Thursday, 27 October 2011

Markets update - Credit - Long faith - Short hope and more on revamped EFSF

"To withdraw is not to run away, and to stay is no wise action, when there's more reason to fear than to hope."
Miguel De Cervantes

Epic capitulation in the Credit space CDS wised. Both dealers and clients were short credit via CDS and basically everyone ran for the hills and the short squeeze was massive. Most of the action was in the CDS space, from single names, to credit indices, to sovereign CDS. In this long post, we will first review today's price action as well as revisiting EFSF revamped and risk it entails.

This was the picture today for sovereign CDS - source CMA:
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The core countries of the euro area - source CMA:
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In the banking CDS space, the rally was significant, as well in equities - source CMA:
Daily Focus Graph

The squeeze was massive in Itraxx credit indices, 23 bps in Itraxx Main Europe 5 year CDS (investment grade credit index) which closed at 150 bps and 72 bps on Itraxx 5 year Crossover CDS index (High Yield credit index) which closed around 630 bps. It was a complete short capitulation and CDS curves steepened massively in the process in the front end of CDS curves - Source Bloomberg:

In the financial space Itraxx Financial Senior 5 year CDS index and Financial Subordinate 5 year CDS index tightened significantly and the spread between both CDS compressed as well - source Bloomberg:

But the most significant compression we have seen between indices has been between the Itraxx Financial 5 year CDS index and Itraxx Main Europe 5 year CDS, meaning financial spreads are converging towards corporate non financial spreads (investment grade)- source Bloomberg:

In terms of flight to quality, we had a widening in 10 year German Government bond yields and convergence again with German 5 year sovereign CDS spread - source Bloomberg:

In relation to EFSF 10 year bonds versus 10 year French government bond yields and German 10 year government bond yields, correlation is still alive and well - source Bloomberg:

The interesting point following last night agreement relating to Sovereign CDS is the fact that the 50% haircut will not constitute according to ISDA, a credit event. So what is the value of a sovereign CDS exposure?

As my good credit friend put it today:
"ISDA may find that 50% haircut is not a credit event…as the decision is “voluntary”.

So banks who bought CDS to protect their Greek bond holdings could endure more losses: 50 % on the bond, and a worthless CDS. To draw a parallel, it would be like finding after a car accident that the insurance you bought to protect the car does not cover you for anything ! Nice !!!"

In relation to last night's agreement relating to the ongoing European debt crisis, like most, I do not see this as the bazooka which will fix once and for all the European issues, hence the title of the post, this time it isn't "Long hope - Short faith" but, I rather see this as market participants desperately wanting to believe in lasting solution to the crisis and welcoming the respite. Call it "battle fatigue", or CSR (Combat stress reaction) in relation to the short squeeze. The only solution for Europe goes through more integration and ECB stepping in as lender of last resort, in the process changing its DNA and becoming more like a FED in effect, backed by a central treasury.

As research analyst David Watts from CreditSights put it in their latest sovereign analysis report - Eurozone Leaders Produce Belgian Waffle:
"It is possible that the measures taken will actually resolve the issues plaguing Eurozone governments. But there are very real risks that this will prove to be just another divet in the road that the "can" is currently being punted down. For the moment stock markets are up and credit markets are rallying. Given that this is at root a crisis of confidence over some Eurozone governments ability to repay their bonds at maturity, a change in sentiment for the better might be sufficient. If enough investors think that Italy (or at least the EFSF / ECB / IMF) will definitely pay them their money back when the bonds mature, they will buy the bonds and the financing become self-fulfilling.

But the markets are in no mood for "possible and "might". And the reality is that the institutions that the Eurozone policy makers have decided to create to underpin confidence in government's financing needs are themselves open to crises of confidence. Unless the backstop is cast iron, in other words, there can be no question over its ability to source and provide liquidity, there is always a risk that the market will lose faith and the house of cards will fall. That is why, we sincerely hope that this convoluted leveraging of the EFSF will prove sufficiently, we suspect that unless the ECB throws its weight behind government's, their liquidity position will always be open to question."

So yes, long faith but short hope.

We already discussed the EFSF structure in depth. In relation to the proposal of the EFSF proposing to write protection on the first loss tranche, effectively transferring first-loss risk from Italian bondholders to EFSF bondholders, we know by now that our CPDO/EFSF is not risk-free from the post "Much ado about nothing":
"when losses are incurred in our CPDO, the SPV must increase leverage in order to make up the increased shortfall in NAV (Net Asset Value), and by the way principal is not protected."
and we also know:
"In a CPDO/leveraged EFSF, when multiple downgrades happen, creating significant widening in spreads/higher interest rates, the loss in NAV can be significant."

EFSF fails if Spain or Italy require assistance or if France loses its AAA rating in the coming months. As a reminder, we have upcoming elections in France in May 2012.

And CreditSights commented on their latest note:
"The problem with proposal that first loss insurance is provided to Italian or Spanish bondholders by the EFSF is that it doesn't actually tell investors whether they are truly protected from losses."

We know they are not protected and my good credit friend to comment:
"A boost of the EFSF firepower to euro 1 trillion: This is less than what the market was initially expected, but expectation has been driven lower over the last days. It remains to be seen if the SPV will find some investors (I have strong doubts following Brazil, Russia and India refusals…Of course, everybody is expecting China to fill the gap, like a hero coming to the rescue. It is possible but, I tend to think that the PBOC will not put so much money to work. Also, the first loss guarantee on new primary issues is raising a lot of technical issues, and may not be implemented as it will create a “2 speed” markets (the new issues will be partially guaranteed while the old ones will not), and there will be a lot of conditions to be met by the country issuing to get the first loss absorption insurance…"

The first loss approach has been compared to the monolines which wrote protection on RMBS (Residential Mortgage Back Securities). It did not end up too well for many of them (AMBAC, and others...). But, as CreditSights put it, there is a VERY big difference in the revamped EFSF:
"The monolines wrote protection on the last loss tranche, i.e. the last part of the capital structure to experience losses. The EFSF is proposing to offer to write protection on the first loss tranche, the part certain to take losses in any write-down."

And given the Greek CDS credit event comedy, who gets to determine the recovery? European politicians...

The issue of circularity we previously discussed means that perception of debt sustainability is depending on economic growth. You cannot have growth expansion with fiscal consolidation and too much austerity.

The question now is: Will China buy the equity tranche of the gigantic European CDO and assume first loss? I doubt.

"Faith: not wanting to know what is true."
Friedrich Nietzsche

Stay tuned!

