Saturday, 28 July 2012

Credit - European Derecho

"Derecho comes from the Spanish word for "straight" (cf. "direct") in contrast with a tornado which is a "twisted" wind. The word was first used in the American Meteorological Journal in 1888 by Gustavus Detlef Hinrichs in a paper describing the phenomenon and based on a significant derecho event that crossed Iowa on 31 July 1877." - source Wikipedia
"A derecho  is a widespread, long-lived, straight-line windstorm that is associated with a fast-moving band of severe thunderstorms. Generally, derechos are convection-induced and take on a bow echo form of squall line, forming in an area of wind divergence in the upper levels of the troposphere, within a region of low-level warm air advection and rich low-level moisture. They travel quickly in the direction of movement of their associated storms, similar to an outflow boundary (gust front), except that the wind is sustained and increases in strength behind the front, generally exceeding hurricane-force. A warm-weather phenomenon, derechos occur mostly in summer, especially during June and July in the Northern Hemisphere, within areas of moderately strong instability and moderately strong vertical wind shear. They may occur at any time of the year and occur as frequently at night as during the daylight hours." - source Wikipedia

Looking at the recent storms which have recently unfortunately hit our American friends, and given the sudden rise in Spanish yields to record levels, touching a euro record high of 7.56%, we thought this time around, our "Derecho" analogy would be appropriate. Although these "Derechos" storms most commonly occur in North America, "Derechos" can occur elsewhere in the world, hence our recurring theme of severe weather patterns (Plain sailing until a White Squall? - 18th of March, The Tempest - 8th of May, St Elmo's fire - 26th of May). After all, "Derechos" in North America form predominantly from May to August and the “Sell in May and go away” has persisted as a profitable market-timing strategy for stock investors. Could it be in similar patterns to "Derechos"? We ramble again:
"The CHART OF THE DAY shows the average percentage-point gaps in stock performance between the six months ended in April and the next six months, as presented in the study. The figures cover MSCI Inc.’s local-currency indexes of 23 developed markets for November 1998 through April 2012.
Every index did better in the November-April period, led by MSCI Ireland, which had a differential of 17.9 points. Fourteen emerging-market indexes were included in the research, and all of them showed the same tendency. “The Sell in May effect occupies a special place among seasonal anomalies,” University of Miami Assistant Professor Sandro C. Andrade and two of his colleagues wrote in the study, posted yesterday on the Social Science Research Network. That’s because it only takes two trades a year to make money, unlike other patterns that require more frequent buying and selling. The research by Andrade, Vidhi Chhaochharia and Michael E. Fuerst followed up on a study published in 2002 by the American Economic Review, an academic journal. The earlier work tracked the disparities in the 37 MSCI indexes from their inception, as early as 1970, through October 1998.
In the earlier period, the gap averaged 8.7 points. The differential climbed to 10.5 points after excluding Argentina and Brazil, which experienced hyperinflation. The overall average in the new study was 9.7 points."
- source Bloomberg.
So in our long credit conversation, given the interesting turn of events of the week, with some very important legal evolution, we think, in the subordinated bond space relating to "Bail-ins" and exit consents challenge (h/t FT Alphaville Joseph Cotterill for pointing this out), we will take a look at implied recovery in bank credit and credit events. This recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders (facing the music of haircuts, coercive or not, in true Irish fashion). But first our credit overview.

The Itraxx CDS indices picture, with indices tightening on the back of Mario Draghi's declarations  - source Bloomberg:
The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) tightened by 22bps to 642 bps level. Both the Itraxx Financial Senior 5 year index (25 banks and insurers) as well as the Itraxx Financial Subordinated 5 year index fell significantly in the process, respectively by 12.5 bps and 21 bps. Truth is, during this summer lull, with poor liquidity, market makers are not seeing big sellers of protection (going long credit, being "Risk-On" that is), and are scrambling to bid for protection with no offer available and remain wary of this market movement akin to short covering. We have seen this movie before...
Although French President Francois Hollande and German Chancellor Angela Merkel said Friday their nations are “bound by the deepest duty” to keep the currency bloc intact, following on the commitment made Thursday by ECB President Mario Draghi, we remain deeply concern by the economic situation in the peripheral space with Spain registering a new unemployment record at 24.6% from 24.4% in the prior three months, the most since at least 1976, the year of the democratic transition.

