Sunday, 8 July 2012

Credit - Europe - The Game of The Century

"You have to learn the rules of the game. And then you have to play better than anyone else."
- Albert Einstein

We could have used the title "The Scientific Cardplayer" in a continuation to the theme of Great Classic Movies. In fact, we hesitated, given that, in similar fashion to the latest European summit with Germany opposing France, Italy and Spain, in this 1972's masterpiece from film director Luigi Comencini, there is a regular showdown between a rich American widow (Bette Davis) and an impoverished Italian couple (Alberto Sordi and Silvana Mangano) over the card game scopa. The widow provides them with the stakes to play, as well as a chance to gain a small fortune. But she always wins, not returning until the same time the following year. It continues that way until Cleopatra (Antonella Demaggi), the couple’s daughter, steps in to gain a measure of revenge against the sadistic old woman...

In respect to the recent European summit, if European countries such as Italy, Spain and France gang up on Germany and ask for material changes in the rules and treaties of the "chess game" being played, we believe that "the only possible Nash equilibrium for Germany will be to defect":
-with the help of the German Constitutional Court
-with rising tensions in the German economists world - President of the Ifo Institute of Economic Research in Munich, Hans-Werner Sinn is convinced that bailing out European countries in difficulty is against Germany’s interests, and has organised a petition signed by 170 economists who urge their “fellow citizens” and the country’s parliament to put a stop to a “dangerous” policy and avoid a banking union.
 Angela Merkel is getting some more solace/help in defecting this on-going prisoner's dilemma which we recently discussed.
So why our chosen title? Many pundits have been arguing about Merkel being the big loser of the latest European summit (number 19...). It might be that, after all Angela Merkel, could be one of the greatest chess players around and has just used "castling". Many of the greatest chess players throughout history have considered the endgame to be of paramount importance because endgame theory is finite. So are Europe's possibilities in escaping the demise of its fragile construct.

In relation to our endgame chess analogy and the current European situation:
"Rook endings are probably the deepest and most well studied endgames. They are a common type of endgame in practice, occurring in about 10 percent of all games (including ones that do not reach an endgame) (Emms 2008:7). These endgames occur frequently because rooks are often the last pieces to be exchanged. The ability to play these endgames well is a major factor distinguishing masters from amateurs (Nunn 2007:125). When both sides have two rooks and pawns, the stronger side usually has more winning chances than if each had only one rook." - source Wikipedia.

In what was labeled "The Game of the Century" and in reference to our chosen title (in the end, we had to make a choice), Bobby Fischer 13 years old at the time, won the game by making material sacrifices:
"Material sacrifices are likely to be effective against a king still in the middle and an open central file."

We would therefore be inclined to agree with Wolfgang Munchau in the FT on the second of July, namely that after all the biggest winner from the last European summit was indeed Angela Merkel:
"One of the lessons from the history of financial crises is that bazookas must be big to be effective. This one is not. Nor was the now defunct securities markets programme of the ECB. It did not stem the crisis because the ECB’s commitment was strictly limited – and contested by members of its governing council. The ECB still spent more than €200bn on this programme, and yet it did not work. The ESM’s budget for bond purchases will probably be lower. Mr Monti may have secured the right kind of deal politically but to solve the ESM’s size problem he really should have insisted on a banking licence. With that, the ESM could have leveraged its lending ceiling to a more realistic level. It will not be able to do this now. This is why I believe the real winner of last week’s summit was not Mr Monti but Ms Merkel after all. She managed to keep Germany’s liabilities unchanged. Someone will have to explain to me how we can have no change to Germany’s overall liabilities, nor of ECB policies, and yet Italy and Spain can now be safe when they were not safe a week ago.
The deal on Spain was marginally better – on paper. But it, too, is not what it seems."

"Usually in the endgame, the stronger side should try to exchange pieces (knights, bishops, rooks, and queens), while avoiding the exchange of pawns." - source Wikipedia.

This exactly what Angela Merkel has done and what Bobby Fischer did on that 17th of October 1956 game against Donald Byrne which led to his victory...
"When both sides have two rooks and pawns, the stronger side usually has more winning chances than if each had only one rook". Bobby Fischer had one rook at the end of the game and 5 pawns...
By managing to keep Germany’s liabilities unchanged Angela Merkel appears to us as the winner of the latest European summit (number 19...). Question being for us now, can Europe survive in the current form (number of countries) without making material sacrifices in true Bobby Fischer fashion? One has to wonder.

