Credit - The Raft of the European Medusa

"The man who has experienced shipwreck shudders even at a calm sea."
Ovid

"The Raft of the Medusa (French: Le Radeau de la Méduse) is an oil painting of 1818–1819 by the French Romantic painter and lithographer Théodore Géricault (1791–1824). Completed when the artist was 27, the work has become an icon of French Romanticism. It is an over-life-size painting that depicts a moment from the aftermath of the wreck of the French naval frigate "Méduse", which ran aground off the coast of today's Mauritania on July 5, 1816. At least 147 people were set adrift on a hurriedly constructed raft; all but 15 died in the 13 days before their rescue, and those who survived endured starvation, dehydration, cannibalism and madness. The event became an international scandal, in part because its cause was widely attributed to the incompetence of the French captain perceived to be acting under the authority of the recently restored French monarchy." - source Wikipedia

Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa".

"In an effort to make good time, the "Méduse" (Medusa) overtook the other ships, but due to poor navigation it drifted 100 miles (161 km) off course. On July 2, it ran aground on a sandbank off the West African coast, near today's Mauritania. The collision was widely blamed on the incompetence of De Chaumereys, a returned émigré who lacked experience and ability, but had been granted his commission as a result of an act of political preferment." - source Wikipedia.

Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market.

So in our long credit conversation, we will of course look at the recent price actions, but we will focus on Greece and the recent comparisons made with Argentina being the comparison "du jour" (of the day), rebuking in the process some "urban legends" and economic myths.

But first our credit overview!

The Credit Indices Itraxx overview - Source Bloomberg:

The price action was undoubtedly experienced in the European morning session with a significant widening of most Itraxx Credit indices coming from rising tensions in the European Government bonds space. Itraxx Crossover 5 year CDS index widened to 751 bps (50 European High Yield entities), before receding in the afternoon to end up around 740 bps. Itraxx Main Europe 5 year CDS representing 125 Investment Grade entities widened as well, and moving towards the 200 bps, indicating significant risk perception rising in the European credit space. This index, like most, has been steadily rising for the last seven days. Both indices have reached their highest level since the 9th of January according to Bloomberg. The financial space wasn't spared either with Itraxx Financial Senior 5 year CDS index, representing a gauge for renewed financial tensions, touched 300 bps before receding slightly in the afternoon, whereas the Itraxx Financial Subordinated 5 year CDS index jumped towards the 500 bps level, closing around 480 bps. Upcoming additional Moody's downgrades of additional European banks (Moody's has already cut 26 Italian banks), will cause this index to drift wider still. We have discussed the impact of the upcoming downgrades on subordinated bank debt in our last conversation "Interval of Distrust".

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge):

High Yield Risk perception rising in conjunction with Volatility.

At the same time we are seeing Financial risk reconnecting fast with Sovereign risk, as indicated by the convergence of Itraxx Financial Senior Spread 5 year CDS and SOVx Western Europe 5 year CDS - source Bloomberg:

The spread between the Itraxx SOVx Western Europe and Itraxx Financial Senior is moving towards 0 clearly indicating the LTRO effect is a becoming a distant memory with an increased correlation of both indices with rising sovereign risk concerns (Spain, Italy). The drop witnessed in March in the graph is due to Greece falling out of the SOVx index (15 Western Europe countries) and replaced by Cyprus ("SOVx Western Europe - And Then There Were 14...").

The current European bond picture with Spain experiencing a serious bout of volatility in conjunction with Italy- source Bloomberg

Spanish 10 year government yield intraday movements on the 16th of May - source Bloomberg:

Moving fast and furiously towards 6.50% yield levels before receding due to rumors of ECB emergency meeting and possible re-activation of SMP (Securities Market Programme).

As indicated by Bloomberg, Spain spread over bund at 450 bps, has been previously a key level for previous European bail-outs - source Bloomberg:

"With Spain's CDS reaching new highs (544 bps), the spread of its 10-year sovereign over the German bund has reached 4.5%, a level viewed as significant for triggering bailouts in both Portugal and Ireland. At a time when profitability is falling thanks to new provision rules, elevated sovereign CDS and spreads will also drive higher funding costs for Spain's banks." - source Bloomberg.

The slump in Spanish bonds risks LCH margin increases which is concerning. This margin increase on the LCH exchange could happen given in the past the 450 bps difference with German Bund has been the threshold as indicated by Bloomberg:

"LCH said in October 2010 that a yield premium of more than 450 basis points would “be indicative of additional sovereign risk,” and may cause it to “materially increase the margin required for positions in that issuer.” Clearing houses guarantee trades are completed by standing in the middle of two counterparties, and raise margin requirements to protect themselves against losses should one side of the trade fail."