We have indeed reached intervention time given Spanish yields and rising NPLs have as well reached new record highs:
"Spain's ability to fund itself at the shorter end suffered a severe blow as two-year yields breached 6.5% on fears that regional governments beyond Valencia would seek aid, rendering the 18 billion euro bailout fund insufficient. Beyond funding difficulties, bank bad debt will deteriorate faster as debt rollover costs continue to rise." - source Bloomberg.
While Europe’s success in severing the link between Sovereign Risk and Financial risk remain to be seen as indicated by the difference in spreads between the Itraxx SOVx 5 year CDS index (representing 15 Western Europe sovereign CDS including Cyprus) and the Itraxx Financial Senior 5 year index which remains broadly flat - source Bloomberg:
“We have got to cut the fatal loop between sovereigns and banks, which will otherwise bring the euro-zone project as it exists now down,” Adair Turner, chairman of the U.K. Financial Services Authority, said in a London speech as reported by Bloomberg (wishful thinking). The Commission is working against a "self-imposed" September deadline to carve out plans that would give oversight of banks to the ECB as the first step in a campaign to break a cycle of banks and sovereigns fuelling each other's solvency risk.

Truth is time is running out for Spain, probably the reason why Mario Draghi felt compelled to "buy" some time in order to give sufficient time to the market to calm down before the September deadline:
"The CHART OF THE DAY shows the difference in yield between the two securities narrowed this month before flipping on the 26th of July. The five-year note yield surged to as much as 7.785 percent, the most since the euro was created in 1999, and more than three basis points higher than the 10-year rate, which reached 7.751 percent. The selloff also pushed yields on Spain’s two-year securities to more than 7 percent for the first time since September 1996. The bonds subsequently rebounded and the five year rate dropped below 10-year yields amid speculation Spain’s fiscal predicament will convince the European Central Bank to augment the firepower of the region’s bailout fund." - source Bloomberg.

With Mario Draghi's timely intervention, no wonder Spanish yields receded very significantly by more than 100 bps in our European bond picture while German government yields rose back towards higher levels around 1.40% on the close (1.16% on the 20th) with other European core bonds (France, Netherlands) rising as well in conjunction with German yields - source Bloomberg:
Spain's 10-year yield fell 52 bps this week to 6.74%, the biggest weekly drop since the period ended December 2nd according to Bloomberg.

While Spanish banks have been busy lowering their sovereign holdings for a third straight month:
"Euro zone financial institutions increased sovereign debt holdings by more than 145 billion euros during 1Q, as ECB cash was put to work. Spanish banks, having purchased 78 billion euros of sovereign in the four months to end-March, lowered their exposure for a third month in June. A euro-zone wide, sustainable solution is required to stem the crisis." - source Bloomberg.

Looking at Santander 1H deposit mix, Spanish structural funding issues are very clear for these institutions:
"While Santander's total customer deposits grew 3% yoy to 1H, its time deposits fell 22 billion euros. The key delta was growth of more than 38 billion euros in non-resident "other" deposits. As Spain's troubles continue, a shortening of liability duration and withdrawal of mutual and pension fund support will likely continue across banks, pressuring funding costs further." -  source Bloomberg.

Hungary has been long been our pet subject (Hungarian Borscht, Hungarian Dances) in relation to the study of systemic risk diagnosis (Modicum of relief):
"The reason behind our choice is that it appears to us as very good case study for systemic risk diagnosis from a macroeconomic point view (after all our blog is called Macronomics)."
We argued at the time:
"A liquidity crisis happens when banks cannot access funding (LTRO helped a lot in preventing a collapse). A solvency crisis can still happen when the loans banks have made turn sour, which implies more capital injections to avoid default (hence the flurry of subordinated bond tenders we have seen). Rising non-performing loans is a cause for concern as well as rising loan-to-deposit ratios. "
It was not really a surprise therefore to see Hungary Yields dropping below Spain for the first time this week:
"Hungary’s borrowing costs dropped below Spain’s for the first time as the European Union’s most
indebted eastern member held talks on an international bailout and Spain’s regions requested aid
. The CHART OF THE DAY shows investors this week demanded
lower yields to hold Hungary’s debt than Spain’s after Hungary began talks for an International Monetary Fund credit line and Spain’s Valencia region sought financial assistance. Hungary’s 10-year bond yields were at 7.39 percent on July 23, compared with 7.49 percent for similar-maturity Spanish debt. “The primary reason why Hungarian bonds have been doing well is because anticipation has been building up that the country is moving toward an IMF program,” Arko Sen, a strategist at Bank of America Corp. in London, said in a phone interview yesterday. Hungarian yields were as high as 10.8 percent after Prime Minister Viktor Orban’s government passed legislation the IMF and the EU said threatened the central bank’s independence in December, obstructing talks on aid. Hungarian yields were as much as 539 basis points above Spain’s in January." - source Bloomberg.