In our credit conversation we would like to discuss the latest European summit focusing on the European Banking Union proposal as well as the latest decision of the ECB to cut the deposit rates to zero (meanwhile Denmark has taken the bold step of going negative). But first our credit overview.

The Itraxx CDS indices picture, a tale of ongoing volatility - source Bloomberg:
Once again the rally courtesy of the European Summit in Brussels was short lived as the markets where disappointed by the latest ECB rate decisions. The ECB on Thursday cut its main refinancing rate to a record low of 0.75% from 1% and cut its deposit rate to zero. Non-standard tools such as the SMP (Securities Market Programme) was not re-activated leading to a significant rise in Spanish government yields in the process. In that context the Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) rose significantly towards the 700 bps level, closing around 682 bps, widening by 18 bps on the day. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index rose significantly in the process, respectively by 14 bps and 24 bps, erasing the gains registered courtesy of the European summit.
Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain under pressure - source Bloomberg:
The spread differential between both countries is rising close to the record levels registered in March with a spread differential between both Sovereign CDS at around 63 bps.

The current European bond picture with Friday's rise of Spanish and Italian yields, with Spain moving back towards the 7% level while German government yields closing back to lower levels around 1.32% (1.60% last week) - source Bloomberg:

Moving back to "Risk-Off" in our "Flight to quality" picture, Germany's 10 year Government bond yields fell towards 1.32% and the 5 year CDS spread for Germany has remained below 100 bps in the process for now - graph below, source Bloomberg:
Disappointing jobs report in the US (Nonfarm payrolls at 80K) in conjunction with anxiety surrounding the global economic outlook led to the flight into safety assets, pushing down core benchmarks such as the German bund in the process.

"The Gap is back": Now both the Eurostoxx and German 10 year Government yields seems to be moving out of synch, with falling German Bund yields and a higher Eurostoxx 50 index. - 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:

It is still the "D" world (Deflation - Deleveraging) - 2 year German Notes going negative making again a new record versus 2 year Japanese Notes - source Bloomberg:

In this deflationary environment, it has long been our position that the two LTROs operations would not lead to lending to the real economy and amounted to "Money for Nothing". The latest money multiplier clearly indicates that provisions of credit remains weak at best - source Bloomberg:
"While the ECB cited a lack of direction from the June EC summit, it is clear that the ECB liquidity earmarked to kick-start the banks' provision of loans to the real economy has so far failed.
The money multiplier, broadly the expansion of money supply in the economy as a result of bank lending, remains very weak and further measures will be likely."
- source Bloomberg.

Although the ECB has reduced its deposit facility rate to zero in an effort to encourage banks that have parked their LTRO cash back with the ECB, we do not believe it will be successful even, if it goes into negative territory, like Denmark just did. The central bank in Copenhagen cut the rate it offers on certificates of deposit yesterday by a quarter of a percentage point to minus 0.2 percent. Central bank Governor Nils Bernstein declared: “I hadn’t expected that. It’s the first time in this institution’s nearly 200-year history, so obviously I hadn’t expected it.”
"After the two LTRO ECB loan facilities, recipient banks of more than 700 billion euros of cheap liquidity redeposited more than 500 billion back on deposit at the ECB. Initially paying 1% for
the loan and receiving 0.25% interest on deposit, it is unlikely that a drop to 0% will offset the benefits to the banks of liquidity access."
- source Bloomberg

Moving to our subject of the need for European Banking Union, in a recent note from Cheuvreux from the 6th of July, Nicolas Doisy argued the following:
"The banking union is essential as it will maintain a longterm link between the Eurozone's core and periphery.
Indeed, politically speaking, the banking issue is the one most pressing common problem to solve, due to the inter-connectedness of the Eurozone financial system. A fortunate side effect of this inter-connectedness is that it imposes a de facto duty of solidarity. Otherwise the Eurozone's banks would start collapsing one after the other in a series of bankruptcies, just like US (and later European) banks did back in the 1930s.
The Eurozone is thus making do with the need to collectively repair its banking sector, whose side effect is to make for (the very premise of) a political (union) project. In a sense, thus starting with shaping the indispensable banking union is like creating the European Coal and Steel Community in 1951, which opened the way to the European Union in 1957. This seemingly unassuming approach will hopefully obtain the same result.
In this respect, the finalisation of the plan to rescue the Spanish banking sector will be key in using the bank resolution scheme to maintain a core-periphery link. Indeed, one particularly central issue is no longer hanging up in the air: the Eurozone financial aid for Spanish banks will go directly to banks (and not via the Spanish government). Given the deadlock on the federalisation of the Eurozone, this is a breakthrough."