"Spanish government bonds risk incurring higher trading costs at LCH Clearnet Ltd. as their performance relative to Europe’s safest assets deteriorates. The CHART OF THE DAY shows the difference in yield between Spanish 10-year bonds and a benchmark of AAA rated euro-region sovereign debt is approaching 450 basis points for the first time since the shared currency was created. LCH, Europe’s biggest clearing house, increased the cost of trading Irish and Portuguese bonds by 15 percent when yield spreads for those securities climbed to similar levels." - source Bloomberg.

The 10 year German Bund and the Eurostoxx seem to reconnect at least from a directional point of view with volatility rising as indicated in the bottom part of the graph - source Bloomberg:

Some change in the "Flight to quality" picture, with wider Germany 5 year CDS closing towards 100 bps and 10 Government bond well below 1.60% yield level - Source Bloomberg:

As a reminder, bear in mind we previously saw a spike in Germany's sovereign CDS back on the 29th of November 2011 ("The Eye of The storm"), prior to the German "failed" auction which lead to a significant widening of the German Bund yield above 2.30%, when Germany's sovereign 5 year CDS went above the 100 bps level. We are getting closer to 100 bps for Germany's sovereign CDS. The cost of insuring German debt is rising fast, even as its bond yields are falling. Credit-default swaps on Germany jumped 10 basis points this week to a four-month high of 98, signaling worsening perceptions of German credit quality. The German Sovereign CDS was at 67 basis points on March 19 according to Bloomberg.

In relation to Spanish banking woes, Bankia share price is indeed suffering from the "partial" nationalization process undertaken by the Spanish government and from the plight of its real estate issues and significant exposure, being the focus of attention - source Bloomberg:

The second phase of real estate provisioning reforms announced on the 11th of May, enforces a 30% generic reserve coverage of performing loans instead of 7% and make it compulsory for banks to transfer all problem foreclosed assets into a separate work-out subsidiary at "fair value", which will have to be appraised by an independent auditor, in similar fashion to what Ireland did for the set-up of its work-out entity NAMA. The additional cost to banking giant Santander will be 2.7 billion euro of provisions in addition to the 2.3 billion euro ear-marked for provision to be passed before end of 2012. While Santander, has not provisioned the 2.3 billion needed under RDL 1 (Royal Decree Law 02/12), BBVA has so far provisioned 175 million euro in the first quarter. The total cost for each of them will amount to one or two quarters worth of earnings on a net basis according to CreditSights (5 billion euro for Santander, around 4.025 billion for BBVA). For our ailing Bankia, the cost will amount to 4.7 billion euro pre-tax, which is more than ten times 2011 pre-tax profit...Oh dear...

According to CreditSights, the New Real Estate Rules means significant additional provisioning under RDL 2:

"Additional provisioning under phase 2 will cost the whole banking system almost 30 billion euro in 2012, on top of 39 billion euro from Phase 1, most of which has still to be charged to income statements over the next three quarters."

As we type, Bankia shares have touched a new low, falling another 26% to 1.29 euros experiencing a similar fate witnessed with Portuguese banks Banco Espirito Santo and Banco Comercial Português (BCP).
Banco Espirito Santo stock price evolution - source Bloomberg:

Banco Comercial Português (BCP) stock price evolution - source Bloomberg:

We believe subordinated debt to equity swaps are coming for some weaker financial institutions with more pain for both shareholders and bond holders ("Peripheral Banks, Kneecap Recap"). Bankia's IPO initiated in July 2011 drew 347,000 investors, most of them individuals, have lost as of today's price action two-thirds of their ill-fated 2011 investment. The IPO, as indicated by Bloomberg was successful because it was made on "illusory promises":

"To lure buyers, Bankia held out the promise of distributing about 50 percent of its net income as dividends. “The IPO was mainly a dividend play, so it appealed particularly to retail investors when interest rates elsewhere are so low,” said Ipox’s Schuster. “Bankia has a strong retail network and that’s basically how the deal got done. Now not only their shares get diluted, it’s also a question mark whether Bankia will be able to deliver future dividends.”

15 underwriters or undertakers, one as to ask oneself, given as indicated by Bloomberg:

"A total of 15 underwriters led by Bank of America Corp., Deutsche Bank AG, JPMorgan Chase & Co. and UBS AG earned a commission of about 1.2 percent on the 3.1 billion-euro IPO, or about 37 million euros, data compiled by Bloomberg show. While managers were taking orders for Bankia’s IPO, investor concern about Europe’s deepening debt crisis was already propelling Spanish bond yields to what was then a euro-era record. The lender had to reduce its IPO price by about 26 percent from its initial range in order to complete the sale.