Looking at Mario Draghi's speech we could not resist to reminding ourselves our previous December 11th post "The Generous Gambler" where we quoted the wonderful poem by French poet Baudelaire which inspired Verbal Kint in The Usual Suspects:
"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!" - Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"If it hadn't been for the fear of humiliating myself before such a grand assembly, I would willingly have fallen at the feet of this generous gambler, to thank him for his unheard of munificence. But little by little, after I left him, incurable mistrust returned to my breast. I no longer dared to believe in such prodigious good fortune, and, as I went to bed, saying my prayers out of the remnants of imbecilic habit, I said, half-asleep: "My God! Lord, my God! Please make the devil keep his word!"
Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

People are trading on hope: "Please make Mario Draghi keep his word", we could posit in similar fashion to what we commented in our September 2011 conversation "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"
"So far the devil's best trick has been to persuade us that risk-free interest rates did exist. It ain't working anymore and that is a big cause of concern." - Macronomics.

We could not resist but we chuckled when we read the following comment from a credit desk:
"Equities = Hope, Credit = Reality, unfortunately, Reality follows Hope until the Hope dies, then Reality settles in."
As a reminder from our "Generous Gambler" conversation this is what Arnaud Marès, from Morgan Stanley in his publication of the 31st of August 2011 -Sovereign Subjects had to say:
"Does it matter that sovereign debt is risk-free? It very much does. If sovereign debt is no longer a safe haven, then the ability of governments to implement counter-cyclical policies is impaired. Fiscal policy is becoming at best neutral, at worst pro-cyclical. At a time when growth is rapidly slowing, the economic cost may be high.
Weakening the quality of government credit means weakening the fiscal backstop from which banks benefit. This risks resulting in an accelerated de-leveraging of bank balance sheets, with equally costly economic consequences."
This is exactly what has happened so far with the ill-fated EBA June 2012 request of asking European banks to reach a Core Tier 1 ratio which precipitated the deleveraging as well as the withdrawal of credit, bond tenders and other liability management exercises, hitting hard in the process the real economy in European countries. This withdrawal of credit has also been confirmed by the latest results from British bank Barclays as indicated by Bloomberg:
"The exodus from debt-ridden peripheral Europe continues, with Barclays detailing reduced sovereign exposure of 22% and 5% lower retail lending in 1H. Plagued by liquidity shortages, EU Banks have also rushed to reduce local funding mismatches: Barclays took additional Spanish deposits since 2011 year-end, while taking 8.2 billion euros from the ECB's LTRO in Spain and Portugal." - source Bloomberg.

As we pointed in a "Tale of Two Central banks", we would like to repeat Martin Sibileau's view we indicated back in October 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."

We would like to take the opportunity of debunking further the "efficient market theory" (if there are any believers left out there...) in relation to Draghi's intervention. We agree with a recent note from French broker Aurel, namely that this "theory" has taken yet another blow. The markets did not react to Mario Draghi's declarations  made in an interview last Saturday in French newspaper Le Monde but "only" reacted strongly on Thursday when similar declarations were displayed in bold red on Bloomberg: « Believe me, it will be enough ».
Oh well...
In relation to our recent theme of "Yield Famine",  Unibail has sold this week EUR750m of bonds at 2.25% maturing on 1st August 2018 (6 years). The issue was 4 times oversubscribed with the order book reaching over EUR 3bn in less than 1.5 hours...We saw similar action this week on numerous new high quality issues coming to the market.
The rush for yield and strong appetite for credit is cause for concern and caution particularly in the High Yield space where risk is lurking.
"unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today", we argued last week.