Tuesday, 25 October 2011

Markets update - Credit - Subordinated debt - Love me tender?

"Junk bonds prove there's nothing magical in a Aaa bond rating."

Merton Miller

Debt tender offer:
"When a firm retires all or a portion of its debt securities by making an offer to its debtholders to repurchase a predetermined number of bonds at a specified price and during a set period of time. Firms may use a debt tender offer as a mechanism for capital restructuring or refinancing."

In our post "The European issue of circularity", we discussed recapitalization issues in general, and subordinated Tier 1 bond tender in particular.

As a reminder:
"We know that "access to capital is depending on growth outlooks", a cheaper way for a bank to beef up its Core Tier 1 capital is to buy back at a discount its Hybrid Subordinated perpetual bonds in the secondary market."
We know that 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."

We also know from this previous post that French bank BPCE tendered their bonds "to further enhance the quality and efficiency of the Company's capital base".

We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap. So, yes, another long post.

But before we go through the nitty-gritty details, it is time for a quick market overview - Source Bloomberg:
Tighter slightly in the morning as per above picture but wider by the end of the day given concerns related to the cancellation of the meeting of European Union Finance ministers on Wednesday.
Itraxx Financial Senior 5 year CDS index increased by 7.5 bps to around 242 bps.
Itraxx Financial Subordinated 5 year CDS index increased by 6 bps to 474 bps. Overall, this month, the market is tighter by 80 bps since the end of last month, as we have seen a slight improvement in the credit markets so far in October in relation to spreads movements.
Itraxx Crossover 5 year CDS index (High Yield) ended up 7 bps wider as well on the day at around 714 bps.

The liquidity picture - source Bloomberg:
Some improvements but ECB overnight deposits are climbing at a faster pace compared to last month.
Flight to quality mode, on a slight hold pattern as indicated by the relationship between Germany Sovereign 5 year CDS and 10 year German government bonds yield slightly above 2% - source Bloomberg:
We started the day at around 2.13% yield and ended up around 2.05% yield.

EFSF bond versus 10 year German and French government bonds, correlation is still there between French bonds and EFSF bonds - source Bloomberg:

Itraxx Financial Senior 5 year CDS index, Eurostoxx and German Bund 10 year bond yield above 2%, Volatility levels - Source Bloomberg:
So, where do we go from there? It all depends on Wednesday European outcome and the can kicking game.

We all know by now we have moved from convergence to divergence in relation to bonds yields - source Bloomberg:

ECB has been stepping in since the 8th of August to support Italian and Spanish bond yields as they are again moving closer to the dangerous 6% yield threshold.

But back to our Subordinated bond tender story for our Portuguese bank.
The need to raise capital will be acute for peripheral countries due to issue of circularity we previously discussed. Given we know by now that access to capital is only open to better quality issuers in the financial space, the current level of financial spreads for weaker issuers, make it impossible for them to access funding at reasonable rates. Survival of the fittest is still the name of the game with the liquidity support provided by the ECB for these weaker players.

Bloomberg - "Savings Wars From Italy to Portugal Drive Bank Costs Higher"
By Charles Penty and Sonia Sirletti:
"The five largest banks in Italy, Spain and Portugal combined have more than 200 billion euros in medium- and long-term debt maturing before 2013, according to data compiled by Bloomberg.
The last time a Portuguese bank tapped wholesale debt markets was in March 2010, while Banco Santander SA’s 1 billion-euro sale of bonds in June was the most recent by a Spanish lender. UniCredit SpA, Italy’s largest bank, paid a record spread for Italian covered bonds in August when it raised 1 billion euros from a sale of 10-year notes that yielded 215 basis points more than the benchmark mid-swap rate.
Banco Espirito said in August that it trimmed lending by 3.1 percent from a year earlier and boosted customer funds by 23 percent to bring its loan to-deposit ratio down to 155 percent from 198 percent a year earlier. A lower loan-to-deposit ratio is a sign the bank is less reliant on sources of funding such as bond sales to fund its business."

Anabela Reis in a Bloomberg article indicated the following:
"Portuguese banks are being squeezed by demands that they boost capital as the government’s effort to reduce the deficit deepens the recession.
Echoing the struggles of their Greek counterparts, Portuguese lenders are unable to tap the financial markets for funds and hobbled by debt-laden state companies. At the same time, international regulators are forcing them to raise capital as they’re dependent on the European Central Bank for funds."

So austerity measures in conjunction with loan book contractions will lead unfortunately to a credit crunch in peripheral countries, seriously putting in jeopardy their economic growth plan and deficit reduction plans.
We discussed our concerns back in August in the post "It's the liquidity stupid...and why it matters again...":
"Lack of funding means that bank will have no choice but to shrink their loan books. If it happens, you will have another credit crunch in weaker European economies, meaning a huge drag on their economic recovery and therefore major challenges for our already struggling politicians.

As a reminder, 50% of banks earnings for average commercial banks come from the loan book: no funding, no loan; no loan, no growth; and; no growth means no earnings."

In a Bloomberg article by Liam Vaughan and Aaron Kirchfeld on the 25th of October -"Italy, Spain May Bear Brunt of European Bank Capital Plan":
"Banks with large holdings of U.K., German and French bonds may avoid raising additional capital, while those with Greek, Irish, Italian, Portuguese and Spanish debt will have to raise the most, according to London-based analysts at JPMorgan Chase and Co. and MF Global Ltd."
Hence the issue of circularity weighting on banks' capital needs.

Liam Vaughan and Aaron Kirchfeld commented:
"In Portugal, Banco Espirito Santo SA, the country’s largest lender by market value, may require about 3.4 billion euros, and Banco Comercial Portugues about 3.9 billion euros, according to MF Global.
Spain’s two largest banks, Banco Santander SA and BBVA may require about 3.1 billion euros each, Banco Popular SA 2.8 billion euros, Banco de Sabadell SA 2 billion euros and Bankinter SA 914 million euros, according to JPMorgan."
We also learn from the same article an interesting point:
"Banks with large holdings of U.K., German and French bonds may avoid raising additional capital, while those with Greek, Irish, Italian, Portuguese and Spanish debt will have to raise the most, according to London-based analysts at JP Morgan and MF Global Ltd."

