Saturday 30 June 2012

Credit - The European crisis: The Greatest Show on Earth

"We bring you the circus — that Pied Piper whose magic tunes lead children of all ages, from 6 to 60, into a tinseled and spun-candied world of reckless beauty and mounting laughter; whirling thrills; of rhythm, excitement and grace; of daring, enflaring and dance; of high-stepping horses and high-flying stars.
But behind all this, the circus is a massive machine whose very life depends on discipline, motion and speed . . . a mechanized army on wheels that rolls over any obstacle in its path . . . that meets calamity again and again, but always comes up smiling . . . a place where disaster and tragedy stalk the Big Top, haunt the backyards, and ride the circus rails . . . where Death is constantly watching for one frayed rope, one weak link, or one trace of fear.
A fierce, primitive fighting force that smashes relentlessly forward against impossible odds: That is the circus. And this is the story of the biggest of the Big Tops . . . and of the men and women who fight to make it — The Greatest Show on Earth! "
 - Cecil B. DeMille, 1952, opening remarks, source Wikipedia.

In continuation to the theme of Great Classic Movies (which we recently touched in our conversation - River of "No Returns") and looking at the on-going European circus, we thought our reference to Cecil B. DeMille 1952 classic would be more than appropriate. After all, in similar fashion to this Best Picture Academy Award winner, our European circus storyline is supported as well by lavish production values, actual circus acts, and documentary, behind-the-rings looks at the massive logistics effort which made big top circuses possible (ECB's SMP, EFSF/ESM...).
But the similarity of our European circus does not stop there. In the storyline of the movie, the show's board of directors planned to run a short 10 week season rather than risk losing $25,000 a day in a shaky post-war economy. The hero Brad Braden, the no-nonsense general manager, bargained to keep the circus on the road as long as it was making a profit, thus keeping the 1,400 performers and roustabouts who made Ringling Bros. and Barnum & Bailey Circus' the Greatest Show On Earth working.
Unfortunately for us, the European "board of politicians" have clearly decided to take the long run option (19th European summit) in our shaky post-financial crisis economy, very much bargaining in similar style to Brad Braden in trying to keep the European circus on the road as long as it is making a profit (Germany's economy being key). But it looks like we are rambling again...
Time for our credit overview, where we will review the latest European plan as well as looking at some worrying trends in the French economy which needs close monitoring, namely margin ratio in the corporate sector as well as rising delays in Terms of Payments as reported by corporate treasurers in the latest AFTE monthly report (French association of corporate treasurers).

The Itraxx CDS indices picture, a tale of ongoing volatility, and recent short covering - source Bloomberg:
Following some break through at the European summit in Brussels, Friday's month end rebalancing trades triggered a buying spree in the credit market courtesy of Real Money demand, fuelled by tighter swap spreads, bund widening and soaring Eurostoxx (+4.96%), with high beta names such as carmakers and perpetual bonds leading the tightening move on the day.

In the credit indices space, most of the credit indices experienced a similar experience to the equity markets, namely a significant tightening move, no surprise therefore to see Itraxx Crossover 5 year index ((High Yield risk gauge, 50 European entities) receding by around 38 bps on the close towards the 660 bps level. Same applies to Itraxx Financial Senior 5 year index and Itraxx Financial Subordinated 5 year index, receding as well in similar pattern by 27 bps and 34 bps.

The slight underperformance of the Itraxx Subordinated 5 year index versus the Senior Itraxx index can be explained by credit markets expecting additional pain to be inflicted to Spanish subordinated bondholders in the necessary restructuring process that needs to take place. Both  the Itraxx Financial 5 year index and the Itraxx Main Europe 5 year index (Investment Grade risk gauge based on 125 European entities including financial institutions)  indices recorded a fourth weekly decline, and the biggest monthly drop since January.

