Saturday 9 June 2012

Credit - Eastern Promises

"One promises much, to avoid giving little."
Luc de Clapiers - minor French writer, a moralist. Friend of Voltaire.

In our previous conversation "Credit - Something Wicked This Way Comes"as a tribute to American Writer Ray Bradbury, while looking at the ongoing nightmarish European carnival, we mentioned the carnival's leader in Bradbury's book being the mysterious "Mr. Dark". In the book, he bears a tattoo for each person who, has been lured by the offer to live out his "secret fantasies" (markets rumors such as using ESM funding to recapitalized peripheral banks). We thought we would use as a reference for our title this time around the 2007 British-American-thriller-crime film directed by David Cronenberg "Eastern Promises" given the main characters wore detailed tattoos: "Basically their history, their calling card, is their body." - Viggo Mortensen

While our reference to "Eastern Promises" is a reference, somewhat to continuous "broken promises" from the likes of "Mr Dark" in our European carnival, it is also a reference to the growing eventuality of a Euro Break up in the sense that the collapse would be reminiscent of the collapse of the 15 State-Ruble zone in 1994. It is also a reference to December 2011 market talks about "Eastern Promises", namely that China would be the white knight to the rescue of Europe, which came at the time with reports that China's central bank was preparing a $300bn vehicle to invest in the US and Europe. These "Eastern Promises" hopes were dashed on Thursday as the country's sovereign wealth fund said it will not buy any more debt in Europe until the region takes radical steps to restore credibility: "The risk is too big, and the return too low," said Lou Jiwei, the chairman of the China Investment Corporation. He also said in May:
"If European governments want to issue bonds, CIC is not a main target institutional investor."
Of course, why would they, given the "unintended consequences" of the Greek PSI with the imposed subordination of private bondholders in favor of the ECB and EIB leading to a "buyers strike".

Anyone who believes China will be the White Knight is deluded. China has been executing its long term strategy for decades. They are investing on their own terms and in "real assets" like agricultural land, prime buildings, infrastructure (ports, toll roads, energy networks, rail) and commodity and mining companies to name a few. We do not think China will invest in Euro bonds, ESM bonds or any other "European promises".
So while our European carnival moves on from one country to the next, with the heightened possibility of a break-up, deposits are indeed moving East, leaving Germany awash with cheap deposits, as it is becoming a magnet for depositors, seeking a safe haven.
So in our credit conversation, we will go through these "Easter" deposits movements and the collapse of the 15 State-Ruble zone in 1994. But, as always, first our credit overview.

The Itraxx CDS indices picture on Friday - source Bloomberg:
Although Itraxx Crossover 5 year CDS index (50 European High Yield entities - High Yield credit risk gauge) is slightly tighter, the SOVx index representing the CDS gauge risk for 15 Western European countries (Cyprus replaced Greece recently in the index) remains at elevated levels around 323 bps and so does the Itraxx Financial Senior Index at 277 bps, while much tighter, a further indication of the existing correlation between financial and sovereign risk. It also indicates that the ECB's support so far is still resting with the financial sector.

Itraxx SOVx index versus Itraxx Financial Senior 5 year CDS (senior unsecured financial risk gauge) - source Bloomberg:

The spread difference between Sovereign Risk and Financial Risk has been rising to 44 bps recently indicating additional stress in the sovereign space. No surprise given they are some rising concerns relating Cyprus, which replaced Greece in the SOVx index comprising 15 Western Europe countries and Fitch recently downgraded Spain three notches from A to BBB on Thursday following the Spanish auction which saw Spain placing 2022 bonds at around 6.04% (At a sale of the 5.85 percent January 2022 bonds on April 19, Spain paid an average yield of 5.743 percent according to Bloomberg).

As indicated in the below graphs from a recent study made by French bank Natixis on the 7th of June, correlation between Sovereign risk and Financial risk is different between countries since January 2010 - Spain versus Germany:

For instance in the graph indicating 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.

Friday's price action in the European Bond Space saw Spanish yields wider towards 6.20%. Germany saw their yields falling again to 1.29%  in another move towards "flight to quality" - source Bloomberg:
Indeed, time is running out for Spain, time is running out for the ECB to deliver a substantial policy response to pull the "European carnival" back from the brink.
As Nomura put it in their recent note "ECB : Primed for QE?" from the 1st of June:
"It feels like we have been here before. The euro area seems to be edging closer to its breaking point. Markets are again calling on the ECB to deliver a substantial policy response that can pull the euro area back from the brink. Our core view is that an ECB policy response is coming, initially as rate cuts and ultimately QE in the form of outright asset purchases."