We "agree to disagree" with Nicolas Doisy in that respect. 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 strong correlation between financial and sovereign risk - source Bloomberg:
Both indices remain at the same level. In respect to the subject of a European Banking Union, we agree with Nomura's take on the subject in their recent note - The EU Summit - Why the rally, from the 29th of June:
"Either way the creation of a single banking regulator may be useful, but is not a solution to the bank/sovereign crisis. Likewise the creation of a bank deposit guarantee scheme may be useful, but we think it is more likely a distraction from resolving the root cause of the current banking crisis – the sovereign-banks link, impaired assets and deficient capital and recapitalisation structures.
-The German Bundestag could require further sign-off of a direct recap agreement. The German Bundestag (lower house) could further complicate utilising the ESM for direct banking recaps by requiring parliamentary agreement of the new measures. Norbet Barthle argued that this represents a new aid instrument of the ESM to which the plenary of the German Bundestag must first agree.
-Bailouts are unlikely to encourage lending. The strict conditions put on banks that have requested aid are likely to make them less willing to lend. With an unstable economy the extension of credit is unlikely to rise particularly if there is a risk that further losses could lead to a bailout and the constraints being imposed.
-A combination of solutions is required to stabilise the banking system. In general, though, for any bank bailout to work one needs to create a stable environment on both the asset and liability side of the balance sheet. To create stable assets ECB QE and haircut reduction on collateral assets would likely be required. Further to this a bad asset manager should be created to take impaired assets off bank balance sheets."

The issue of circularity will not be broken by a European Banking Union. In our conversation "The Daughters of Danaus" we reminded ourselves of the issue of circularity namely the Danaides punishment which we also discussed in October last year. The issue of circularity we mentioned last year could not be clearer than the two  graphs below, one from Martin Sibileau in his post - "The EU must not recapitalize banks":

The other one from a Morgan Stanley note:

We might be sounding like a broken record but once again is all about Stocks versus Flows. In our Danaids analogy and their never ending task of filling the tub because, we posited the following in various conversations:"We mentioned the problem of stocks and flows and the difference between the ECB and the Fed in our conversation "The European issue of circularity", given that while the Fed has been financing "stocks" (mortgages), while the ECB is financing "flows" (deficits). We do not know when European deficits will end, until a clear reduction of the deficits is seen, therefore the ECB liabilities will have to depreciate."

From the same Nomura note from the 29th of June, the stocks versus flows issue, (hence the difference between the FED and the ECB) will not be resolved by a European Banking Union. This will not break the correlation between the sovereign and the banks:
"With regards to the marginal buyer of Spanish sovereign debt, over the past six months this has tended to be the banks. However, this appears to have come to a dead stop. Banks marginally decreased sovereign debt holdings in May according the ECB. A move in deposits to the larger banks would explain this to a degree as it would reduce the ability of smaller banks to buy sovereign debt. At the same time the bigger banks, BBVA and Santander, announced in April that they had reached their risk concentration limits on sovereign debt and could not purchase any more.
Spain's banks and sovereign are mutually infectious, but in the short run banks will continue to weaken perception of the sovereign, in our view. The knock-on effect could be that Spain weakens Italy at a sovereign level, but in Italy a weakening of the sovereign would then weaken the banks because of their holdings of BTPs. Indeed, Monte de Paschi's this week said that its capital shortfall was partly due to the loss in value on its BTP holdings."

The vicious cycle of banks and sovereigns cannot be solved only by a European Banking Union:
"The opening line of the EC's release that set markets racing stated that it must break the increasingly interconnected nature of some euro zone banks and their respective sovereign. ECB data show that Italy's banks have recorded positive inflows of sovereign debt every month in 2012 totaling 89 billion euros, a situation which should reverse in the near term." - source Bloomberg.