High Yield is indeed becoming very expensive as indicated by Lisa Abramovicz in her Bloomberg article - BofA Cools on Junk Priciest to Stocks Since ’93:
"Junk bonds are losing their sheen after becoming about the most expensive relative to stocks in at least two decades, prompting firms from Bank of America Corp. to Loomis Sayles & Co. to warn that gains on the debt may wane. Junk bonds are returning less than the highest-rated corporate notes for the fourth straight week, the longest stretch since the period ended Nov. 27, Bloomberg data show".
Time to reduce duration and favor short term High Yield if you are "starving" for yield and can stomach the volatility risk we think.

Moving on to the very important subject of the legal evolution in the subordinated bond space relating to "Bail-ins" and exit consents challenge,  this recent interesting legal challenge has indeed significant implication for recovery rates in the subordinated bond space, particularly for Spanish subordinated bondholders.
 As indicated on the FT Alphaville comment section, Claudio Borghi Aquilini made some very valid comments:
"This is an extremely important ruling. Basically it (rightfully) denies the very concept of forced burden sharing at the basis of the eurodebt disaster. Either you let the bank fail or if you decide to save it you may not kill bondholders (albeit subordinated) ad random. Reducing the burden for taxpayers might seem a good reason to do silly things but debt is based on rules, if you create doubts and "special situations" no wonder if funding costs skyrocket (and if a judge tells you that you can not play with contracts). "
We could not agree more. Debt is based on rules. The capital structure is there for a reason when it comes to bank debt and the difference between junior debt from senior debt as well as the recovery values and credit events triggering CDS contracts relating to the capital structure. Looking at the recent discussions relating to "Bail-in" proposals (a subject we discussed in "Something Wicked This Way Comes"),  Morgan Stanly in their Credit Strategy review from the 27th of July entitled - Implied Recovery in Bank Credit, argued the following:
"One hears every possible argument in the debate over whether senior bank debt in Europe should bear losses. There is the moral (better that bondholders pay for bank rescues than ordinary taxpayers). The practical (senior bonds are a small slice of the capital structure, burning them saves relatively little money). The game theory (country that imposes losses saves money, everywhere else suffers). The theoretical (if the institution’s insolvent, of course its lenders should bear loss). The psychological (debt haircuts will scar funding markets for years to come). The list goes on. We believe that the costs of haircutting senior bank debt in Europe vastly outweigh its rewards."
On that matter, we "Agree to Disagree" with Morgan Stanley, given that, as we posited in "Long hope - Short faith, Hungary and Bank Recapitalization", the study realised by Stanford University Anat R. Admati (Why Bank Equity is Not Expensive) shows that banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati.

The latest legal spat as reported by FT Alphaville (link above) involving credit asset manager Assénagon and Anglo Irish, is a relative important matter given the latest European Bail-in resolution and, because, as indicated by Morgan Stanley in their research piece:
"Fixing the recovery of subordinated debt and taking the spreads on senior and sub debt observed in the market, it becomes possible to solve for a recovery rate on senior."
"The eight banks in the top of the table provide observations of actual loss severity. Why do we focus on CDS? Our approach provides a simple way to solve for implied recovery, but only if the probability of default between two instruments is similar. This isn’t strictly the case with bank bonds, as the restructuring of Lower Tier 2 bonds in the Irish banks bound holders to a large loss, but left senior debt unscathed. CDS, in contrast, triggers at the entity level, meaning that senior and sub CDS are much more likely to take loss at the same time" - source Morgan Stanley.

In terms of market observations, Morgan Stanley also indicates:
"Although senior bank bondholders have generally been protected in Europe, it has been more common for sellers of senior CDS to face losses when contracts are triggered by restructurings. Recoveries in such events have been generally high, at around 50%.
The range of pricing, however, has been enormous – senior CDS on Bradford and Bingley recovered at 95c, CDS on Landsbanki recovered at 1c – especially with regards to the ratio of loss (or the implied ratio of loss).
Across current banks in Greece, Portugal and Spain, pricing also remains highly disperse." - source Morgan Stanley.
"What’s notable? For most banks, implied senior recovery is surprisingly ‘average’ relative to the last seven years, despite all the recent rhetoric. The range of implied recovery is also very narrow (35% to 57%), in direct contrast with the large variation in senior recovery under stress seen in previous table, although we acknowledge that the banks above are for the most part higher-quality than the names in that data-set.
Per our framework, the UK banks (e.g., Lloyds, RBS, Barclays) as well as Commerzbank enjoy the highest implied senior recoveries (i.e., sub debt trades the widest to senior). This is somewhat odd, given that both the UK and Germany have resolution regimes in place whereby subordinated and
senior bondholders could potentially take losses. One explanation could be that investors feel more comfortable in UK and‘core’ European bank senior debt, yet more cautious on subordinated debt, given the resolution regimes. We’re generally happy to lean against this, and would note that the wide senior/sub differential is consistent with our generic preference for UK LT2 and certain Commerzbank subordinated debt structures.
In contrast, Spain and Italy have among the lowest implied recovery rates. Consistent with what we note on UK and German banks, we suspect that this relates to the high degree of sovereign stress which has pushed out senior spreads to very wide levels. Equally, the potential risks of some form of burden-sharing spreading up the capital structure to even include senior debt are also a source of concern for investors, even if a low-risk tail event, in our view." - source Morgan Stanley - 27th of July 2012.