Reason behind, another interesting accounting trick according to the same article:
"Lenders may be able to mark up the value of bonds that are trading above face value, allowing them to mitigate the cost of writing down their southern European sovereign debt, the people said."
So we have the direct effect of circularity we discussed at play as indicated again by Bloomberg:
"That may benefit U.K. and German lenders such as Royal Bank of Scotland Group Plc and Deutsche Bank AG, whose biggest holdings of bonds are those issued by their own governments. It may also allow French banks to avoid further fundraisings."

And we know from our conversation "Long hope - Short faith", that:
"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."

Liam Vaughan and Aaron Kirchfeld in their Bloomberg article indicated the following:
"Lenders including Deutsche Bank have opposed further capital injections because they risk diluting shareholders without addressing the underlying problem of a potential Greek default. BNP Paribas SA, France’s largest bank, is among financial firms that have said they can meet demands for increased capital without cash injections."

So what will happen now and how will these banks raise money to meet capital ratios before the June 2012 deadline?

They will contract their balance sheets, in effect impacting access to credit and triggering most likely another credit crunch and it is already happening.

Source Bloomberg, Anabela Reis - "Portuguese Banks Pinched With Recession Deepening: Euro Credit"
"Loans to companies dropped to 116.2 billion euros in August, the lowest since March, and loans to individuals declined to 140.8 billion euros, the lowest in a year, according to the Bank of Portugal."
So what's all about your Banco Espirito Santo tender Martin?
Well as Espirito Santo Chief Executive Officer Ricardo Salgado put it nicely:
"Its more interesting for banks to extend their shareholder base, by converting bonds into shares, than having the state as a shareholder."
On October 18 Banco Espirito Santo announced a capital increase in effect via its bond tender:
BESPL 6.625 Perp callable 2012 Exchange at 74 Upper Tier 2 XS0147275829 Amount: 423,561,000

BESPL 4.50 Perp callable 2015 Exchange at 66 Upper Tier 2 XS0207754754 Amount: 474,033,000

BESPL 5.58 Perp callable 2014 Exchange at 61 Tier 1 XS0171467854 Amount: 553,265,000

And my good credit friend to comment:
"First debt to equity swap for a Portuguese bank: Banco Espirito Santo … but I guess not the last one for European banks … as we have been saying for a while…
The total amount of debt to be exchange for equities is euro 1,450,859,000 ! Banco Espirito Santo total market cap is approximately euro 1,743 million…which means 83.5% dilution for the current shareholders!"

This is the recent price action on Banco Espirito Santo share price:

So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?

Subordinated debt - Wikipedia:
"From the perspective of policy-makers and regulators, the potential benefit from having banks issue subordinated debt is that the markets and their information-generating capabilities are enrolled in the "supervision" of the financial condition of the banks. This hopefully creates both an early-warning system, like the so-called "canary in the mine," and also an incentive for bank management to act prudently, thus helping to offset the moral hazard that can otherwise exist, especially if banks have limited equity and deposits are insured. This role of subordinated debt has attracted increasing attention from policy analysts in recent years."

But if you think the credit crunch will only happen in the peripheral countries because of banks shrinking their balance sheets, think again:
According to my good quant friend at Macro Research house RCUBE (Risk - Return - Research), and from the latest “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association), the latest survey confirms the reality of a credit crunch in France, respondents now consider that the cash situation for French corporates is nearly as bad as in late 2008! - "Our readers know that we pay very close attention to bank lending standards, especially in Europe where banks represent around 70% of corporate financing."

Europe Banks Vow $1 Trillion Shrinkage as Recapitalization Looms - Bloomberg by Anne-Sylvaine Chassany and Liam Vaughan - October 19:
"European banks, assuring investors they can weather the sovereign debt crisis by selling assets and reducing lending, may not be able to raise money fast enough to prevent government-forced recapitalizations.
Banks in France, the U.K., Ireland, Germany and Spain have announced plans to shrink by about 775 billion euros ($1.06 trillion) in the next two years to reduce short-term funding needs and comply with tougher regulatory capital requirements, according to data compiled by Bloomberg. Morgan Stanley predicts that amount could reach 2 trillion euros across Europe as banks curb lending and sell loans and entire businesses. A lack of buyers and the losses lenders face on loan sales are making those targets unrealistic."

On a final note I leave you with Bloomberg - Chart of the Day - Euro Area Debt Quality Worsens at Record Pace:
"The CHART OF THE DAY shows the average rating for the bloc, calculated by Bloomberg from the assessments of the three main evaluators, has worsened to 3.14, representing the third-best grade, from 2.12 in May 2010 when the European Financial Stability Facility was designed. The measure fell 0.23 point in the previous 15 months. The average is calculated by giving a numerical grade for each grading, where 1 is the highest, and adjusting it for each country’s share of the EFSF guarantee.
Seven of the 17 euro-sharing nations have had their ratings downgraded since the announcement of the facility, which maintains a top grade from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. As the contagion has spread to banks, prompting governments to work out recapitalization plans, further cuts, mainly for the top-rated countries, may reduce the strength of the fund."

"How few there are who have courage enough to own their faults, or resolution enough to mend them."
Benjamin Franklin

Stay tuned!

Friday, 21 October 2011

EFSF - If you are in trouble - double

"What investors should never forget about credit risk is that it is an event risk!"
Credit Crises: From Tainted Loans to a Global Economic Meltdown by Jochen Felsenheimer and Philip Gisdakis

For a change, it is going to be a shorter post than usual. In this post we will review the extension of the EFSF and the risk it entails.

I have already touched on the EFSF and its similarity with CPDO products which were the craze during the halcyon days of structured credit in the post - "Much ado about nothing": "in our levereraged EFSF play, the lower volatility in interest rates, the lower likelihood of default. But in a CPDO/Leveraged EFSF, there is a risk of failure of repayment of full principal at maturity."

I discussed this very subject with my good credit friend today, and here is what he had to say about the EFSF following our conversation:
"To summarize, European states only guarantee each bond issued by the EFSF in accordance to the percentage of their contribution. Each time a country needs the funding of the EFSF, that country cannot guarantee anymore the future bonds to be issued … so the remaining countries have to share the cost of guaranteeing the future bonds. Initially, Portugal was a guarantor for the bond issued to help Ireland. Once Portugal asked for help, the EFSF lent money and Portugal could not guarantee any new bonds issued by the fund, while still guaranteeing the one issued before to help Greece and Ireland. So each time a country suffer a rating downgrade, the pressure increase on the other contributors.
That explains the subordination of the EFSF bonds to the sovereign bonds of its contributors … and why leveraging the fund is not the right solution !
Here below is a chart where you can see the correlation of the EFSF bonds with the French 10 years OAT bonds … versus the German 10 years Bund. The correlation between the EFSF 10 years and the French OAT 10 years is 1.
As French spreads keep on widening, so does the EFSF spreads. This is frightening and explain why a France downgrade will jeopardize the whole scheme."