Interestingly, given the recent downgrades which took place in the financial banking space courtesy of the on-going review of rating agencies, it is not a surprise to see the relative stability in spreads between the High Yield risk gauge index Itraxx 5 year Crossover index  and the Itraxx 5 year Subordinated Financial index - source Bloomberg: 
Given the evolution of subordinated bond debt towards the High Yield frontier (below BBB-) since October last year (courtesy of downgrade rating actions), the spread between both indices is staying in a range between 200-250 bps. As we indicated in our conversation "Interval of Distrust", in reference to Morgan Stanley's note - Who Will Catch the Falling Banks?":
"We appreciate that a number of Tier 1 index dropouts, including large names like UniCredit, have recently happened without much disturbance to the market. However, the sheer volume of bonds dropping out in the next couple of months will be unprecedented – following the Moody’s downgrades, we expect €18 billion of Tier 1 and €17 billion of LT2 to have dropped out of the € IG indices since the start of the year." This explained our "interval of distrust" and cautious stance in relation to subordinated bank debt. At the time we also agreed with Morgan Stanley, namely that traditional Real Money High Yield buyers would probably not come to the rescue of the € iBoxx Tier 1 index dropouts...

"Just cause you got the monkey off your back doesn't mean the circus has left town." - George Carlin, American comedian.
While many pundits are lauding the results of the European summit as an important "inflexion point" in breaking the sovereign/banking death spiral correlation spiral that has plagued the European "circus", we "agree to disagree" with them and have yet to see the results in breaking the aforementioned correlation between both the Itraxx SOVx 5 year index (representing 15 Western European sovereign countries CDS including Cyprus) with the Itraxx Financial Senior 5 year index - source Bloomberg:
As far as we can see, this relationship still holds with a relative stable spread between both indices currently at 23.5 bps, highlighting the on-going relationship between sovereign risk and banking risk. While the performance for some financial CDS such as Banco Santander SA dropping by 40.5 bps from a record closing price to 434, and  BBVA falling 41 bps from an all-time high to 458.5 bps, as well as for European financial stocks and Sovereign CDS spreads on Friday have been significant in terms of performance, it remains to be seen if this relationship can be broken.

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS, receding in synch - source Bloomberg:
CDS on Spain fell by 46 bps to a one month low of 543 bps according to Bloomberg on Friday to a one-month low of  around 543. Italy fell by around 26 basis points to 513 according to Bloomberg.

Truth is, relating to the on-going relationship between Sovereign CDS spreads and European CDS spreads, additional rating actions on the sovereign could as well trigger a "Big-Bang" for the European High Yield market. If peripheral giant companies such as Iberdrola, Enel, Telefonica and others fell into the High-Yield rating category, overall it would represent an additional 40 billion euros worth of bonds and 30% of the existing size of the European High Yield market crossing the frontier from the Investment Grade space towards the High Yield space.

"The Gap is closed" we indicated on the 16th of June in relation to the European space. Now both the Eurostoxx and German 10 year Government yields seems to be moving in synch, higher that is while credit spreads for financials as indicated by Itraxx Financial Senior 5 year CDS index is moving tighter following the European Summit results - 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:

The current European bond picture with Friday's fall of Spanish and Italian yields - source Bloomberg:
While Spanish and Italian government bond yields fell sharply on Friday and safe-haven German government debt sold off heavily in the morning towards 1.67% yield before receding on the close towards 1.60 after euro zone leaders agreed to re-model the bloc's rescue funds, the relief may be brief in this "Risk-On" episode.

No surprise to see a different display in this "Risk-On" stint in our "Flight to quality" picture, Germany's 10 year Government bond yields rose in the morning towards 1.70% before receding and the 5 year CDS spread for Germany has remained firmly above 100 bps in the process - graph below, source Bloomberg:
In the latter part of the European session German Bunds were off their intra-day lows, as market participants slowly digested the European summit announcements and already highlighting holes in the measures. Market participants are indeed becoming more "cynical" towards our "European circus" in its now 19th show.