Even as the ECB helped boost Italian bond returns in the first quarter, the country’s budget deficit increased. Italian yields climbed in the second quarter as Spain was forced to request as much as 100 billion euros ($125 billion) to help recapitalize its banks. The extra yield investors demanded to hold Italy’s 10-year debt over similar-maturity German bunds surged to as much as 490 basis points, or 4.9 percentage points, in June, up about 200 basis points from their March low. It was at 469 basis points on Friday. Italy is now heading for a deeper and more protracted recession even after approving a deeper set of spending cuts, expected to reduce state expenditure by 4.5 billion euros in 2012, 10.5 billion in 2013 and 11 billion in 2014. These planned fiscal tightening followed those implemented in July, September and December 2011 which amounted to a cumulative 49 billion in 2012, 76 billion in 2013 and 81 billion in 2014.

In our Danaus conversation we argued:
"Until we see a clear reduction in deficits, (which we might never see in true Danaides punishment or fashion), the ECB liabilities will indeed depreciate." - Macronomics - 30th of May 2012.

It is therefore not a surprise to start seeing "Mutiny on the Euro Bounty":
-Mutiny in Germany with the head of IFO supported by 170 economists rejecting a European Banking Union.
-Mutiny in Italy with Monti’s popularity with investors damaged after he passed watered-down labor-market legislation on June 27 and was forced to temper proposals to revive Italy’s economy by making it easier for distressed companies to fire workers after Italy’s biggest union called a general strike and a key political ally vowed to oppose the bill and widespread public opposition to paying property tax, raising risks of structural tax slippage meaning Italy will miss its 2012 budget forecast.
-Mutiny in Finland and Holland, rejecting ESM bond buying. There exists no unanimous agreement on the bond purchases because Finland and the Netherlands reject the model, the Finnish government said in a report dated June 29 and presented yesterday by Prime Minister Jyrki Katainen to the parliament’s Grand Committee in Helsinki. The government reiterated its opposition today, citing the rescue funds’ limited resources and the shown “ineffectiveness” of bond purchases according to Bloomberg.

No wonder Angela Merkel in this "Game of Century", while only appearing to be making material sacrifices, she has managed to keep Germany's liabilities unchanged.
As indicated by Nomura in their recent note - Italy, Tacking into the headwinds from the 5th of July, in our European game chess of the century, we think Germany still has the upper hand: "Hence, we doubt that Ms Merkel and her allies in northern Europe are ready to cross the proverbial Rubicon by mutualising Italy's debts to a paradigm-shifting extent. That said, Italian domestic politics could be a continuing threat to the survival of the euro area."
We could not agree more. With general elections looming in Italy, the probability of survival of the Monti administration is in fact falling. The risk of the Monti administration not surviving the "electoral cut" after May 2013 should not be underestimated.

On a final note if Europe is a story of growing divergence, from a sovereign-credit rating's point of view, the East-West rating gap clearly indicates convergence - source Bloomberg:
"The CHART OF THE DAY shows the average credit rating of seven emerging and eight developed European countries from Moody’s Investors Service. Each nation’s rating is weighted for the size of its economy. The average in the east has improved to Baa1, the third-lowest investment grade, from Ba3, the third-highest junk rating, in 2000. For western Europe, it’s fallen to Aa2, the third-highest investment grade, from Aa1." - source Bloomberg.

The European Union’s seven former communist members outside the common currency will have
an average budget shortfall of 2.6 percent of gross domestic product and an average debt load of 44.7 percent of GDP this year, the European Commission estimates. That compares with 3.2 percent and 91.8 percent for the euro region according to Bloomberg. No wonder Germany, frustrated in the West, is increasingly looking more and more to the East:
"Russia is important for German companies. In 2011, there was a 30 per cent increase in trade between Germany and Russia, with a total volume of 75 billion euros. German economic representatives have been talking about the huge potential of the Russian economy for many years, and it is seen as advantageous that Russia is nearly as important for trade as Poland. In 2011, Russia ranked 12th in German exports behind Poland (10th) and before the Czech Republic (13th)."
"Russia is Germany’s biggest supplier of gas and oil, providing around 40 per cent of its gas and 34 per cent of its oil supply in 2011. With the government’s decision to stop producing nuclear energy by 2022, German demand for gas will increase in the short and medium term." - Source An Alienated Partnership - Vestnik Kazkaza - 7th of July 2012.

As we indicated in our conversation "Eastern promises" on the 9th of June:
"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."

"The human element, the human flaw and the human nobility - those are the reasons that chess matches are won or lost."
Viktor Korchnoi - oldest active grandmaster professional chess player.

Stay tuned!

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