And to illustrate our conversation we came up with the nice illustration below:
In white… EFSF 10 years bond
In yellow … French 10 years OAT
In orange … German 10 years Bund

What's wrong with this picture? You probably know by now.

EFSF existing bonds:

EFSF 10 year bond versus German Bund

And my good credit friend to add:
"Main talks were about E.U. combining the EFSF and the ESM by mid 2012 to create 1 Fund with 940 billion euro (1.3 trillion US $) firepower.
Well, obviously there is a number of issues about such a conclusion….

The 500 billion Euro ‘permanent” bailout fund (ESM) was slated to replace the 440 billion "Temporary" European Financial Stability Facility (EFSF) fund. Well, the latest proposal that has the stock markets excited is to merge the two funds …. But there is a bias, it double counting the money."

“European governments may unleash as much as 940 billion euros ($1.3 trillion) to fight the debt crisis by combining the temporary and planned permanent rescue funds, two people familiar with the discussions said.
Negotiations over pairing the two funds as of mid-2012 accelerated this week after efforts to leverage the temporary fund ran into European Central Bank opposition and provoked a clash between Germany and France, said the people, who declined to be identified because a decision rests with political leaders.
Disclosure of the dual-use option helped reverse declines in U.S. stocks and the euro on speculation it could help break the deadlock among European leaders. Their wrangling led to the scheduling of a summit three days after an Oct. 23 gathering.
The 440 billion-euro European Financial Stability Facility has already spent or committed about 160 billion euros, including loans to Greece that will run for up to 30 years. It is slated to be replaced by the European Stability Mechanism, which will hold 500 billion euros, in mid-2013.
A consensus is emerging to start the permanent fund in mid-2012, the people said. During the transition between the two funds, euro-area governments originally agreed to cap overall lending at 500 billion euros, a figure deemed sufficient when Greece, Ireland and Portugal were the primary victims of the debt crisis.”

On this very subject my good credit friend commented:
"Now …. Have a look:
The total overall cap is 500 billion euros, of which 160 billion have already been committed or spend to help Greece. Therefore there is only 340 billion left! So how can you get 940 billion euros? This would raise the permanent fund above the agreed upon amount…. And the German Supreme Court has stated this cannot be done without a popular vote (referendum) !!! Also bear in mind that the German Supreme Court has ruled there should not be a permanent bailout fund at all…. Which add to the already constitutional issue.
I do not see a popular vote in Germany having a positive outcome!"

Please find here after the link to the ESM term sheet as of March 21st 2011:

Page 10 of the term sheet :“As originally foreseen, the EFSF will remain in place after June 2013 so as to administer the outstanding bonds. It will remain operational until it has received full payment of the financing granted to the Member States and has repaid its liabilities under the financial instruments issued and any obligations to reimburse guarantors. Undisbursed and unfunded portions of existing loan facilities should be transferred to the ESM (e.g. payment and financing of installments that would become due only after the entry into force of ESM). The consolidated EFSF and ESM lending shall not exceed € 500 bn.”

So, please fasten your seat belt as the weeks ahead might be quite volatile indeed.

"When written in Chinese, the word "crisis" is composed of two characters. One represents danger and the other represents opportunity."
John F. Kennedy

Stay tuned!

Monday, 17 October 2011

Markets update - Credit - Bedtime story and the European issue of circularity

"Nothing is more frequently overlooked than the obvious."
Thomas Temple Hoyne

Volatility again today. We had a better tone in the morning in the European space credit wise, but we were back to flat at the end of the day. Following the G20, everyone expecting in a week's time big resolution coming out of the European summit. They should be bracing themselves for some disappointment.

As per Bloomberg article today by Tony Czuczka and Rainer Buergin:
"German Chancellor Angela Merkel has made it clear that “dreams that are taking hold again now that with this package everything will be solved and everything will be over on Monday won’t be able to be fulfilled,” Steffen Seibert, Merkel’s chief spokesman, said at a briefing in Berlin today. The search for an end to the crisis “surely extends well into next year.” Group of 20 finance ministers and central bankers concluded weekend talks in Paris endorsing parts of Europe’s emerging plan to avoid a Greek default, bolster banks and curb contagion. Providing a week to act, they set the Oct. 23 meeting of European leaders in Brussels as the deadline."

In this post we will have a look again at bank recapitalization, given it is still the ongoing subject, as a follow up on our previous discussion. We will also discuss the issue of circularity. We touched on the subject in our post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." in relation to European banks liquidity issues:
"The circularity issue weighting on liquidity:
In highly-indebted Euro zone countries, the issue of circularity comes from the high correlation with their sovereign creditworthiness, meaning they are experiencing very high level of stress on their current funding."

So here we go for another long conversation.

But first, a credit overview.
The Itraxx Credit Indices picture today - Source Bloomberg:
While the tone had been much positive at the open, on credit indices with at one point Itraxx Crossover 5 year index (High Yield) tightening by 23 bps, the market closed the day roughly unchanged, as equities moved from the positive territory to negative. German Finance Minister Wolfgang Schaeuble comments weighted heavily on the market by the end of European close.

Enel, Italy's largest power company came to the market with 2014 and 2015, with a new issue premium to secondary of around 50 bps for the 2014 bonds and a new issue premium of 90 bps for the longer tranche.

There was as well some resurgence in news issues in the financial space with an interesting 2 year Senior Unsecured Floating Rate note from Commerzbank, rated (A2/A/A+ outlook : stbl/neg/stbl), which priced at Euribor +158 bps. On the 12th of October SEB (Skandinaviska Enskilda Banken AB - A1 / A / A+) priced a similar note at around Euribor +120 bps.
We know from the post "Markets update - Credit - Misery loves company" that ABN Amro (Aa3 /A/A+ all stable outlook), priced a similar floater on the 30th of September at around Euribor +130 bps, as a follow up on Deutsche bank which priced at around +100 bps.

So no surprise there, new issues are not only repricing the secondary issues, but coming with big concessions given the need for banks to raise capital. It is interesting to note that apart from these 2 year Senior unsecured notes, for some prime issuers, it seems the subordinated market is still completely shut down.