Markets participants, like ourselves, have to be more cynical, given that the European Union's two rescue fund namely ESM and EFSF only amount to about 20% of the outstanding debt of Italy and Spain, limiting in effect their ability to effectively lower these two countries borrowing costs as indicated by Bloomberg:
"The CHART OF THE DAY shows the EU’s two rescue mechanisms, the European Financial Stability Facility and the yet-to-start European Stability Mechanism, may have 500 billion euros ($621 billion) available for purchases. Italy and Spain have about 2.4 trillion euros combined of outstanding bonds, bills and loans, according to data compiled by Bloomberg.
EU leaders start a second day of talks in Brussels at the 19th summit since the euro region’s debt crisis began almost three years ago. The 27 members will discuss buying Spanish and Italian government bonds to bring down yields that are near the highest since the shared currency began in 1999, Finnish Prime Minister Jyrki Katainen said yesterday. The EFSF and ESM could buy the bonds in the primary market, he said."
- source Bloomberg.
The EU’s permanent fund, the ESM, has a target start date of July 9 and will have a capacity of 500 billion euros. Its predecessor, the 440 billion-euro EFSF, has about 240 billion euros remaining, which euro area officials plan to phase out as the ESM ramps up. Combined use of the funds is capped at 500
billion euros.

As indicated recently by CreditSights in their report from the 26th of June Eurozone Inc:
"For the moment, the €500 bn capacity of the ESM (which is being added to the €200 bn that the EFSF has already earmarked) will be enough to cover:
-The up-to-€100 bn cost of recapitalising Spain's banks.
-The reported €25 bn cost of funding the recapitalisation of Cyprus's banks,
-And the roughly €275 bn needed to cover the Spanish government's forecasted budget deficit and refinancing requirements until the end of 2014 (assuming that the T-bills can continue to be rolled in the private sector).
But the Italian government, if it lost access to market financing, would need around €425 bn over the same period, an amount that would break the bank. And fears over Italy's ability to fund itself would definitely spread contagion to other Eurozone governments. That will require further expansion in the lending capacity. Additionally, expansions of the ESM won't resolve the political pressures that such programmes create. Therefore, we also expect to see the terms of existing programmes renegotiated and eased over the coming 12 months.
The debt of the ESM is a contingent liability of all the non-bailed out Eurozone countries. It is therefore understandable that covering the borrowing requirements of troubled governments without reducing their spending would be unpopular. But those spending cuts are not only equally unpopular in the bailed out countries, they are also self-defeating. Spending cuts won't improve the ability of the bailout countries to produce goods and services through which they can earn euros that will repay the debts. And they are also spreading the recession to the rest of the Eurozone and threatening an already weak recovery.
So while insisting on austerity plays well in Germany, we believe we will see some easing in the conditions imposed on borrowers. The fact that Italy and Spain, the third and fourth largest economies in the Eurozone, are likely to be the next to request assistance may also strengthen the hand of borrowing countries in renegotiating the terms of any macro-economic adjustment programme."

As a reminder from our previous conversation, as reported by Societe Generale, Spain and Italy have significant funding needs until 2014:

