"Spain is about to boost the capital of the rescue fund after writing down investments in lenders including Bankia group, according to the fund’s annual report dated July 26. The fund posted a net loss of 10.56 billion euros in 2011, sparking a negative equity of 1.86 billion euros." - source Bloomberg, Angeline Benoit and Estaban Duarte, 24th of August 2012 -
We think our analogy this week is once again appropriate. In our computational reference, namely the Banker's algorithm, in similar fashion to the upcoming Spanish rescue request, in our Banker's algorithm:
"When the system receives a request for resources, it runs the Banker's algorithm to determine if it is safe to grant the request. The algorithm is fairly straight forward once the distinction between safe and unsafe states is understood.
1. Can the request be granted? If not, the request is impossible and must either be denied or put on a waiting list
2. Assume that the request is granted
3. Is the new state safe?
-If so grant the request
-If not, either deny the request or put it on a waiting list.
On the 31st of August, the Spanish government will detail the rules for the Spanish lenders to access funds from the European bailout of as much as 100 billion euros earmarked in June to support the Spanish financial system. Spain must create a "bad bank" as a condition for accessing the loan from the 16 other European countries. The European Commission has asked Spain to delay by another week the plans to create this very "bad bank" so that its experts in Brussels can review the project. We might be speculating again but maybe the European Commission is as well using the "Banker's algorithm".
The Spanish government is introducing new rules to restructure and, if needed, dismantle non-viable financial institutions according to Bloomberg. One can therefore posit that Spanish FROB could indeed use as well the Banker's algorithm in its allocation process...but here is the catch:
CreditSights in their note from the 9th of August entitled - Spanish Government - We Need to Talk about Cutting made the following points:
"The Spanish government has negotiated with Eurozone partners a budget-deficit target for 2012 of 6.3% of GDP. The plan is then to reduce the deficit to below the 3% Maastricht Criterion by 2014. But this year’s target has already been revised up twice from the original 4.4% illustrating how difficult cutting government spending and raising taxes is when the economy is deep in recession.
Following Spain’s 1990s recession, the budget deficit exceeded the 3% Maastricht Criterion in all but two quarters in the eight years between 1991 and 1998. Since the 2007 recession, budget deficits have been larger, but have so far only exceeded the 3% Maastricht Criterion for three-and-a-half years.
Yet, the problems facing the Spanish economy are this time around much larger than they were in the early 1990s. The private-sector debt position at the start of the 2007 recession was equivalent to 215% of GDP. At the start of the 1992 recession, household and business debt was 65% of GDP.
And in the 1990s, Spain’s exit from the ERM allowed the currency to depreciate and the current account to move into surplus. In this recession, Spain’s membership of euro means there is no ability to recover competitiveness via currency depreciation;
The result is that the Spanish government will need to run budget deficits that are far larger than the targets it has negotiated with its Eurozone partners. But it is impossible to see the market continuing to buy the bonds to fund such deficits, Spain is all but certain to need a full government funding programme from the EFSF/ESM."
The process whereby lenders to Spain are paid back thanks to an implicit loan from the Eurosystem to the Spanish government won’t be allowed to persist indefinitely. And when it stops, the money to repay those Spanish government bonds won’t be available.
Absent the Spanish people tolerating a wrenching reduction in their incomes within an unrealistically short timeframe in, they believe a government request for EFSF / ESM funding is all but inevitable."
We would have to agree to the above key points from CreditSights, both Italy and Spain pose the biggest threat to the survival of the Euro. In fact the Spanish Misery index beats Greece as crisis bites as indicated by Bloomberg:
The CHART OF THE DAY shows a composite gauge of Spanish jobless and inflation rates, known as the misery index, is rising quicker than those of other European economies, and as Greece’s retreats from a 2012 high. Globally, only South Africa is faring worse, according to data compiled by Bloomberg News. Spain’s misery index is 26.83 percent, comprising a jobless rate of 24.63 percent and inflation at 2.2 percent. Greece’s score is 23.9 percent and that of the euro region is 13.6
percent. South Africa, which has an inflation rate of 5.5 percent and 23.2 percent unemployment, has a misery reading of 28.7 percent, according to data compiled by Bloomberg News.