Using Santander as a proxy in determining "Implied Recovery and Default Rates:
For SANTAN, subordinated CDS spreads are ~1.5x senior, implying 1.5x higher loss severity for the same probability of default. Fixing the potential loss on Lower Tier 2 at 90% (10% recovery), this gives an implied loss on senior debt of 59% (90%/1.5x), for an implied recovery of 41% (1-59%).
Similar to the story in the broader index, implied recovery is only marginally lower than its historical average, while spreads now suggest a near-record probability of default over five years (32%). Stress on the Spanish sovereign has led to an increase in the risk of default, but not a decline in perceived recovery." source Morgan Stanley, 27th of July.

Forced burden sharing and coercive action in similar fashion to the Anglo Irish situation, would indeed, lead lower perceived recovery for Spanish  banks bonds, hence the importance of this legal ruling relating to Anglo Irish.
Morgan Stanley in their note Senior and Sub Financials - Credit Derivatives Insights on the 27th of July point to the following:
"What are the historical examples of senior and sub CDS triggers in Europe?
We now have a few precedents for bank CDS triggers in Europe (see table below): The Icelandic banks, Bradford & Bingley (UK) and now Irish banks are the financials credit events for CDS in Europe in the last five years. The above can be sorted into three groups: i) banks that were not backstopped and allowed to default (Icelandics); ii) banks that had an extremely credible backstop (Bradford& Bingley) and a well-supported senior; and iii) banks that were perceived to have a backstop for seniors but not fully robust (Irish banks)."
"We think the Anglo Irish example is good template for how bank restructurings could evolve from a CDS perspective and how auctions could work. Anglo Irish Bank announced a tender offer following equity injections, offering to exchange all the three existing LT2 bond issues into new 1yr government guaranteed senior FRNs (Euribor +375bp) equivalent to 20c of existing face value. In addition to the exchange offer, the Bank convened meetings to approve the inclusion of a right to redeem all (but not some only) of the existing notes at practically zero to encourage acceptance. This series of events triggered a restructuring credit event for Anglo Irish CDS. The requirements in determining a restructuring credit event were fairly straightforward to establish in the case of Anglo Irish: a loss of principal for a multiple holder obligation, made binding on all holders and which resulted directly from deterioration in credit quality.
While all thee LT2 bonds were restructured ultimately, the timeline was in a staggered fashion in order to avoid a lack of LT2 deliverables if all were restructured in one go. Thus, the auction was conducted in an accelerated timeframe, after the first bond was restructured and triggered CDS, but before the other bonds was restructured." - source Morgan Stanley.

The recent legal ruling for Anglo Irish versus Assénagon (rightfully) denies the very concept of forced burden sharing which has been used in the determination of the recovery during the restructuring credit event for the CDS auction process and the results, a process which will inevitably occur for weaker Spanish and Italian institutions at some point:
"While the recoveries for the senior CDS of different buckets were largely in line with each other, sub CDS had very different recoveries for the 2.5yr bucket (74.5) vs. for the other two buckets (around 18). In practice the recovery for different buckets of senior CDS could also vary considerably, as the dollar prices of a 2.5yr bond could be very different from a 7.5yr bond in a restructuring scenario." - source Morgan Stanley.

As indicated by FT Alphaville in their post,  IFR reports that IBRC, the successor to Anglo Irish, is considering an appeal. The awarding of any damages is yet to come. A truly interesting legal development in the banking space.

