Saturday 16 June 2012

Credit - Agree to Disagree

"Politics is the art of postponing decisions until they are no longer relevant."
Henri Queuille

Looking at the growing spat between Germany and France in relation to the on-going European saga, we thought this time around we would use the term "Agree to Disagree", given that the term "agree to disagree" or "agreeing to disagree" is referring to the resolution of a conflict (usually a debate or quarrel) whereby all parties tolerate but do not accept the opposing positions:
"It generally occurs when all sides recognise that further conflict would be unnecessary, ineffective or otherwise undesirable. They may also remain on amicable terms while continuing to disagree about the unresolved issues." - source Wikipedia.

While our European politicians continue to be irrational/irresponsible in their behavior, and "agree" to continue to "disagree" for now; as indicated by Wikipedia, investors can as well follow a similar path:
"Economist Frank J. Fabozzi argues that it is not rational for investors to agree to disagree; they must work toward consensus, even if they have different information. For financial investments, Fabozzi posits that an investor's overconfidence in his abilities (irrationality) can lead to "agreeing to disagree"—the investor thinks he is smarter than others."

When looking at the growing divergence between US stocks and US Bond yields, and softening US economic data, one can wonder our long US investors can "agree" to "disagree" - source Bloomberg:
"Any multiyear rally in U.S. stocks may depend on a signal that the bond market has yet to send, according to Michael Hartnett, Bank of America Corp.’s chief global equity strategist.
Bond yields have to reach “an inflection point” before shares can move into what’s known as a secular bull market if history is any guide, Hartnett wrote in a June 12 report.
The CHART OF THE DAY compares the Dow Jones Industrial Average and the yield on 10-year Treasury notes since 1900, as Hartnett did in his report. The yield figures were compiled by Yale University Professor Robert J. Shiller and obtained from his website.
Hartnett highlighted three inflection points in the past century, as shown in the chart. They foreshadowed stock-market booms during the 1920s, after World War II, and throughout most
of the 1980s and 1990s.

A comparable surge in share prices is unlikely, he wrote, “until Treasury yields rise in response to stronger growth and a healthier global economy.” The 10-year yield fell to a record 1.4387 percent this month.
Even so, lower yields are giving investors more incentive to shift into stocks from bonds, the New York-based strategist wrote. He estimated that it will take a 0.6 percent yield for the 10-year’s return in the next 12 months to match stocks’ 20th-century average of 10.5 percent a year."
- source David Wilson, Bloomberg, 15th of June 2012.

"Mind the Gap" we indicated on the 8th of May in relation to the European space. European investors had agreed to disagree, we thought at the time, for too long, and now it looks like the gap has been closing. - Top Graph Eurostoxx 50 (SX5E), Itraxx Financial Senior 5 year CDS index, German Bund (10 year Government bond, GDBR10), bottom graph Eurostoxx 6 month Implied volatility. - source Bloomberg:

So, as we go through a credit overview, this time around we will focus our attention on the future of Europe, given that our European politicians, in true "Henri Queuille fashion" are once again playing the "can kicking game". Unfortunately for them, with Spanish yields at 7%, crumbling Spanish Cajas and Greek elections on top of weak economic data, it is decision time.
Henri Queuille was the epitome for "professional politician": he served three times as Prime Minister and was 21 times minister in a French government under the IIIrd and IVth French Republic. He was the symbol of the inefficiency and the failure of the French IVth Republic, but we ramble again (do we really?). Time for our credit overview touching again on our pet subject of "subordinated bond holders" ("Peripheral Banks, Kneecap Recap"), Spanish bondholders are starting to experience similar pain than Irish and Portuguese subordinated bond holders. "Liability" exercises are already leading to some interesting debt-to-equity swaps.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:
While Spanish bonds breached 7% on Thursday, Spanish bonds eased 6 bps on Friday to close at 6.90% while Italian yields receded to around 6%, falling 15 bps. Some of the intra-day relief in Italian and Spanish debt was due to short covering.

