ ability to be global lenders."
In relation to the issue of circularity, Morgan Stanley has come up with an interesting illustration - Source Morgan Stanley Research:

In fact financial stocks performance has been deeply correlated to Sovereign risk according to Morgan Stanley research:

We already know how difficult term funding issuance has been in recent months and is an ongoing problem moving towards 2012 - source Morgan Stanley Research:

Itraxx Financial Senior 5 year CDS index evolution versus Itraxx Financial Subordinate 5 year CDS index - source Bloomberg:
Moving back towards the widest levels reached in September.

Here is Morgan Stanley's take on the subject:
"• Term markets have stuttered throughout the summer, unable to regain the momentum of H1; there have been ~30 covered bond deals and a handful of senior unsecured since late August.
• However, our 2011 funding survey shows that European banks are now 100% funded on average, having frontloaded their issuance inH1.
• Notably, the Nordics and BNP have prefunded some of 2012.
• But given the sector has ~€700bn of rolling debt in 2012, we see headwinds if funding conditions persist, resulting in a pick-up in the velocity of delevering and further compression of NII (Net Issuance)."

In that context, it is of no surprise to see a rise in bond tenders (on that subject please refer to our post "Subordinated debt - Love me tender?") , in fact Spanish bank Santander just announced a bond tender on 9 callable LT2 bonds:

Santander Issuances, S.A. €1,500,000,000 - Exchange ratio 90.50 (%)
ISIN - XS0291652203 - Callable Subordinated Step-Up Floating Rate Instruments due 2017
Santander Issuances, S.A. €550,000,000 - Exchange ratio 90.00 (%)
ISIN - XS0261717416 - Callable Subordinated Step-Up Floating Rate Instruments due 2017
Santander Issuances, S.A. €1,500,000,000 - Exchange ratio 90.00 (%)
ISIN - XS0327533617 - Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2017
Santander Issuances, S.A. £300,000,000 - Exchange ratio 88.00 (%)
ISIN - XS0284633327 - Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2018
Santander Issuances, S.A. €500,000,000 - Exchange ratio 88.00 (%)
ISIN - XS0255291626 - Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2018
Santander Issuances, S.A. €500,000,000 - Exchange ratio 87.00 (%)
ISIN - XS0301810262- Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2019
Santander Issuances, S.A. €449,250,000 - Exchange ratio 99.50 (%)
ISIN - XS0440402393- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019
Santander Issuances, S.A. £843,350,000 - Exchange ratio 94.00 (%)
ISIN - XS0440403797- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019
Santander Issuances, S.A. €500,000,000 - Exchange ratio 87.00 (%)
ISIN - XS0201169439- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019

In our new Santander proposed haircuts, bond holders have until the 23rd of November to decide if they want a new "hairstyle".

Not even our CPDO/EFSF has been successful in raising recently much needed funding to help out on the ongoing European debt crisis, in fact, 10 year French Government bonds are yielding now for the first time above June issued 10 year EFSF bond - source Bloomberg:
It looks like the EFSF is too late to be materially effective in preventing contagion to spread in Europe.

So, given what we know so far, with heightened volatility, liquidity dwindling and European solitons, as in indicated in our previous post, please "mind the gap" - source Bloomberg:
There is still a disconnect between the 10 year German Bund and the Eurostoxx, while it had been moving in lockstep until recently, it appears the divergence between both still does not look correct, and warrant caution.

On a final note I leave you with the European Zew Indew, relating to European investor and analyst expectation - source Bloomberg:
"The ZEW center in Mannheim Germany said today its index of investor and analyst expectations, which aims to predict developments six months in advance, declined to minus 55.2 from minus 48.3 in October. That’s the lowest since October 2008." - Source Bloomberg.

"If we take the generally accepted definition of bravery as a quality which knows no fear, I have never seen a brave man. All men are frightened. The more intelligent they are, the more they are frightened."
George S. Patton

Stay tuned!

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