In relation to flight to quality, convergence of German 10 year Government Yield and German Sovereign CDS seems to have stopped in its tracks - Source Bloomberg:
From 2.18% Yield to 2.08% on the 10 Year German Bund.

But the interesting part today was the new record set in terms of spread between the German 10 year Bond and the French 10 year Bond (OAT), which reached 95 bps - Source Bloomberg:
France still in the crosshairs of the European bond vigilantes.

The liquidity picture - Source Bloomberg:
Some improvement but nothing major so far.

And Nomura had a good comment relating to recent market action in their recent Rates Strategy Europe weekly from the 14th of October:
"Convalescence with relapse risk:
Beyond October, we are worried by the possibility of a relapse in market sentiment. There is ample scope for disappointment on the euro plan (see Euro plan: Bazooka or damp squib?). Our take is that the "bazooka" will not happen. But in a risk-on phase partly triggered by better economic sentiment, it would take a really disappointing announcement to immediately derail markets. In July, there was a very incomplete announcement in a very negative market; the background is different this time. So at this stage, we are not necessarily waiting for a major risk off, but we are aware of the risk of relapse in the aftermath. There are several triggers: (1) the PSI will be revisited with tougher terms, paving the way for a possible CDS trigger, (2) the political situation in Greece is very unstable and the Troika returns to Athens no later than end-November (assuming the next tranche is paid, the government has money only until January), and (3) it is not clear how the ECB's bond buying will continue and how the central bank will react to a GGB default (the collateral issue can be by-passed in the event of a temporary selective default; it would be more complicated with a CDS-triggering event)." much for all the recent European politicians "Bedtime story"...

And Nomura to add relating to the periphery:
"The market has largely shaken off the recent euphoria over possible quick fixes to the Eurozone and sovereign spreads have come under pressure to some extent as a consequence. While many would look for a large scale solution on the horizon, from the possibility of extra IMF funds (possible with many caveats), to large scale recap of banks (obviously not a solution in and of itself), to various insurance schemes (which could come with practical and legal challenges), the likelihood of any single solution arriving imminently appears remote.

Against this backdrop we continue to believe that sovereign spreads that are unsupported by the ECB will come under pressure."

So, unfortunately, no Bazooka to be expected anytime soon.

And that leads us to the issue of circularity we previously mentioned. And, in relation to bank recapitalization, don't expect wizards, fairy tales and magic tricks in our "Bedtime story".
The issue of circularity we mentioned earlier again cannot be clearer than the graph realised by Martin Sibileau in his latest post - "The EU must not recapitalize banks":
And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

To illustrate further the issue of circularity, here is a table from Bloomberg displaying Greek debt ownership:
The 6 top owners of Greek debt are 6 Greek banks.

And I have to agree with Martin Sibileau's view:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

And the clear difference between the ECB and the FED in relation to bond purchases is as follows, as pointed out by Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”
Stock and flows:
"Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time (say, December 31, 2004), which may have accumulated in the past. A flow variable is measured over an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is roughly analogous to rate or speed in this sense."

And following the circularity, let's discuss current recapitalization issues as there were some interesting developments today namely involving subordinated Tier 1 debt.

BPCE, the French bank decided to launch a tender and offered to buy back subordinated bonds as much as 1.8 billion Euros of four subordinated hybrid securities:

Why so? Given we know that "access to capital is depending on growth outlooks", a cheaper way for a bank to beef up its Core Tier 1 capital is to buy back at a discount its Hybrid Subordinated perpetual bonds in the secondary market.

We discussed this very subject in the post "Markets update - Credit - Crash Test for Dummies":
"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.

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)."

and bingo! French bank BPCE strikes today!

And a market maker to comment following the BPCE tender:
"Very big moves in T1 space mainly driven by BPCE T1 tender which came approximately 13 points above secondary (for the low coupons bonds). The market rapidly drew the conclusion that similar moves would be coming on in French names - with a particular focus on low-cash, step-up bonds."

BPCE Tier 1 subordinated perpetual bonds indicative round up:
BPCEGP 4.625% 07/15 (call date) cash price - 61/64 +13.75 points
BPCEGP 5.25% 07/14 (call date) cash price - 62/65 +11 points
BPCEGP 6.117% 10/17 (call date) cash price 61/64 +9 points
BPCEGP 9% 03/15 (call date) cash price 78/80 +4 points
BPCE 9.25% 04/15 (call date) cash price 76/79 -

BPCEGP 5.25% 07/14 (call date) - Source Bloomberg

BPCE commented on its tender:
"The Tender Offer is being undertaken in order to further enhance the quality and efficiency of the Company's capital base."
Of course it is!

On a side note, FAS 159 is fashionable again in the banking space:
DVA/CVA in earnings:
UBS = 1.6 billion USD
JP Morgan = 1.9 billion USD
Citi = 1.9 billion USD
To be continued...(Bank of America, Goldman Sachs, Morgan Stanley, etc.).

And on a final note I leave you with Bloomberg chart of the day, showing that Asian stocks are yet to reach bear-market floors:
According to Bloomberg:
"Stocks in Asia excluding Japan may extend a bear-market rally for “several” weeks before resuming declines that could send them to new lows next year, according to Mizuho Securities Asia Ltd. The MSCI All Country Asia excluding Japan Index rebounded 13 percent in the six days through Oct. 13, following a 31 percent plunge from its April 28 intraday high. In the four previous periods when the Asian gauge dropped more than 30 percent from peak to trough closing levels since records began in 1988, all were interrupted by rallies of between 14 and 45 percent, before the routs resumed. A minimum drop of 20 percent from a peak signals to some investors a bear market."

"There cannot be a crisis next week. My schedule is already full."
Henry A. Kissinger

Stay tuned!

Tuesday, 11 October 2011

Markets update - Credit - Long hope - Short faith, Hungary and Bank Recapitalization

“A good solution applied with vigor now is better than a perfect
solution applied ten minutes later.”
General George S. Patton

Call it a bear squeeze or a short squeeze, the action today in the credit space is clearly pointing to short covering with some players capitulating and forced to cover their short positions in both Corporate Single names CDS as well as in some credit indices.
Regardless of how you call it, given the short bias of the street, some got hurt pretty bad probably today, not helping their profit and loss trading account in the process.

So yes, another long post, looking slightly at the periphery with Hungarian mortgages and approaching the hot subject of Bank recapitalization and the somewhat apparent issue of raising equity.