Indeed Spanish bond yields have reached "intervention" level for the ECB, with Prime Minister Rajoy pleading for additional support, although the SMP (Securities Market Programme) has been on hold since March, after reaching 219.5 billion euros - source Bloomberg:
"The CHART OF THE DAY shows Spain’s 10-year yields climbed to the highest rate since the start of the euro yesterday, reaching 6.998 percent, on the brink of the 7 percent threshold that helped trigger bailouts for Greece, Ireland and Portugal. Yields are rising even as Spain requested as much as 100 billion euros ($126 billion) in aid for its banks on June 9." - source Bloomberg

As far as Credit Markets were concerned on Friday, it was short covering time, as a European credit market maker put it:
"Market caught between fears over the Greek elections and prospect of a new QE on both sides of the pond. Generally speaking spreads closed somewhat better today in low beta probably fueled by tightening swap spreads. Flow was balanced and trading remains very technical."
The Credit Indices Itraxx overview - Source Bloomberg:
Indeed, short covering it is, in both government bonds market and credit markets as investors and traders alike do not want to be short risk with the looming Greek elections. No surprise to see Itraxx Crossover 5 year index ((High Yield risk gauge, 50 European entities) receding therefore by  more than 20 bps towards the close. Same applies to Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index, receding as well in similar pattern. The Iraxx Europe index, (which comprises 125 high-grade borrowers, 25 of which are banks and insurers), was at 175 bps, five basis point tighter from Thursday's close.

What remains concerning, as we argued in our conversation "St Elmo's fire" on the 26th of May, is that the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March in the index) remains at elevated levels and so does the Itraxx Financial Senior Index, a further indication of the existing correlation between financial and sovereign risk:
In fact the rising spread between Financial risk and Sovereign risk to 38 bps is indicative of the growing solvency fears of some sovereigns which received additional pressure this week with both Cyprus and Moody's seeing their sovereign rating downgrade, with both countries requesting support for their ailing financial system.
-Moody’s downgraded Spain 3 notches from A3 to Baa3 on the 13th of June, and placed Spain on review for further downgrade, following Spain’s announcement that it may seek up to 100 billion euros from the EFSF/ESM to recapitalise its banking system (twice Moody’s previous base case estimate and in-line with its adverse scenario).  FROB was also downgraded from A3 to Baa3 accordingly.  Moody’s is further concerned about Spain’s limited access to markets and its dependence on domestic banks, who in turn rely on the ECB, to support new issues.  Moody’s added it would conclude its review within three months as it awaits clarity on the size/terms of the recap, additional estimates from Wyman/Berger, further euro-area initiatives on a fiscal or banking union, and the impact of the recap package to restore market confidence.
-Moody’s downgraded Cyprus as well by two notches from Ba1 to Ba3, on review for further downgrade, due to a material increase in the likelihood of a Greek exit and its impact on the level of support needed by Cypriot banks.  Moody’s  previously estimated Cypriot banks would need support in the range of 5-10% of GDP but now expects it could be materially higher, with Cyprus Popular Bank alone probably accounting for 10% of GDP.

As we indicated in our conversation "The Spread Also Rises" on the 24th of March following the credit indices rebalancing:
"Replacing Greece by Cyprus is the SOVx series 7 index might not be enough to preserve the 15 member's number status. On the 13th of March, Moody's rating agency joined its peer Standard and Poor's in slashing Cyprus to junk status on heightened concerns over its banking sector’s exposure to Greece. Only Fitch rating agency has maintained its rating for Cyprus one notch above junk."

On the back of Spain's downgrade, Moody's downgraded 12 Spanish Sub-Sovereigns, 2 Gov-Related Entities on Friday.