“Time is really the only capital that any human being has, and the only thing he can’t afford to lose.’” – Thomas Edison

But as Nomura put it in the same note, "Mr Dark's" European promises are luring less and less believers to the markets altar:
"Markets, however, have little faith in a banking union plan for three reasons. First, Bankia may not be alone, so the ESM would need more funds to support potentially large parts of the Spanish banking sector. Second, it is highly unlikely there will be any political backing for a plan in Northern Europe that uses taxpayer money to directly bail out Spanish banks. Third, markets have lost patience with the incremental approach taken so far by policymakers. The Governor of the Banca d'Italia summarised the view of the international investment community, namely that international investors have doubts about the ability of euro-area governments to ensure the survival of the single currency. The view is plain and simple . time is about to run out."

We would have to concur with the above statement. Time is the most precious commodity and it has been properly wasted as far as Europe is concerned.
“Time stays long enough for those who use it.“ – Leonardo Da Vinci

Nomura also added in their note:
"If markets are losing faith that the euro area will survive, that's very serious. Foreign exchange traders have already voted: in effective terms, the euro is now at its lowest level since 2003."

Moving on to the subject of deposits flying to German banks with Germany's appeal working as a powerful magnet (we already discussed the dollar's magnet appeal in our conversation - "Risk-Off Correlations - When Opposites attract"), as indicated in Bloomberg by Annette Weisbach, Nicholas Comfort and Boris Groendahl, Germany is awash with liquidity:
"As Europe’s sovereign debt crisis escalates, Germany is becoming a magnet for depositors keen to stow their savings in the euro area’s safest market.
Deposits in Germany rose 4.4 percent to 2.17 trillion euros ($2.73 trillion) as of April 30 from a year earlier, according to European Central Bank figures. Deposits in Spain, Greece and Ireland shrank 6.5 percent to 1.2 trillion euros in the same period, including a 16 percent drop for Greece, the data compiled by Bloomberg show.
As banks in Europe’s periphery fret over lost deposits, German lenders are awash in liquidity that comes on top of more than 1 trillion euros the ECB has made available in three-year loans to banks since December to ease the flow of credit. The prospect of Greece leaving the 17-nation euro region is fueling the capital flight as parties opposed to the terms of the country’s second bailout prepare for a new ballot on June 17 after winning most of the votes in elections last month. “The longer the debt crisis lasts, the more funds will flow to Germany,” said Dieter Hein, a banking analyst with Fairesearch GmbH in Frankfurt suburb Kronberg. “People think of Germany as the euro area’s safest country.” The funds are a boon for domestic lenders, contributing an extra 5 billion euros in customer deposits at Deutsche Bank AG from September to March. Frankfurt-based Commerzbank AG added about 7 billion euros in deposits in the first three months of 2012, helping to erase its need to tap bond markets for refinancing this year, according to a May 9 presentation."

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 1.50% yield) with 5 years Germany Sovereign CDS slightly above 100 bps - source Bloomberg:

We voiced our concerns to "Mr Dark" in our last credit conversation "Something Wicked This Way Comes" the following from our conversation "From Hektemoroi to Seisachtheia laws?"
"We keep repeating this, but it is still very much a game of survival of the fittest....Cash is clearly king in the Basel III framework and, as Nomura put it, will therefore could lead to a war for deposits in Europe...The British stiff resistance to the latest regulatory proposals come from the fact that banks are very large in the UK relative to their GDP."

As confirmed by Bloomberg's article a war for deposits is happening given:
"Bank deposits are a main source of funding independent of the interbank and wholesale markets. Deposits by retail clients in particular are less likely to be withdrawn quickly in times of stress because the funds are secured by state-backed deposit insurance programs. New liquidity rules proposed by the Basel Committee on Banking Supervision stipulate that retail and small-business
deposits are a source of funding that’s almost as stable as equity in crisis situations.
A loss of deposits leaves banks in Greece and Spain even more dependent on the ECB for funding."

In facts German banks can thank their good fortune and the appeal of their safe-haven country given that following the downgrades of German banks this week by rating agency Moody's (undertaking the review 114 financial institutions, after Italy, and Spain). As Bloomberg rightfully so indicates:
"Moody’s Investors Service, which downgraded Commerzbank and six other lenders in Germany this week, said the credit rating cuts would have been deeper if not for the banks’ diversified funding."
So, German banks thank you European depositors united.
From the same article, dear credit friends, welcome to the European "war for deposits"!
"Non-German banks are trying to attract customers by offering higher interest rates than German peers. New clients with 10,000 euros of available cash would get annual interest rates of 2.4 percent for deposits without maturity at Paris-based BNP Paribas SA’s Cortal Consors unit, and 2.55 percent at MoneYou, a unit of Amsterdam-based ABN Amro Bank NV, according to financial consultant FMH Finanzberatung. That compares with 0.25 percent at Deutsche Bank and 0.3 percent at most German saving banks."
In relation to the 1994 demise of the 15 State-Ruble zone in 1994, as budget deficits spiraled out of control, only two members survived. Remember, it is still a game of survival of the fittest.
"While differences between the Soviet Union and the EU are greater than their similarities, there are parallels that may prove helpful in assessing the debt crisis, historians say. Both were postwar constructs set up in response to a collective trauma; in both cases, the founding generation was dying out as crisis hit and disintegration loomed."
Europe's "Prisoner's dilemma" (The prisoner's dilemma is a canonical example of a game analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so):
"The alternative scenario of deeper political union in a bid to save the euro may be even more dangerous, the British historian Antony Beevor said in an interview in Stockholm, where he was promoting his new book, “The Second World War.” “We are about to see a terrifying paradox,” Beevor said. “If the European Union goes for sudden unification to control the economies of the south which are doing so badly, then we are going to see almost an elective dictatorship from Brussels, with just the presidential elections being direct. That is going to produce the opposite of what they wanted -- i.e. it will reawaken the monster of nationalism.”