Here is the market overview for Itraxx Credit indices in the European space - Source Bloomberg:
Itraxx Crossover CDS index 5 year of 50 High Yield names tighter by 23 bps on the day to around 746 bps.
Itraxx Main Europe CDS index 5 year (Investment Grade) tighter by 5.5 bps to around 173 bps.
Itraxx Financial Senior CDS index 5 year closed the day tighter by 8 bps to around 233 bps and the Itraxx Financial Subordinate Index declined 16 bps to around 468 bps.
Itraxx Main Europe 5 year CDS index (Investment Grade) versus Itraxx Crossover 5 year CDS index (High Yield):

Slightly better between both indices from the widest point.

Letting off the gas in the credit space, European Gas companies an example of the tightening move in the single name CDS space:
[Graph Name]
Source CMA

The Liquidity picture - Source Bloomberg:
Some improvement. Keep in mind the drop in the level of deposits at the ECB is due to the start of the new reserve period as of yesterday (September reserve period was shorter at 28 days). Also we learned today that the ECB had lent 1.4 billion USD to 6 European banks for three months at a fixed rate of 1.09%. One bank was also allotted 500 million dollars in its weekly operation, reason being and we know from our previous credit conversations as reminded by Bloomberg: "European banks need dollars to fund their own lending in the U.S. as well as to clients elsewhere doing business in the world’s leading reserve currency."

So all in all, we have, Itraxx Financial Senior 5 year index falling, Eurostoxx rising with German Bund 10 year bond yield above 2%, Volatility falling in the process - Source Bloomberg:
As you can see Eurostoxx and German Bund yield moving in lockstep, as there is a reduction in the flight to quality mode.

Germany Sovereign 5 year CDS level and German 10 year bond yield, from divergence to convergence - Source Bloomberg:

In the Emerging Markets Bond Yield space we also have a significant tightening wove. We discussed previously the sell-off in Emerging debt in the post "Markets update - Credit - Anterograde and Retrograde amnesia" - JP Morgan EMBI Global Diversified - Source Bloomberg:
The J.P.Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets:

And in relation to the SOVX Western Europe 5 year CDS index versus the SOVx CEEMA (Central Europe and Middle-East and Africa) we have complete convergence currently as both trade roughly at the same levels - Source Bloomberg:

But what I have been following more closely in the Sovereign CDS space for the last couple of months is the relationship between France Sovereign 5 year CDS and Austria 5 year Sovereign CDS:
Why did it catch my attention? Because 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.
According to an article from CreditSights from the 11th of October relating to Erste bank in particular and Hungary in general:
"With subsidiaries of foreign banks accounting to 80% of the banking system, the bulk of the losses will be suffered by western European banks. These include Erste Bank, Raiffeisen Bank International, Intesa, Unicredit, Bayerische Landesbank and KBC."
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.

And the losses are significant, according to Boris Groendahl in Bloomberg on the 10th of October:
"Erste Group Bank AG, eastern Europe’s second-biggest lender, fell the most in more than two years in Vienna trading after saying that it expects to post a full-year loss of 800 million euros ($1.1 billion) this year.
Erste wrote down the value of its Hungarian and Romanian units by a combined 939 million euros, the Vienna-based bank said in a statement today. Erste won’t pay a dividend for 2011 and shelved for at least a year a plan to repay 1.2 billion euros of aid from the Austria government."

And Boris Groendahl in Bloomberg adding:
"Erste is writing off its remaining 312 million euros of goodwill in Hungary and made additional bad-debt provisions of 450 million euros. The lender will also inject 600 million euros of fresh capital into its business, Hungary’s fourth-biggest bank."

And about the mortgage relating problems in Hungary this is what CreditSights had to say in their report in relation to the size of the problem and the deleveraging needed:
"For several years now, the widespread practice in Hungary of mortgage borrowers taking out loans in foreign currencies, predominantly the Swiss franc, has seemed like an accident waiting to happen."
And we know it did...

CreditSights size up the problem:
"With foreign currency mortgages accounting for roughly 75% of total mortgage loans in Hungary on a system-wide basis (of which 80% are in Swiss francs), this will result in some losses for the banks."

And CreditSights to add:
"Based on the latest disclosure by Erste Bank, it appears that the proportion of mortgage lending in foreign currency is even higher for foreign banks than the 75% system average, reaching about 100% in the cases of Erste Bank and Raiffeisen International."
The two largest Austrian banks and CreditSights estimates the impact could be significant as the 10% to 30% of mortgage borrowers could take advantage of the new legislation covering mortgages issued before 2009.
CreditSights estimates under three scenarios (10%, 20% and 30%) pre-tax losses, as a percentage of the banks consolidated, annualised 1H11 pre-tax profit ranging from 6.6% for Erste Bank (10% scenario) to 19.7% (30% scenario) and 2% to 6% for Raiffeisen International.

And CreditSights to conclude:
"Although the specific damage from the FX mortgage legislation looks containable, the legislation casts wider doubt on contract enforceability in the system in the context of a difficult economy, which is likely to lead to other impairments."
So, when the economic situation change, the government can indeed, change the rules...

But another interesting item from the CreditSights article was relating to the CDS exposure for Erste:
"180 million euros P&L reclassification of CDS protection written by the bank, to account for it in the derivatives category, instead of classifying the CDS as financial guarantees. This followed a clarification from the IASB (International Accounting Standards Board), that, in order to use the guarantee classification and avoid marking contracts to market, a protection seller would have to suffer a loss on an underlying reference instrument. The CDS book largely relates to Western European sovereigns and amounts to between 2 billion euros and 2.5 billion euros. Some of this in periphery countries, but total sovereign exposure (including derivatives) to Greece, Portugal, Spain, Ireland and Italy is down to 0.6 billion at 3Q11, from 1.9 billion at FY10, within which the Greece/Portugal component has been reduced to just 10 million euros. Management pointed out that the CDS book was built up prior to the euro zone sovereign crisis as a risk diversification trade to compensate for Erste Bank's concentration in Central and Eastern Europe. The recognition of formerly unrealised losses accumulated from prior years in Available-for-Sale reserves in shareholders' equity leads to simultaneous adjustments of 310 million euros to regulatory capital, or 460 million euros to shareholders' equity in the balance sheet."
So to compensate for Eastern Europe exposure, Erste bank sold CDS protection on Western Europe countries prior to the European sovereign crisis. No comment.