The misery index is calculated by adding the 12-month percentage change in the consumer price index to the jobless rate. Arthur Okun, an adviser to Presidents John F. Kennedy and Lyndon Johnson, created the indicator in the 1960s." - source Bloomberg.
In our credit conversation we would like to focus on the changing corporate bond environment and focus once again on the structural change in market liquidity as well as default risk, in the credit space. But first our credit overview!
The Itraxx CDS indices picture, ending the week on a weaker note in the credit derivatives space - source Bloomberg:
Both the Eurostoxx and German 10 year Government yields seems to be moving are still moving in synch. It seems the short burst of "Risk-On" is marking a pause, with fast falling German Bund yields towards 1.30% yield level and a slightly weaker Eurostoxx 50 at the end of the week - 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:
In relation to the European bond picture, Spanish 10 year yields remain elevated at 6.43, slightly below 7% whereas Italian 10 year yields are below 6% around 5.76% and German government yields fell towards 1.33% - source Bloomberg:
Severing the Sovereign risk / Financial risk link has been the main concern of European authorities as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index and the Itraxx Financial Senior 5 year index. The recent rise of Itraxx Financial Senior CDS 5 year above the Itraxx SOVx Western Europe 5 year index is only indicative of the respite provided to Sovereign CDS spreads for Italy and Spain provided by the recent discussions surrounding ECB intervention. - source Bloomberg:
Our "Flight to quality" picture marking a pause in "Risk-On" with Germany's 10 year Government bond yields falling again towards 1.30% and the 5 year CDS spread for Germany rising above 60 bps after having touched a low point as well during the week - source Bloomberg:
Credit wise, while in our last conversation "Desperado" on the 21st of August we touched on Santander 2 year senior unsecured 2 billion euro new issue, which had been the first Spanish bank to issue since mid-march, we were taken aback by the latest "liability management" exercise which Santander followed immediately after its new issuer with. Banco Santander and Santander Financial Exchanges (each an Offeror and jointly the Offerors) inviting holders of certain Tier 1, Upper Tier 2 and Lower Tier 2 securities to tender such securities for purchase for cash at prices to be determined pursuant to an Unmodified Dutch Auction Procedure (as such term is defined in this Tender Offer Memorandum). The maximum aggregate principal amount of Securities that the Offerors intend to accept for purchase jointly pursuant to the Offers, will be an amount equivalent to €2,000,000,000. The impact of the announcement triggered a rally in some of the securities being proposed for the "liability management" exercise:
As we argued recently (Peripheral Banks, Kneecap Recap), "losses will have to be taken, it is all going Dutch, Dutch auction that is". The moment for losses to be taken has arrived at least for preference shares holders given Spain will impose losses of as much as 80% on owners of preference shares of banks that have received state aid and may be liquidated courtesy of an operation "Banker's algorithm" but we ramble again...In relation to Bankia, being clearly in the crosshair of such "exercise", back in June (Agree to Disagree - 16th of June 2012) we indicated:
"Spain has yet to apply the full extent of the Irish recipe which we discussed in "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..."
The pain is definitely about to be inflicted.
This latest move reminded us of some of the comments our good credit friend had relating to Spanish banking woes back in April in our conversation "Mutiny on the Euro Bounty":
"Main Spanish banks have so far refused the government suggestion to create a bad bank which would carry all property toxic assets, arguing that they could manage their assets on their own. The dire reality is that the creation of such bad bank will bring transparency to asset prices, which is not what Spanish bankers want! The murkier the market, the better it is to extend and pretend..."
