Dear credit ramblings readers, apologies for the recent lack of posting, but, as of late we have been travelling, to attend a board meeting, windsurfing that is, hence our lack of "availability" in posting our regular weekly credit feature. Yet, we did manage to take with us the laptop, to keep abreast of the evolution, or should we say lack of resolution of the on-going European debt crisis. We also manage to take with us some handful of books, one being "The Debt-Deflation Theory of Great Depressions" by the great Irving Fisher, which was originally published in Econometrica, Vol. 1, No. 4 in October 1933.
In this 1933 publication, Irving Fisher pointed out some very relevant points in relation to debt and deflation (which has been a regular theme on this blog). For instance, according to Irving Fisher, "the chief secret of most, if not all great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the most it tends to tip. It is not tending to right itself, but is capsizing."
Looking at some of our 2012 conversations, we have used in numerous occasions sailing analogies for this very precise reason, and, in particular back in May 2012 in our conversation "The Raft of the European Medusa":
"Following up on the theme of navigation and sailing dear to our heart, given "The Tempest" raging and the unraveling of the "Mutiny on the Euro Bounty" courtesy of the high stakes poker game being played by Greek politicians and their European creditors (reminiscent of "Schedule Chicken" once more...), we have decided to use yet another sailing analogy but this time referring to Géricault's painting masterpiece "The Raft of the Medusa".
Similar to the fate of the Medusa ship, the story so far has been the European Commission in an effort to make good time in reducing budget deficits, decided to impose unrealistic budget reduction objectives ("A Deficit Target Too Far") while imposing drastic reduction in bank leverage and balance sheets, courtesy of the European Banking Association (EBA) June 2012 deadline of 9% of Core Tier 1 capital. These combined actions led to credit contractions, no surprise there, leading to reduced economic growth in Europe compared to the US ("Growth divergence between US and Europe? It's the credit conditions stupid..."). While utter financial meltdown disaster was narrowly avoided thanks to the ECB's LTRO operations, the lack of experience or ability (or both...) of the captains of our "European Flutter" ship have indeed landed the European project on a sandbank, with of course, a "raft" full of "unintended consequences" such as mutiny, with Greek bond subordination during the recent PSI leading to insubordination (a buyers strike...) in parts of the European bond market."
When it comes to Europe, we have not changed "tack", as we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 2011 when discussing circularity issues:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."
So, why our chosen title and what is the link with Irving Fisher you might rightly ask? Well, dear readers we owe you some explainations. Synchronicity is the experience of two or more events that are apparently causally unrelated or unlikely to occur together by chance, yet are experienced as occurring together in a meaningful manner. The concept of synchronicity was first described in this terminology by Carl Gustav Jung, a Swiss psychologist, in the 1920s.
When one look at the event of the 1930s as related by Irving Fisher and the on-going discussions surrounding the "Fiscal Cliff", we could not resist but refer to Carl Jung's principle of Synchronicity:
"In fact under President Hoover, recovery was apparently well started by the Federal Reserve open-market purchases, which revived prices and business from May to September 1932. The efforts were not kept up and the recovery was stopped by various circumstances, including the political "campaign of fear". - source "The Debt-Deflation Theory of Great Depressions" by Irving Fisher, originally published in Econometrica, Vol. 1, No. 4 in October 1933.
Carl Jung believed, like we do, that many experiences that are coincidence due to chance in terms of causality could be an expression of deeper order. Concurrent event that first appear to be coincidental can later turn out to be causally related are termed incoincident. The "collective unconscious" defined by Jung is inherited, which is supportive of the idea of Synchronicity he developped:
"When coincidences pile up in this way, one cannot help being impressed by them - for the greater the number of terms in such a series, or the more the unusual its character, the more improbalbe it becomes." - Carl Jung
Admittedly, Carl Jung's theory of synchronicity is equal to intellectual intuition, but we digress as per our usual rambling habits.
Therefore in this week credit conversation, we would like to point out to the upcoming subordination of European sovereign debt courtesy of the much anticipated broad introduction of CACs (Collective Action Clauses) by January 2013 which implies at some point, debt will be much more easily repudiated. Given our title is namely Synchronicity, we will of course make further references to the great work of legendary Irving Fisher.
While musing through Irving Fisher's nine factors occuring and recurring (together with distress selling), indicative of cross-currents of a depression, we could not resist but focus on point VII from Irving Fisher's table leading us to experience Carl Jung's Synchronicity theory.
- (5) Decrease in Profits
- (5) Increase in Losses
- (7) Increase in Pessimism (fall in Consumer Confidence in Europe is indicative, we think)
- (8) Slower Velocity
- (1) More Liquidation
- Reduction in Volume of Stock Trading
In addition to factor (8) coined "Hoarding" by Irving Fisher, Europe is as well a good example of the application of "Synchronicity" given as described by Irving Fisher, "Banks have been curtailing Loans for Self-Protection" courtesy of the European Banking Association rule of reaching 9% of Core Tier 1 Capital before the end of June 2012 with the economic impact we all have witnessed by now mostly in peripheral countries (see our conversation "Money for Nothing"):
"We mean "Money for Nothing" given our friends at Rcube Global Macro, in their latest study of the ECB quarterly bank lending survey indicate a significant worsening of the credit crunch in Europe, meaning plenty of liquidity impact for banks but confirming our 2011 fears of credit contraction for corporates and households ("Money for nothing and the Casino Chips for free..." - Macronomics)- February 2012
No wonder European Banks CDS spreads receded significantly in 2012, touching an 18 months low - source Bloomberg:
In addition to factor number 8 and as indicated in Irving Fisher's work, banks have been busy selling investments.