Looking at the first insights relating to the European Summit/Circus, there are indeed binding problem with the proposals as highlighted by Desmond Supple from Nomura in his 29th of June note:
"The main conclusion that sparked market optimism was the decision that the EFSF/ ESM would be able to directly recapitalise Spanish banks and would give up its seniority on this issue. Moreover, there were suggestions that the EFSF/ESM could purchase government bonds and maybe provide a yield cap to non-core debt markets. We have already analysed the possible uses of the EFSF/ESM, and highlight three key problems.
1) The EFSF cannot fund itself in sufficient size in the market. Moreover, for the EFSF to access the ECB, it would require an EU treaty change that would enable it to become a bank. The structure of the ESM is more conducive to it being able to fund in the market, but we similarly doubt that it can issue in the size and at a pace that is required. For the ESM to be relevant as a eurozone TARP or a bond buying entity it will realistically need to be converted into a bank and leverage itself via the ECB. This is not being discussed at present and we believe it is currently a step too far for the ECB at this stage.
2) Even if we assume that the ESM can fund itself, another problem is that the seniority of the ESM in bond buying has not been removed. Subordination of investors by a bail-out entity does not matter if the scale of buying is so large that it represents a solution to a crisis. That is not the case with the ESM as we discuss below.
3) The EFSF/ ESM is sub-scale. The EFSF has around EUR240bn in usable funds, and the ESM has a ceiling of EUR500bn. Raising the ESM ceiling is problematic in that it represents a direct potential fiscal liability for eurozone sovereigns, whereas the ECB balance sheet does not since there is no legal requirement for the ECB to be recapitalised if it suffers losses. The ESM is of sufficient size to represent a TARP, but is far below what is required to be a bond buying entity that could alter the asymmetry of risk facing investors. At its current size it would merely – like the SMP – provide an exit route for investors. This is why we have been highlighting that the ESM – if it receives funding from the ECB – could be valuable as a TARP but would not be effective as a bond buying entity, and could even be negative if its seniority on bond holdings was not addressed.
A practical consideration is that the ESM is unlikely to be ready as planned for 9 July. Italy has suggested it may not ratify the ESM until after the summer recess of parliament.
Given these factors, the announcements regarding the EFSF/ESM do not meaningfully improve the policy response to the crisis. (Italy has said that it does not have any intention of applying for aid through a bond buying programme.) The market reaction – Bund weakness, rally in non-core debt markets – would appear a significant over-reaction. However, we now await Day 2 headlines." - source Nomura

We already highlighted point number 1 made by Nomura in our December conversation "The Generous Gambler":
"The EFSF has only raised 16 billion euros from four bonds this year and looking at the amount that needs to be raised in 2012, the prospect of raising more money is looking slimmer by the day."

At that time our good credit friend indicated:
"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 are 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 is double counting the money.
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."

The constitutional issues are indeed are very important issue to take into account as it has the potential in throwing a major real spanner into the on-going European circus. As reported by Annette Weisbach and Karin Matussek from Bloomberg on the 30th of June - Germany’s ESM Role, EU Fiscal Pact Challenged in Court:
"German lawmakers and a democracy group filed suits challenging the country’s participation in Europe’s fiscal pact and the permanent bailout fund after parliament approved the measures late yesterday.
The group “Europe Needs More Democracy” filed a complaint at the Karlsruhe-based Federal Constitutional Court on behalf of about 12,000 people who signed up via the Internet, it said on its website after the bills were passed. Peter Gauweiler, a lawmaker from the Bavarian sister party of Chancellor Angela Merkel’s Christian Democrats, also filed a petition with the court, he said on his website. Opposition Left Party lawmakers also filed a complaint, spokesman Michael Schlick said by phone today.
The plaintiffs claim that the ESM and the fiscal pact undermine the principle of democratic rule and intrude on the powers of German lawmakers. The new instruments overstep the limits the German constitution sets for European integration. The new rules should only take effect if approved by a referendum, the documents contend.
Germany’s parliament approved the laws last night. The measures won two-thirds majorities in both the lower and upper chambers, the Bundestag and Bundesrat, in sessions that stretched until nearly midnight.
Put on Hold
The two measures now await the signature of German President Joachim Gauck, who said June 21 that he would withhold passage pending potential lawsuits to challenge the new laws, as requested by the Karlsruhe court.
The suits also ask the judges to put both laws on hold while they consider their actions.
The plaintiffs rely on a September top court ruling which, while clearing Germany’s participation in the European Financial Stability Facility temporary bailout fund, said parliament must keep control over “elementary budgetary decisions.” Parliament may not relinquish its budget autonomy by “surrendering” to mechanisms that could lead to unpredictable burdens, the judges said at the time.
The court at the time cleared the EFSF because currency union rules didn’t allow the assumption of liability for financial decisions by other states, “including direct or indirect communitization of government debt.”
Germany’s top court has limited Merkel’s discretion in EU bailout policies in at least three rulings. On June 19, the court said the constitution requires the government to have parliament participate in matters of European Union integration, which also covers the ESM.
The judges in February limited the powers of a parliamentary committee set up to approve emergency actions by the EFSF, saying more lawmakers need to be involved." - source Bloomberg.