In relation  to our Flight to quality" picture, Germany's 10 year Government bond yields have been recently rising towards 1.50% and the 5 year CDS spread for Germany has remained firmly above 100 bps in the process. In the recently quoted 24th of March conversation "The Spread Also Rises" we also wondered if the rise in German 5 year CDS was an ominous signs of upcoming stress in the markets, which in retrospect was a good sign - graph below, source Bloomberg
While some "agree to disagree", we, on the other hand "agree to agree" with Nomura in relation to their lower forecasts relating to 10 year German yields. In their 14th of June note they added:
"We are bullish Bunds and in recent months have had a series of lower forecasts for 10yr yields - 1.50%, then 1.25% and currently 1.0%. In all cases, we referred to our forecasts as interim, which reflected our view that as the eurozone crisis nears its denouement, yields could fall far below 1.0% as Bunds came to be traded less as yield instruments and more as collateral instruments with a sizable embedded FX option.
 Such bullishness can be somewhat uncomfortable when the asset you recommend experiences a pronounced sell-off. 10 year Bund yields have risen from 1.127% on 1 June to 1.49% currently! Does this sell-off represent the pricing in of new information or does it provide an opportunity for investors who missed the Bund move to establish fresh longs? We think the latter. Two factors have driven the Bund move, and we do not expect either to persist:
1) Bund “Risk” has been reduced ahead of Greek elections. This could increase the market impact of a “bad” election result, while we fear that even a market-positive election outcome would entail an uncertain period while a coalition was formed. More importantly, the Greek election matters less than it did even a fortnight ago. Then, many investors viewed Greece as a catalyst for the latest market down-leg. But in our view Greece was always a symptom of a European policy mix that is undermining growth, fiscal stability and bank solvency. These broader trends have already led to Spain’s need to request bail-out funds and fuel the growing risk that the country loses market access. A positive Greek election will not assuage these risks.
2) Fears of a fiscal union. Hopes have increased that we will see a European Redemption Fund (ERF) or European Banking Union. However, we do not expect meaningful progress towards fiscal union in a timeframe relevant to the current crisis. Of the various Eurobond proposals, the only one which we believe could generate any period of optimism would be the ERF, but even then only until the market analysed the proposal in detail and concluded – as we do – that it is not a solution and may increase the scale of the crisis. Meanwhile, progress in creating a European TARP would be positive but of limited use unless it was combined with talk of turning the ESM into a bank to allow it to fund the recapitalisation via the ECB. (It is difficult to see another source of sufficient funding for the ESM.)
There is also the risk that the escalation of the crisis means that a truly proportional policy response may be more than can be delivered. After all, the response needs to restart rather than just maintain investment flows from core to non-core countries. While we still expect the ECB to initiate QE in Q3, this may now need to combine with an ECB funded TARP. Even then, we assume that the crisis needs to escalate far further before the ECB/ Germany agree to such options. Given these risks, 10yr Bunds around 1.50% seem attractive."

No wonder in the current European context, there is such a difference between the Spanish and German sovereign yield curve  with a much more flatter German curve - source Bloomberg:

Moving on to the core subject of the future for Europe as we are reaching the end for this extended game of "can kicking", we have been wondering what could make us "agree to agree" rather than continue to "disagree" in relation to our European saga. We think Exane BNP Paribas did a good work in summarizing what is needed to review our negative stance, in their recent note "Crunch time is still not with us" from the 14th of June:
"What policies would we regard as sufficiently radical to upgrade?
Any solution to the Euro area debt crisis is going to have to involve one of three unpalatable policies: a) large scale default, b) mutualisation or c) monetisation.
At present, mutualisation appears to be the most likely solution, with the European Redemption Fund (ERF) under discussion in the German parliament; however aggressive monetary action by the ECB remains a possibility."

In relation to the ongoing issue of circularity, which we discussed in our conversation "Eastern Promises", it means that correlation between Sovereign risk and Financial risk is different between countries since January 2010 - Spain versus Germany:
"Spain 5 year Sovereign CDS versus Santander 5 year Senior CDS, correlation is at 0.92. In Germany, the second graph, since January 2010, Germany's Sovereign 5 year CDS correlation with Deutsche Bank Senior 5 year CDS has only been 0.76.
From the above, one can clearly conclude that the more stress you get on a country's sovereign debt, the higher the correlation with the financial sector."

Exane BNP Paribas in their note added in relation to the 100 billion euros plan for the Spanish banking sector added:
"We do not believe that the Spanish programme will materially alter perceptions of that part of the tail risk which related to the danger of a break-up of the Euro. Furthermore, although, as noted above, the benefits from clearing up the financing issues are considerable, and the difference between the market and official interest rates represents a benefit to Spain, all that has really been done here is to move a liability from the banking sector to the sovereign, in the process potentially introducing a layer of subordination to private sector sovereign creditors. Since it is the sovereign credit which is the driver at present (most major bank CDS have tightened markedly relative to their domestic sovereigns), increasing the sovereign indebtedness in order to recapitalise marginal banks does not necessarily benefit that part of the banking sector which is not directly being assisted."

We have long argued that subordination would lead to insubordination, leading to a buyers strike in the European bond markets which is exactly what has happened courtesy of European politicians meddling.
So what could be the possible solutions for the Eurocrisis? These are the possible outcomes according to Exane BNP Paribas:
"In our opinion, unless one of these major bottlenecks is tackled with a plausible solution, any policy initiative, whether actually implemented or merely suggested, is either a non-solution or simply an exercise in buying time. A number of potential solutions are currently circulating in the policy community, along with a distressingly high number of non-solutions." - source Exane BNP Paribas.