Looking at rising correlations, in conjunction with the fall in volatilties which we tackled courtesy of our friends at Rcube Global Macro in our conversation "Why have Global Macro Hedge Funds underperformed", the recent rise in these correlations as indicated by this graph from JP Morgan 2013 Derivatives Outlook, it is, we think a cause for concern:
As our friend Martin Sibileau puts it in his latest post "The year 2012 in perspective":
"At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US. As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency."
In relation to our "Synchronicity" theory and Irving Fisher, let us quote him again:
"When the starter consists of new opportunities to make unusually profitable investments, the bubble of debts tends to be blown bigger and faster than when the starter is great misfortune causing merely non-productive debts. The only notable exception is a great war and even then chiefly because it leads after it is over to productive debts for reconstruction purposes".
Furthermore, if Irving Fisher's debt-deflation is correct and if Synchronicity is correct as well, the "infectiousness of depressions internationally is chiefly due to a common gold (or other) monetary standard and there should be found little tendency for depressions to pass from a deflating to an inflating, or stabilizing country". We can easily conclude that the infectiousness of the European depression is chiefly due to a common monetary standard, namely the Euro. Therefore a break-up of the Euro would not be a "Black-Swan" per se, but the Euro not breaking up would be one.
Moving on to the subject of CACs namely Collective Action Clauses, the European Commission has agreed with the other European countries that as of the 1st of January 2013, all new issues will include CACs. Welcome to subordination in the European government space!
What are CACs?
"CACs are contractual provisions that:
1. Facilitate an issuer approaching bondholders with a proposal to modify ey terms of the relevant bond;
2. Enable a majority of these bondholders to agree to the proposed modifications; and
3. (where the requisite majority has so agreed) provide that the modifications are binding on all bondholders." - source Linklaters
As of the 1st of January, all new debt maturing above 1 year will include these clauses. According to a recent report published by Natixis, the European model for CACs allows for a much easier mobilisation process as well as an easier way of reaching majority and impacting similar securities at the same time. The modification of single series of one bond necessitate 75% of the notional represented in the meeting and 66 2/3 % of the total notional for the written resolution, but as well as for any securities taken individually (66 2/3% and 50% respectively). The objective is to reduce the majority level for a bond taken individually to facilitate the process.
CACs will be integrated to new issues, and the European Commission has imposed a threshold of a minimum of 55% of new issues including CACs, the other 45% will enable the liquidity of non-CAC related stock of government bonds. Going forward, the European Commission ambitions to reach a level of 95% of CAC bearing government bonds by 2023, the additional 5% will remain to maintain the liquidity of the current 10-30 year range. According to the note from Natixis, European issuers will need 5 to 7 years to obtain a stock level equivalent to the existing stock of non-CAC bonds. Since the default of Mexico in 1997, and Argentina in 2001, the use of CACs has risen significantly.
But what are the "unintended consequences"?
According to the same note from Natixis, with the introduction of CACs, one of the very first unintended consequences, will be that government will be tempted by using restructuring via CACs rather than solve their budgetary issues.
This moral hazard come with a cost, namely, rather than lowering the cost of funding, it will raise it given most new issues coming with CACs will be issued under domestic law.
We see another parallel with one of our pet subject, namely "bond tenders" in the capital structure of banks which has been a regular topic. Raising subordinated debt always come at the price because of the risk taken by the investor. For instance the possibility of coupon deferrals for Tier 1 bonds as well as UT2 make these junior subordinated debt instruments ineligible as reference obligations for CDS.
With the arrival of CACs and the already dwindling liquidity in the sovereign CDS space courtesy of the naked ban effective the 1st of November, one can only wonder about the attractiveness or use of the Sovereign CDS market in Europe.
Another important point from the Natixis note from an historical point of view (or maybe from a "Synchronicity" point of view) in relation to CACs, is the ability of these instruments to avoid default. A preemptive restructuring is always preferable to a post restructuring. Caveat creditor (let the lender beware...). The difference between haircuts from a pre-restructuring (CACs) and post-restructuring is close to 55% according to Natixis, in the case of restructuring occurring in Emerging Markets. Greece with its PSI and 53.5% is in the higher range of pre-emptive restructuring.
Although the introduction of CACs reduces restructuring costs and facilitate the process, it should nevertheless increase risk premiums attached to the new issues. Welcome to subordination in the European government bond market!
But as we stated, "caveat creditor" given that even non-CACs bondholders can face the music with the introduction of retroactive CACs.
On a final note, some pundits are indicating that Americans could be soon buying again durable goods - source Bloomberg:
While the above sounds reasonable looking at the historical time frame used, when one thinks about "Synchronicity" and the theories of Irving Fisher and the events from May to September 1932, one might begin to wonder because the definition of Zemblanity is "The inexorable discovery of what we don't want to know":
"MV=PT as per Irving Fisher's equation. Unfortunately, it looks like the increase in M with a falling V, is not leading to a rise in T nor in a rise in the US labor participation rate for "Doc" Bernanke. "
Until we see a significant rise in Velocity M2 (a subject we discussed in Zemblanity), we will remain cautious on the US economic outlook and we would like to conclude this conversation with one graph displaying the US Labor Participation Rate with the Unemployment rate in the US since 2007 - source Bloomberg:
"Everything has been said before, but since nobody listens we have to keep going back and beginning all over again" - André Gide, French writer.