The IPO “has been considered a reference point for the Spanish banking industry” and was completed “in the middle of a true storm in the markets that imposed the toughest financial conditions of the last decade,” Rodrigo Rato, Bankia’s chairman at the time, said in a speech on July 20."

Individuals bought about 60 percent of the shares on sale in the IPO...

Back in November we gave a clear warning:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

Like experienced shipwreckers we did shudder during the calm sea ("Plain sailing until a White Squall?").

Moving on to the subject of Greece being compared to Argentina by many pundits, we would like to make the following points:
Most Greek Banks are most likely bust. Greek Banks 5 year CDS on the 16th of May - source CMA:

Greek banks had negative equity given their very large exposure to Greek government bonds. As a reminder Greek banks are required to reach 9% Core Tier 1 by September 2012 first via private sources and if it fails then government. We discussed the issues of raising private sources faced by Apostolos Tamvakakis, chief executive of National Bank of Greece, launching a recent desperate last-ditch attempt in securing private funding in our recent conversation "Kneecap Recap". Greek private bank shareholders will be wiped-out. 30% of National Bank of Greece shares are in the hands of foreign investors such as Bank of New York Mellon, BlackRock, Allianz, Pictet, Prudential Financial, Aviva, AXA, HSBC and BBVA, according to Bloomberg data as we indicated in our recent post.

No wonder the Greek stock index is still tanking on the 16th of May - source Bloomberg:

We already touched on the value of Greek financial shares in our conversation "Equities, there's life (and value) after default! - Russia, Argentina, Iceland, examples for Greece":

"Given the outstanding weight of financials in the Greek ASE index and knowing their current Greek debt holdings, Alpha Bank, National Bank of Greece, EFG Eurobank and Piraeus bank respective equity is probably worth zero. It should in theory equate to an additional write down of at least 16.74% of the ASE Greek index." - Macronomics - 4th of March 2012.

At the time of our conversation the ASE index was at 741...Now below 555.
Financial weights as of the 16th of May 2012 in the ASE index, Banks =15.44% - source Bloomberg:

Greek Banks May Face Same Dilemma as Argentine Banks in 2001-02 according to Bloomberg:

"A key problem faced by the Argentine banks as fears of devaluation drove depositors to switch to foreign currency was the resultant currency mismatch on its balance sheet. Pressure to address this drove many banks to increase foreign-currency lending, which brought with it increased default risk, an issue which Greek banks may need to address."

Greece is not Argentina, and will fare worse as indicated by Bloomberg:

"GDP growth was negative in Greece during the last 14 quarters. While Argentina's banks and economy recovered quickly with 9% GDP growth and a rebound in consumer spending in 2003, austerity measures and lingering sovereign concerns suggest that Greece and its consumers may struggle to achieve this, implying a slower return to profitability for its banks."

Argentine Banking Asset Loss a Stark Warning to Greek Banks - source Bloomberg:

"While Argentina suffered significant deposit outflows prior to devaluation, deposit growth was 19% by the end of 2002, rising to 26% in 2003. By contrast, loans in the system did not return to growth until 2004 and many years later the recovery in assets is far behind deposits. Should a similar fate befall Greece, funding for recovery may be hard to secure." - source Bloomberg.

In relation to Greece, its neighbor Bulgaria (475 kms of frontier with Greece) enjoy a 10% corporate tax rate and a 20 tax rate on individuals. A record rise has been registered in the number of people crossing the Bulgarian-Greek border at Easter:

A total of 220,000 people and 77,600 vehicles crossed the border at the five checkpoints between Bulgaria and Greece on the four days off at Easter (between Friday and Sunday). For comparison, nearly 48,000 vehicles and 142,000 people crossed the border at Easter in 2011...

We have long been enthusiast readers of Dr Felsenheimer from Asset Management Assénagon monthly credit letter. In his latest letter Dr Felsenheimer clearly indicates Dr Krugman lack of understanding of the banking system, core to the current European crisis:

"Dr Krugman now suggests a solution based on three elements: Firstly, the ECB should buy government bonds. Secondly, the foreign trade imbalances between the member states should pursue an expansionary policy to help countries reduce their debt through moderate inflation."

Dr Felsenheimer's clearly indicates why Dr Krugman's assessment is incorrect, given Dr Krugman seems to ignore the interdependence of banks and governments:

"The purchase of government bonds by the ECB (however it is implemented) increases precisely this interdependency further still. You don't need to be a market moralist (if such a thing exists) to see the purchase of government bonds by a central bank as a Ponzi game. But to force the reduction of foreign trade imbalances is to argue against all microeconomic reason. Such a policy would of course solve the problem of the target II balances en passant. However, we should first of all ask how such an imbalance reduction could be achieved. It is clear that reducing a trade surplus is easier than reducing a deficit. This means that Germany in particular would have to accept export restrictions, which would be in direct opposition to the desire for growth impetus. Ultimately, the ECB's extremely expansionary policy must be held partly responsible for the crisis. The demand for further expansion in turn represents the danger of further speculative bubbles.