It will not reawaken the monster of nationalism, the monster is already awake, in Greece:
"Golden Dawn, a Greek nationalist party with a red-and-black logo resembling a disentangled swastika, entered parliament for the first time in the May 6 election." - source Bloomberg.

But it isn't an isolated phenomenon. Populism is rising in France, in Hungary to name a few. Pandora's box has been opened.
As far as we know, in relation to the rise of populism in Europe on the back of this "European carnival", it has long been our expectations, (we reminded ourselves this evolution in our conversation "The Charge of the Light Euro Brigade" ):
In July 2010 in our conversation - "I promise to pay the bearer on demand...- Panics and Populism", we argued the following:
"Populism movements are deeply correlated to Panics and Depression throughout human history.
The emergence of the Tea Party movement in the US in 2009 is reminiscent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war. The Greenback Party was born because of the Great Depression of 1873."
We would add that the same process of rise in populist movements and extremism happened in Europe in the 1930s.
As a reminder we also indicated:
"The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.
The panic of 1873 was followed by a similar panic in 1893 in the US.
Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.
The market overbuilding and the real estate bubble led to the financial crisis of 2007 which started with subprime."
Same apply to Ireland and Spain, over expansion of credit led to a real estate bubble.

The demise of the 15 State-Ruble zone in 1994:
"In the end, it was Russia that dealt the death blow to the ruble zone by setting ever-tighter restrictions and introducing a currency reform in 1993 that took fellow members by surprise."
We think the breakup of the European Union could be triggered by Germany, in similar fashion to the demise of the 15 State-Ruble zone in 1994 which was triggered by Russia, its most powerful member which could lead to a smaller European zone. It has been our thoughts which we previously expressed (which we reminder ourselves in "The Daughters of Danaus"):

Back in November, in a conversation with Cullen Roche on Pragmatic Capitalism - "The Impossible Refinancing Burden...", we argued:
"To put it simply there is no way Italy can refinance without the ECB acting as lender of last resort. The EFSF has not enough firepower to support both peripherals and the bank recapitalization process. It is either one or the other. Given the issue of circularity and the need for economic growth to break debt dynamics, I do not see the solvency issue resolved without the ECB stepping in. The big question is, would Germany allow the ECB to alter its DNA given it would contravene the Lisbon treaty, if it starts intervening massively? I have some doubt about it, and it is a scary prospect. So far the Bundestag and German Constitutional court have stepped in to rein in the expansion of the EFSF, because they do not want to betray German people. Either they know it is not the solution and are buying some time to allow for more integration within Europe and using it as a bargaining tool to force Greece and others to concede their independence somewhat in exchange of stronger support, or, the game is for Germany to buy some time and leave and join force with Austria, Finland, the Netherlands, and leave peripherals on their own."
Could Germany be like Hypermnestra and decide to go her own way as the Danaides story goes? But once again we divagate in our thoughts."

As Ivan Krastev, chairman of the Centre for Liberal Strategies in Sofia was quoted in the Bloomberg article mentioned above on the demise of the 15 State-Ruble zone in 1994 :
“A currency is about trust”
“There is a need for an emotional sense of shared citizenship to have a common currency. It is good to have a shared sense of belonging.”

On a final note, we leave you with a table indicating the total Euro Zone Bank Bail-inable liabilities, a subject we discussed recently in "Something Wicked This Way Comes":
"Total euro-zone bank liabilities reached a new high of 33.9 trillion euros in April. Assuming "bail-inable" liabilities, plus capital, have to meet a minimum 10% of total liabilities by 2018, as mentioned in the E.C. working paper, a total of 1.1 trillion euros of bail-inable bonds could be required, in addition to current capital of 2.25 trillion." - source Bloomberg.

"Unless commitment is made, there are only promises and hopes... but no plans."
Peter Drucker

Stay tuned!

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