In order to "agree to agree" with Exane BNP Paribas, we think the possible solution for the Eurocrisis goes through mutualisation, default and Official sector involvement:
"Finally, there is the option of default (in a general sense of the word "default", taken to include bail-ins, quasi-voluntary debt tenders, negotiated writedowns and similar operations as well as formal defaults within the meaning of CDS contracts). Sufficiently large debt reduction by official sector creditors is simply another means of mutualisation; more chaotic than Eurobonds, less transparent, setting fewer precedents and in nearly every way less satisfactory, but achieving largely the same goal. As long as the eventual defaults, when they happen, involve a majority of official sector creditors (and/or local banks with similarly few international creditors), the potential for contagion to the wider financial markets could be limited." - source Exane BNP Paribas.

Make no mistake, at some point, as our good credit friend put it, losses will have to be taken.
In relation to the recent European political talks relating to Banking Union, "The road to hell is paved with good intentions", we agree with Exane BNP Paribas that it is a "non-solution":
"Europe needs a short term solution before it can consider a long-term one, and the current nature of the short term problem facing Europe is not necessarily one that is addressed by a banking union."

Indeed, looking at the continuous deposits outflows from Greece, European politicians, while continuously agreeing to disagreeing, are once again utterly and completely behind the curve:
"The problem is that the "failure mode" for Euro exit is most likely to be triggered by a banking system collapse in a peripheral economy such as Greece. And the main stress on the Greek deposit base is not coming from bank-specific concerns related to the credit-worthiness of individual banks, or even related to the ability of individual sovereigns to back up their deposit guarantee schemes in the event of systemic bank failure. Put simply, depositors are worried about getting their savings back in drachma rather than in euros. For this reason, the only guarantee scheme that could persuade them to keep money in the local banking system would be a guarantee of the EUR value of their deposits, which would be payable even in the event of euro exit." - source Exane BNP Paribas.

If our European politicians had studied carefully what had happened in Argentina before their default in 2002, they would not be pressing for a "Banking Union" but should rather be more concerned about a deposit guarantee scheme if they are "really serious" about keeping Greece in the Euro. Back in March we argued the following in our conversation "Modicum of Relief":
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios."

In relation to the similarity of Greece in relation to the Argentina crisis of 2001 leading to its 2002 default, we related to a CreditSights article written at the time of the crisis (CreditSights, 31st of July 2001 paper "Defining the Default Path") :
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested. The term structure of deposits doesn't bode particularly well, especially as the government has tried to force the banks out longer on the curve than is ideal given deposit withdrawals. We estimate that almost 2/3 of deposits are eligible to be withdrawn in the next 30-60 days and we would be surprised if those deposits that extend in the system were put in time deposits. In addition to the obvious potential of a run on the banks, the lack of liquidity in the system has forced the central banks to provide unprecedented level of repos to the system and also relax reserve requirements. The problem is that this is very unclear whether that additional liquidity is funding anything but capital flight at this point."

As far as Spain is concerned, deposits flights have not yet materially happened:
"There was little evidence from aggregate data that the Spanish banking sector was under any particular funding pressure; aggregate domestic deposit balances have declined by 1.3% since the start of the year, which is broadly in line with loan contraction and is therefore likely to reflect overall deleveraging rather than capital flight. Although there were press rumours of a deposit run on Bankia on 11 May (El Mundo), these were not followed up and the official denials appear to have been largely correct in asserting that the deposit flows were seasonal. The large TARGET2 negative balance of the Bank of Spain in the Eurosystem accounts seems to indicate mainly that the liquidity provided in the ECB's monetary operations over the last year has facilitated an orderly withdrawal from Spain by foreign portfolio investors." - source Exane BNP Paribas.

Following on our pet subject of bond tenders, and pain for bondholders as well as shareholders, we have long been expecting such a pain to materialise:
"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.

Banco Sabadell on the 14th of June offered to buy back 1.6 billion euros worth of preferred shares and subordinated debt issued by CAM, a former savings bank  which was acquired by Sabadell in 2011. Sabadell offered to buy back 1.3 billion euros of preference shares issued by CAM and 321 million euros worth of subordinated debt which will be re-invested by investors in newly issued Sabadell shares. Most of these "preferred" shares had been issued to retail clients...