The US has pursued a response to the crises of recent years very close to that of Krugman's theory, at least regarding the role of the FED (the largest investor in US government bonds). Any sustained success however is questionable. Even though Europe has pushed the US out of the headlines in recent months, the US debt situation has not improved at all.

Should we not maybe do exactly the opposite of what classical theory suggests? Does a restrictive monetary and fiscal policy not mean that the entire banking system has to "deleverage" and shrink its enormous balance sheets? It could be argued that the state should step in to help during such a transition (e.g. by partially compensating for the cuts in lending that would be expected), however that is something completely different to pursuing expansionary policies itself.

Less liquidity in the banking system reduces the danger that speculative bubbles will form, it forces the necessary consolidation in the banking system and it puts pressure on countries to pursue a sustainable economic policy to attract investors. The logical consequences of the European solution (assuming that this is largely continued even during Hollande's presidency) is that it involves a painful adjustment process that already been underway for two years. The Anglo-Saxon method does not promise a solution, but rather a postponement of the problem. It does not solve the fundamental problems of the euro zone."

A bank is a leverage play on the economy. It is the second derivative of a sovereign.

This is exactly the solution Sweden implemented during its 1990s crisis.

Sweden, suffered a banking crisis in the early 1990s and then again in 2008 and 2009. They chose to inject capital into struggling banks only in return for equity to avoid raising deficits and burdening taxpayers. The government in 2008 set up a financial stability fund by charging banks an annual fee and enacted various crisis-management measures including a bank guarantee program to help support lending.The fund will grow to 2.5 percent of gross domestic product by 2023 and stood at 35 billion kronor ($5.2 billion) at the end of 2010, including shares in Nordea Bank AB, according to the Swedish National Debt Office.

The Swedish example comes to mind when thinking about the ongoing interdependence between banks and governments. Cheuvreux in their recent note "Why the nordics are a safe haven" touched on the deep restructuring process followed by Sweden, which lead to the disappearance of some banks (survival of the fittest) and the following results:

"The rule is only: spend less than you earn…

In addition to substantial tax increases to balance the budget and reduce debt, the social security payments were capped resulting in real decreases as the pay-outs were not kept in line with GDP growth. In addition, checks and balances were introduced with automatic stabilisers which did not allow spending to outstrip growth, such as seen in the pension system where significant reform was passed by all the major political parties in 1995.

Furthermore in the budgetary process the role of the Ministry of Finance has been strengthened forbidding spending ministries to launch proposals without financing, not allowing parliament to make unfunded amendments, introducing a rolling budget ceiling that must not be breached as well as a 1% budgetary surplus intended as a saving to handle the retirement of the baby boomers in the 2020s, i.e. a Swedish balanced budget includes a 1% extra margin of safety which can be compared to the European average budget deficit of around 6%." - Cheuvreux - Why the nordics are a safe haven - 2012.

In addition to Dr Krugman's unwillingness of understanding interdependence, the idea that Germany's economic prosperity has been built on "vendor financing" to peripherals countries is a myth. In a recent paper published by François Chauchat from Gavekal we learned that: "exports to Southern Europe have contributed to only 13% of the increase in German exports since 2000 and never amounted to more than 5% of German GDP. In comparison, exports to non-EMU countries rose to 25% of GDP recently, from 15% in 2000. So even though Germany lent a lot to southern Europe - making its financial sector very vulnerable - this financing was used more to buy Chinese products, oil and commodities than German goods."

Eastern promises for Germany according to Moscow-based economist Liam Halligan:
"Russo-German trade Europe's 'biggest untold story' says top economist" - Chris Sloley - Citywire:
"Russia’s biggest trading partner is now Germany and Germany’s biggest trading partner is now Russia, having overtaken France,’ he said.
‘It is the biggest untold story but western papers don’t want to talk about it. It is part of a trend of Germany looking increasingly east and you feel it much more strongly if you are working in the east and how this has changed on the ground.’"

Finally the Argentina crisis should be a warning on Spanish Banks' Sovereign Holdings (we already know what happened to Greek banks bond holdings...):

"Spanish banks increased their sovereign holdings by 48% since November 2011, Italy increased theirs by more than 30%. Argentine bank sovereign holdings and government loans rose to 21% from 10% of total assets in 1995-01. A consequence of this was less private sector funding, a risk for Spain and Italy should conditions worsen and deleveraging continue." - source Bloomberg.

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

Stay tuned!