In it is not the first time we have been surprised by Santander, back in April we also indicated:
Moving on to the subject of the Spanish banking sector, quite frankly we have been baffled by Santander CEO Alfredo Saenz deriding Spain defaults surge: "“Mortgages get paid in good times and in bad”. He also added: "“Anyone raising this problem as one of the issues for the Spanish financial system is saying something stupid. (We discussed Spanish issues at length in our conversation "Spanish Denial")."
When it comes to Spanish woes and the difficulties in tackling Spain's economic woes, one might wonder how it can be achieved given when Rajoy came to power he split the finance ministry and decided not to give the title of deputy premier for economy to either Montoro or De Guindos, which is creating additional headaches for wary investors as indicated by Ben Sills in his Bloomberg article from the 23rd of March - Montoro Outburst Highlights Rajoy Paralysis as Cabinet Splits:
"The divisions at the heart of Rajoy’s government have hobbled Spain’s ability to operate on a European level. While De Guindos, who represents the government at European meetings, inspires confidence in the bloc’s other finance ministers, they question his ability to deliver on his promises
because he is often contradicted by Montoro, according to an official who takes part in finance ministers’ meetings. In January, De Guindos’s efforts to persuade investors and officials that Spain was fixed on its budget targets was undermined by Montoro’s calls for more flexibility on the pace of deficit reduction."
Moving on to the subject of the changing corporate bond environment and the structural change in market liquidity, we wanted to tackle again this issue of dwindling liquidity and its implication on the credit markets (which we discussed in our conversation "Yield Famine") given yields on corporate bonds worldwide fell to a record low on the 23rd of August as indicated by Bloomberg in their article -
Global Corporate Bond Yields Decline to Record After Fed Minutes:
"Borrowing costs for the most creditworthy to the riskiest companies fell to an unprecedented 3.76 percent yesterday, from 3.8 percent on Aug. 21, according to Bank of America Merrill Lynch index data. Yields on global investment-grade debt dropped to a record 2.97 percent. The extra yield investors demand to own global corporate bonds of all ratings rather than government debt narrowed to 261 basis points Aug. 21, the lowest level since August 2011, Bank of America Merrill Lynch index data show. The gauge widened 1basis point to 2.62 percentage points on the 23rd of August."
Liquidity risk is a concern we share with Thames River Credit fund which indicated the following in their July 2012 letter:
"A structural decline in liquidity has been taking place in the corporate bond market, which has serious repercussions for credit investors. The term liquidity may sound like an obscure, even technical, word but it reflects the ease with which a security can be bought and sold. The most efficient markets are those that benefit from deep pools of willing buyers and sellers, facilitating the transfer of risk. Unlike the equity market, the majority of trading in the corporate bond market is not transacted through centralised securities (also known as market-making).
One of the reasons why corporate securities have traded off-exchange is their greater complexity compared to asset classes such as equity. Features such as duration, maturity, credit risk and subordination can differ even amongst the debt of a single issuer making credit a highly heterogeneous asset class. The trade-off for the greater customisation of corporate securities is diminished liquidity. Of the US$ 8 trillion US corporate bond market only a small proportion of issues will trade with relative frequency. This highlights the important role banks have played in the corporate bond market. A changed regulatory environment, however, is putting increased strain on banks’ ability to make markets in corporate securities."
Thames River conclude their July letter with the following important point in relation to the issue of liquidity for benchmarked credit funds:
"Regulation and bank deleveraging is forcing change on credit markets. This is most notable in the area of liquidity. Without the lubrication of market-making activity, long-only corporate bond mutual funds stand exposed to the risk of a significant sell-off in credit markets. When combined with weakness in the rates market,such an outcome could create a perfect storm for benchmarked corporate bond funds. This is why the decline in corporate bond liquidity matters."