And that leads me to the intense discussions on the subject of banks recapitalization in Europe as the EBA (European Banking Association) is discussing plans for banks to maintain a 9% Core Tier 1 Capital benchmark.
According to Bloomberg article from Ben Moshinsky and Aaron Kirchfeld:
"Nine percent of core capital based on EBA definitions may be roughly equivalent to the 7 percent of reserves that lenders will be obliged to hold from 2019 under measures agreed last year by the Basel Committee on Banking Supervision."
As a reminder, in July, the EBA stress test required Core Tier 1 threshold was put at 5%, 1% lower than the 2010 level of the EBA stress test at 6%.

So where the money is going to come from?

In relation to discussions surrounding Capital Regulation, contrary to many beliefs, Bank Equity is not expensive. It is a myth.
A study realised by Stanford University by Anat R. Admati is a must read and available here:
"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

Anat R. Admati is a professor of finance and economics at Stanford University and the co-author of “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”

and a summary of the presentation made to the Bank of England by the co-author is available here, a must read:

"Historical Facts About Bank Capital
• In 1840, equity funded over 50% of bank assets in US.
• Over the subsequent century equity ratios declined
consistently to single digits.
• There is evidence that steps to enhance “safety net”
contributed to this. In the US
– National Banking Act, 1863
– Creation of the Fed, 1914
– Creation of FDIC, 1933.
• Similar trends in UK, Germany. More trading business.
• Bank equity did not have limited liability everywhere
in the US until 1940s!"

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.

The author of the study Anat R. Admati voiced her opinion on the 25th of February in the following Bloomberg article:

"Fed Runs Scared With Boost to Bank Dividends: Anat R. Admati"

"In 1994, the Financial Accounting Standards Board wanted executive stock options to be expensed to reflect their actual cost. Industry opponents threatened that doing so would prevent entrepreneurial firms from obtaining financing, impede growth and reduce U.S. competitiveness.

Massive lobbying forced the board to back off. A decade later, after WorldCom Inc., Enron Corp. and other corporate scandals, the political atmosphere was different, and the FASB finally changed the rules. Since 2006, all companies must treat executive options as an expense. And the doom and gloom we were promised? There is no evidence that expensing options had any negative economic consequences."

and Anat Admati to comment:
"Like homeowners who took a mortgage with little down payments, when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy."

Source - Anat 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."
Source - Anat Admati -

“More equity… would restrict [banks’] ability to provide
loans to the rest of the economy. This reduces growth and
has negative effects for all.” Josef Ackermann, CEO of
Deutsche Bank (Nov. 20, 2009).

Anat Admati concluded her Bloomberg column 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."

And why do banks need more regulations and larger equity capital buffer?

The answer is given to us by Simon Jonhson, who served as chief economist at the International Monetary Fund in 2007 and 2008, and is now a Massachusetts Institute of Technology professor and a senior fellow at the Peterson Institute for International Economics in the following Bloomberg article - "Low Bank Capital Is Next Fiscal Crisis":
"Why was the financial crisis so devastating to the real economy? The answer is that, in large part, financial firms had become so highly leveraged, meaning they had very little real equity relative to their assets. This was a great way to boost profits during the economic boom, but when the markets turned, high leverage meant either that firms failed or had to be bailed out. Many financial firms in trouble at the same time means systemic crisis and a deep recession. In effect, a financial system with dangerously low capital levels creates a nontransparent contingent liability for the U.S. budget through the fall in GDP and loss of tax revenue."
Source - Anat Admati -

For more on the subject:
"Procyclical bank risk-taking and the lender of last resort" - Mark Mink ©

"Providing banks with liquidity support thus effectively allows them to use maturity transformation as a means to lower their borrowing costs, without worrying too much about the higher illiquidity risk.

Through reducing banks’ borrowing costs, the prospect of receiving liquidity support also stimulates forms of bank risk-taking other than maturity transformation. First, it provides banks with an incentive to increase their leverage, i.e. to use more debt and less equity to finance their activities. Doing so, however, comes at the risk of a small decline in asset value being sufficient to wipe out banks’ equity buffers and cause them to become insolvent."

"A leader is a dealer in hope."
Napoleon Bonaparte

So yes, markets are indeed long "false" hopes and most likely, short faith, or short leaders, or both.

Stay Tuned!

Thursday, 6 October 2011

Markets update - Credit - For whom the vol tolls and the return of FAS 159.

For whom the bell tolls
Definition: "An expression from a sermon by John Donne. Donne says that because we are all part of mankind, any person's death is a loss to all of us: “Any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee.”

Rest in peace Steve Jobs.

Today was clearly a day of volatility in the credit space.
Here is the overview.
The range for Itraxx Financial senior 5 year index was between 247 bps to 266 bps and the market closed around 253 bps.
For Itraxx Financial Subordinate 5 year index, the range was between 480 bps to 517 basis points intraday, closing at around 498 bps.

Although the markets in the credit space felt better, it clearly looked like a short covering move.
And my good credit friend to comment:
"Skew basis trades in the credit derivatives universe had for consequence a tightening of the credit indices versus single names (arbitrage selling the indices and buying the underlying single names components). Meanwhile, the cash market barely moved as we still see a lot of sellers and almost no buyers. The ratio seller to buyer was roughly 8:1, and the selling pressure was broad based. Financial bonds as well as corporate bonds are being offered relentlessly and the dislocation we saw in bank bonds and notes is spreading now to almost all issuers.

The name of the game remain Volatility..."

Yes, the markets expect a bazooka of some sort to relieve the pressure in the European space. The ECB's core mandate is price stability and given inflation has been creeping up recently at 3% in the euro zone, a rate cut, which many were expected today, did not materialise. Jean-Claude Trichet's last meeting, did not generate the bazooka, which the market is still hoping at some point.

Itraxx Credit Indices Market overview - Source Bloomberg

Itraxx Financial Senior 5 year CDS index versus Itraxx Europe Main (Investment Grade) 5 year CDS index - Source Bloomberg:

While volatility has been more muted in the CDS corporate space in recent months. The continuous pressure in the financial space means that volatility remains very high as indicated by the absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year CDS index - Source Bloomberg:
Spread between both indices still at the widest levels at around 245 bps. The unsecured funding market is still utterly shut and most issues coming to the markets from the financial space have been so far, covered bonds backed by pools of prime loans, apart from last week 2 year senior FRN (Floating Rate Note) issued by Deutsche Bank as discussed in previous post.
Access to capital is therefore still limited, no change there, with Nationwide Building Society (rating A+/Aa3/AA-) selling 1.5 billion euros of five-year covered bonds, priced to yield 130 bps than the benchmark mid-swap rate according to Bloomberg. We know from the post "Markets update - Credit - Crossing An Event Horizon", that
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."
We know ING sold AAA 10 year bonds at 80 bps over midswaps on the 24th of August, and Unicredit at 215 bps over midswaps on the 25th. It seems every new issue coming in the financial space is pricier than the previous one, and given covered bonds are the most senior guaranteed bonds you can find, senior unsecured bonds and subordinated are repriced accordingly in the process.