"The only possible Nash equilibrium is to always defect" we posited recently when discussing game theory and the German position with our iterated European prisoners' dilemma: "one might as well defect on the last turn, since the opponent will not have a chance to punish the player."

Could this most recent legal challenge indicate a  clear German defection in the making in true Nash Equilibrium fashion? One has to wonder...

"Democracy is the art and science of running the circus from the monkey cage." - H. L. Mencken

Moving on to our growing French economy concerns, two indicators warrant close monitoring:
Indicator number 1:
As indicated by French broker Oddo's recent review by their chief economist Bruno Cavalier on the 27th of June, the very weak margin ratio of the French corporate sector is at its lowest level in more than 20 years:
French statistical official department INSEE is also seeing additional weakening for 2012 in a context were financial pressure is mounting already on already stretched corporates margins as indicated by Oddo. France is already sliding towards a more severe recession, following the path of Italy and Spain. This will mean that while additional fiscal resources can be found in 2012 via increase fiscal pressure, 2013 fiscal adjustments to comply with budget targets for 2013 will need significantly more budget cuts to reach the approved targets. In fact, in our conversation "A Deficit Target Too Far" from the 18th of April, we argued: "We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections.
Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

Indicator number 2:
When it comes to credit conditions in Europe, not only do we closely monitor the ECB lending surveys, we also monitor on a monthly basis the “Association Française des Trésoriers d’Entreprise” (French Corporate Treasurers Association) surveys. One particular indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us a clear warning signal indicative of a growing deterioration:
The monthly question asked to French Corporate Treasurers is as follows:
Do the delays in  receiving payments from your clients tend to fall, remain stable or rise?
Delays in Terms of Payment as indicated in their May survey published in June have been reported rising by corporate treasurers. Overall +28.8% of corporate treasurers reported an increase compared to April.

When it comes to raising more revenues to plug the  French deficit, while additional fiscal pressure might bring temporary relief to French public finances for 2012, in 2013, the French government will not be in a position to rely on wave of privatizations as it did in the past to bring in much needed revenues. As reported by Bloomberg, France’s contribution to European sales of shares and equity-linked products has tumbled 83 percent from a 2001 peak as state-stake disposals waned and companies opted for debt funding:
"As the CHART OF THE DAY shows, the value of French equity market operations fell to 6 percent of all western European deals last year from a record 35 percent in 2001. French issuers raised $6.8 billion in equity capital in 2011, while the region as a whole sold $116 billion, data compiled by Bloomberg show. “The wave of privatizations has passed,” said Jean-Michel Berling, who heads equity capital markets for Credit Agricole CIB in Paris. “We don’t have any more of them. The statistics might have been bloated at the time by these big IPOs.” The French government sold shares of Electricite de France SA, Europe’s biggest power generator, and Gaz de France SA in 2005, helping bring the country’s ECM contribution to 20 percent of all western European operations, Bloomberg data show. Also, companies such as Danone SA, the world’s biggest yogurt-maker, are opting for the bond market. Danone sold 500 million euros ($633 million) of five-year notes on Sept. 21." - source Bloomberg.

Our 1952 Circus movie reference ended with the troupe mounting a "spec" to open their improvised performance, which kept their show in the black, and enabled them to continue their tour, a magnificent recovery from disaster...We have our doubts in relation to our "European Circus" being able to end in similar fashion to Cecil B. DeMille's masterpiece.

"Every country gets the circus it deserves. Spain gets bullfights. Italy gets the Catholic Church. America gets Hollywood." - Erica Jong, American novelist.

Stay tuned!

1 comment:

  1. good point of view, here other point of view about Greek crisis


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