"We believe additional debt to equity swaps will have to happen for weaker peripheral banks, similar to what we witnessed with Banco Espirito Santo in October 2011, as well as for German bank Commerzbank ("Schedule Chicken" - 25th of February 2012)." - Macronomics - Peripheral Banks, Kneecap Recap.

Spain has yet to apply the full extent of the Irish recipe which we discussed "The road to hell is paved with good intentions":"Given the recent outrage by individuals investors relating to the performance of Bankia's share price following its IPO in 2011, it will be interesting to watch the subordinated bond space when looking at the difference in ownership between Ireland and Spain. One has to wonder if Spanish retail investors will be inflicted additional pain..."

Looking at the recent Sabadell "liability" exercise, it looks like Spanish retail investors are bound to be inflicted additional pain. As indicated by Bloomberg in a recent article - "Irish Tell Spain to Imagine the Worst and Burn Bank Bondholders":
"In all, subordinated bondholders suffered about 15 billion euros of losses in Ireland, helped by the direct or threatened use of the new laws, due to expire this year.
Spain may be reluctant to impose losses on holders of junior debt. Bankia Group is among Spanish lenders that sold 22.4 billion euros of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor.
Because of capital structure rules, these investors should be wiped out before losses are imposed on junior debt holders, a move Spanish Prime Minister Mariano Rajoy’s government may shy away from unless he introduces laws to protect them."

Unless our European politicians rapidly introduce European laws guaranteeing depositors money ("insurance for depositors against the risk of euro exit" is qualitatively different from "deposit insurance"), capital flight might start in Spain as it has already in Greece.
"It should also be noted that for the ECB to guarantee the Euro deposit base against redenomination risk is not necessarily as radical a policy as it might seem; really, all it amounts to is a guarantee that the Euro will function as a currency union. This can be seen through a thought experiment." - Exane BNP Paribas

CreditSights in their article relating to Argentina clearly indicated the dangers of deposit outflows. While complacency is prevailing so far in relation to Spanish deposits, it cannot be taken for granted, as shown by the situation in Argentina which quickly spiraled out of control and led to its default in 2002:
"the most puzzling aspect of the crisis so far is the relative complacency of the public. This is starting to be tested." - CreditSights, 31st of July 2001 paper "Defining the Default Path".

Clearly while our European politicians are continuing to "Agree to Disagree" the clock is ticking on the Doomsday European device. As Exane BNP Paribas put it, our European politicians need to come fast with the defusal kit:
"How to defuse a nuclear bomb:
Managing such a crisis would require the ECB to carry out policies which differ by orders of magnitude from anything it has attempted so far. As we noted in an earlier section, a deposit insurance scheme cannot guarantee the entire deposit base against redenomination risk; this is another example of the general principle that a basically fiscal entity cannot do the work of a monetary authority. Furthermore, in a case of a run motivated by fears of euro exit, the guarantee required could not realistically be restricted to the insured deposit base. Even for Greece, the total deposits (domestic NFCs and households) total EUR160bn; for Spain the liability would be EUR714bn and for Italy EUR1trn. Clearly, the only body that could credibly backstop a guarantee to pay depositors the Euro value of their euro-denominated deposits would be the ECB."

On a final note, as indicated by Bloomberg Italy could rapidly come back in the spotlight, should European politicians fail to stabilise Spanish woes: "Italian corporate and household bad debt, totaling a combined 107.6 billion euros, is more than 65% higher yoy while remaining stable ytd. Spain's reported bad debts total 148 billion and have risen 6% in 2012, driven by construction and real estate. Italian corporate and consumer bad debt will likely rise should contagion fears spread."

"Even as Spain requested up to 100 billion euros to bail out its banks, yields on Italian and Spanish sovereigns rose 20 bps to 30 bps. Respective sovereign CDS have also tracked each other closely, although Italian banks outperformed Spanish peers since mid-2011, as Spain's real estate troubles worsened. This may reverse if contagion fears spread." - source Bloomberg

"Politics is not the art of solving problems, but to silence those who ask. "
Henri Queuille

"There is no problem urgent enough in politics that an absence of decision cannot resolve."
Henri Queuille

Stay tuned!

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