And although credit indices enjoyed a short squeeze tightening move, and ECB has pledged to buy 40 billion euros worth of covered bonds, to provide extra financing for banks, liquidity in the market, remains weak - Source Bloomberg:
ECB deposits still rising. But following today's ECB meeting, banks will be offered two additional unlimited loans of 12 and 13- month durations. Trichet in his last ECB meeting mentioned that the Central bank would continue to lend banks as much money as they need in its regular refinancing operations at least until July 2012 to alleviate current liquidity issues we previously discussed.

German 10 year Government yield, Eurostoxx, Itraxx Financial Senior 5 year CDS index and volatility - Source Bloomberg:
While volatility remains elevated, you can notice the correlation between the German 10 year bund yield and the Eurostoxx index.

In the Sovereign Index Space, SOVx Western Europe index (15 countries) is now tighter than the SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:

Confirming what we had discussed in "Markets update - the EM contagion" :
"The CHART OF THE DAY shows the Markit iTraxx SovX CEEMEA Index of credit default swaps on 15 governments in central and eastern Europe, the Middle East and Africa now exceeds a benchmark of western European creditworthiness by 14 basis points. Europe’s worsening deficit crisis is hurting manufacturers, eroding demand for commodities and undermining capital flows in developing economies. Investors are pulling money out of emerging-market bond and equity funds as the risk of a Greek default and losses on sovereign bond holdings mounts."

Meanwhile Ireland continues breaking away from Portugal, Sovereign 5 year CDS wise - Source Bloomberg:

While equity markets are enjoying a respite, we have yet to see a break upwards of the 2% yield for the German bond, still consistent with flight to quality in the European space - Source Bloomberg:

Truth is in the credit space, cash bonds felt weak today has commented by a market maker, with clients still reducing risks and selling bonds which, should not be a surprise given that corporate issuance is repricing credit curves. And cash bonds selling is not helping market makers given a lot of them have lost their risk appetite, as vol (volatility), in the credit space has indeed taken its toll.
Bloomberg - Bond Traders Left Adrift as Dealers Reduce Risk - Shannon D. Harrington and Sarah Mulholland - 6th of October 2010:
"Europe’s crisis of confidence is crippling credit-market trading as banks shrink bond inventories to the least since the depths of the last recession.
Federal Reserve data show U.S. primary dealers cut their holdings of corporate debt by 33 percent to $63.5 billion since May, bringing stockpiles to within $4 billion of the five-year low reached in April 2009. Trading in investment-grade company bonds has dropped 27 percent since February, according to Trace data compiled by Barclays Capital, and a measure of the cost to buy and sell debt is at the highest in more than two years."

and the two authors to add, in relation to liquidity in the credit space:
"Evaporating liquidity is contributing to the biggest junk-bond losses since the failure of Lehman Brothers Holdings Inc. three years ago as Europe’s leaders seek to prevent the region’s fiscal imbalances from infecting the global banking system and the U.S. economic recovery struggles to gain footing. Sales of new high-yield securities have all but disappeared and prices in debt markets are swinging by the most since 2008."
Volatility we have indeed and from the same article we learn that:
"Volatility is making it harder for Wall Street to underwrite loans, Julia Tcherkassova, a commercial-mortgage debt analyst based in New York at Barclays, said yesterday.“Originators need to see that stability.”It takes several months to accumulate mortgages to package for sale as bonds, and price swings on the debt mean that lenders may be stuck with unprofitable loans if values decline in the interim."

So dealers are as well de-risking and deleveraging, leading to wider bid-ask spreads, higher volatility and poorer liquidity, and we haven't seen complete capitulation yet as we saw in 2008.

So how do banks expect to sustain earnings in this difficult trading environment with less leverage, smaller balance sheet exposure, weak issuance and so forth?

Here comes again FAS 159!

In July 2010 I 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."

Wall Street's tricky profits - CNN Money - Roddy Boyd:
"Here's how FAS 159 works: A company can assign a fair (or market) value to its financial assets and liabilities - such as bonds - in order to smooth out earnings. Say a bank sells debt, an IOU, at $1,000 par value. Because of broader credit-market concerns and a slowdown in earnings, that debt trades down to $800. The $200 differential, under standard 159, is allowed to be counted as mark-to-market income, without the bank having engaged in any business activity. The bank then details its use of the rule in footnotes to its regulatory filings."

And Roddy Boyd to add:
"Moody's Investors Services has also warned investors about FAS 159, noting that it risks giving false perceptions of a bank's financial strength. The agency says it "does not consider such gains to be high-quality, core earnings.""

So we have a similar pattern than what I discussed in 2010 namely that:
"With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard time to reap in similar profits they made in Q1."

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “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.”
Any similarities to today's situation are of course purely fortuitous.

And from the same article we learn:
"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

And as David Hendler, Senior Analyst from CreditSights sums it up in the same Bloomberg article:
“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much.”

So, when you have heightened volatility, FAS 159 and Debit Value Adjustment allows banks to increase earnings in bad times but when CDS spreads tighten it works the other way as discussed in "Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings".

FAS 159 is the reason why UBS is expecting a "modest" net profit in the third quarter - Source Bloomberg - Elena Logutenkova - 4th of October 2011:
"UBS AG, Switzerland’s biggest bank, expects a “modest” net profit in the third quarter as gains from a widening of its credit spreads and the sale of bonds helped cushion the $2.3 billion loss from unauthorized trading.
The bank expects to book a fair-value gain of about 1.5 billion Swiss francs ($1.6 billion) as its credit spreads widened in the third quarter."

So, in coming bank earnings, you can expect more of the same, courtesy of the perfectly legal FAS 159 accounting trick which was as well very effective in 2008.

On a final note and as a follow up on our discussion about contagion to Emerging Markets and the Chinese slowdown, here is the updated picture for Australian Financials - Source data provider CMA:
[Graph Name]

"All of us might wish at times that we lived in a more tranquil world, but we don't. And if our times are difficult and perplexing, so are they challenging and filled with opportunity."
Robert Kennedy

Stay tuned!
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