We could not agree more, the risk is real. We used a reference to Bastiat in relation to liquidity and Credit Markets in our conversation "The Unbearable Lightness of Credit":
"That Which is Seen, and That Which is Not Seen"
The Bond Bubble:
"In 5 out of the past 7 years, inflows to bond funds have exceeded 5% of AUM. Inflows to bond funds are running at an annualized $259bn (versus prior 2010 alltime high of $183bn). Inflows to Investment Grade & High Yield bonds funds thus far in 2012 account for a staggering 63% of total fund flows to all equity, bond & commodities." source Bank of America Merrill Lynch:
"Investor preference for Bonds over other classes is clear to see. Since 2007 there has been $650 billion into Fixed Income. Over the same period, Equities including ETFs saw outflows of $52bn." - source BofA Merrill Lynch.
When it comes to our final subject of default risk, in the credit space, CreditSights in their High Yield Market Trends published on the 20th of August indicated the following:
"The current relationship with HY (High Yield) and HG (High Grade) is more in line with what is seen in high default rate periods in the US such as 2002 and 2009. That still holds true today in both the US and Europe. The 127% quarter-to-date average (113% in 1H12) comes against the current default rate of 3.3% and is dramatically above the 76% long term average. The current HY incremental yield % versus HG is more in line with 2H02 levels of 127% when the trailing default rate declined from 10% to 8%. During the 1H2009 crisis, the 129% average came against a backdrop of 11.5% default rates. In 4Q07, when default rates ran at 1.7% the premium was 50%. Obviously that did not price in a jump in the default rates to over 14% by the end of 2009. There certainly has been a legitimate discussion that the HY market remain cheap by any of these comparisons unless you see a massive spike in defaults ahead.
With respect to the European data, they would add a caveat that the relative lack of depth in the crossover and middle tiers of the corporate universe and the relative absence of industry breadth (i.e. beyond TMT) in the “early years” of the European HY market impairs the usefulness of these metrics in Europe. In terms of framing the very low default rate levels in Europe today with what we saw in late 2007 in HY markets globally, there is an eerie similarity in that systemic is what drove the spike after the subprime mortgage crisis took out Lehman Brothers and the structured finance market while sending banks into a counterparty-driven interbank meltdown. The mere discussion of such risks in the Eurozone could make the risk of a bank system liquidity event more of a threat to the Euro HY market than the US HY market. While all HY markets (and equities) would sell off dramatically in such an event, the fact that actual default rates would more likely spike in Europe (and for a protracted period) would increase the risk of forced realization of such losses. That in theory would be when the price gap between US HY index and Euro HY index would widen more notably and losses would be “crystallized”. While that is a fat tail, they often highlight that still could end more just as a tall tale. The reaction of the HY and equity markets in Europe are voting “tall tail” at this point.
At the end of the analytical process used to frame the relative value of HY assets, it is defaults that matter most, and a material differential in actual defaults will be required to generate a more notable decoupling of returns in the rolling returns over longer time horizons across the US and Euro HY markets. As they look out towards mid-2013, it will take a systemic crisis and more than economic contraction to drive that in their view. To this point the roll-up of individuals credits still shows very manageable defaults in both the US and Euro HY markets."
On a final note, in relation to liquidity and volumes, as far as our equities friends are concerned, Christmas came early volume wise, it came in August as indicated by Bloomberg Chart of the day:
week, according to data compiled by Bloomberg. That’s the fewest since 2002 except for during the traditionally slow periods at the end of the year, when business across the continent all but grinds to a halt.
Investors are staying on the sidelines as European politicians and central bankers wrestle with the region’s debt crisis, which has spread to Italy and Spain as it enters its third year, said Graham Bishop, a strategist at Exane BNP Paribas in London. European Central Bank President Mario Draghi said Aug. 2 that the lender would consider buying distressed countries’ bonds to help lower borrowing costs. “Christmas has come early,” said Exane’s Bishop. “We are now in sight of replicating Christmas in August with investors in wait-and-see mode until the ECB does what they said they will do. There’s a combination of policy uncertainty and the normal summer lull.” - source Bloomberg.
"Complacency is a state of mind that exists only in retrospective: it has to be shattered before being ascertained." - Vladimir Nabokov