On a final note, a weakening of the Euro is likely to be reflected in HSBC, Santander, BBVA 2nd Quarter results as shown by Deutsche Bank's recent profit warning:
"As Deutsche Bank's profit warning demonstrated, the ongoing weakness of the euro can negatively affect results where there is a  mismatch between costs and revenue, or material parts of the business earn and report in different currencies. Euro zone revenue contributions are likely to shrink at HSBC, which has significant euro operations and reports in dollars." - source Bloomberg.
Given Deutsche Bank AG recently announced it would reduce risk to meet a 2013 capital-ratio goal after second quarter profit missed analysts' estimates on expenses tied to a weaker euro (net income fell to 700 million euros), reduced risk will lead to reduced liquidity and inventories provided to the market place. Yet another story of de-risking, deleveraging. No wonder traders are leaving the banking industry for Hedge Funds in this process.

"The greatest trick European politicians ever pulled was to convince the world default risk didn't exist" Martin T - Macronomics.

"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies."  - Groucho Marx

Stay tuned!

Sunday, 22 July 2012

Credit - Hooke's law.

"A complacent satisfaction with present knowledge is the chief bar to the pursuit of knowledge." - B. H. Liddell Hart

"In mechanics and physics, Hooke's law of elasticity is an approximation that states that the extension of a spring is in direct proportion with the Load applied to it. Many materials obey this law as long as the load does not exceed the material's elastic limit. Materials for which Hooke's law is a useful approximation are known as linear-elastic or "Hookean" materials. Hooke's law in simple terms says that strain is directly proportional to stress." - source Wikipedia.
As a follow up to our recent conversation "Yield Famine", we decided this time around to venture towards a law of physics analogy, namely Hooke's law given the level of stress that can be ascertained from the level of core European yields making new record lows (Germany, France, Austria, Netherlands), which we think is indeed, directly proportional to the aforementioned stress. But it not only in Europe, we are seeing an extension of the "negative yield club", the United Kingdom as well is poised for joining the club:
"The CHART OF THE DAY shows the yield on the two-year gilt falling. It reached a record low 0.115 percent today. Similarly-dated Swiss rates dropped to minus 0.44 percent on July 16, with Germany’s and Denmark’s yields sliding to as low as minus 0.074 percent and minus 0.331 percent, respectively, two days ago. Shorter-maturity rates have turned negative for nations perceived as havens from the almost three-year-old debt crisis, which has sent Italian and Spanish yields to euro-era highs and countries including Greece, Ireland and Portugal seeking bailouts. A negative yield means investors who hold the notes to maturity will receive less than they paid to buy them." - source Bloomberg.
While we recently touched on the attractiveness of going long credit and going long equity volatility ("European Credit versus volatility looks increasingly appealing"), we also discussed in our last conversation the complacency and dwindling liquidity pushing investors out of their comfort zone in similar fashion the "yield famine" of 2006 and 2007 engineered the rise and fall of the structured credit market and other esoteric yield "enhancements" products. In our credit conversation, we would like to discuss the "unintended consequences" of this low yield environment will have to corporate balance sheets, which to some extent, tend to explain, why defaults tend to spike in a low rate deflationary environment such as today. But first, as always our credit overview.
The Itraxx CDS indices picture, with indices widening on the back of a worsening Spanish situation while falling core government bond spreads are making new record lows - source Bloomberg:
The Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) widened towards the 665 bps level, wider by 20bps 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 13 bps and 16 bps.
The current European bond picture with Spanish yields back above the 7% level while German government yields closing back to lower record level around 1.16% (1.20% on the 18th) with other European core bonds (France, Netherlands) making again new lows in this "yield famine" environment - source Bloomberg:
"Hooke's law": Core yields strain/levels are directly proportional to peripheral stress/levels.
Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under renewed pressure on the back of Sovereign government yields - source Bloomberg:
Spanish Sovereign 5 year CDS now wider by 80 bps, making a new record high, above Italian Sovereign 5 year CDS in conjunction with Government Bond Yields. Back in March, in our conversation "Spanish Denial", we highlighted the differences between Italy and Spain. In our conversation "Modicum of relief"  in March we stated:
"We think Spain Sovereign CDS will drift wider, indicating increasing default risk perception given:
-Italy's shrinking budget deficit to -3.9% in 2011 from -4.6% in 2010,
-Spanish unemployment level expected to reach 24.3% in 2012,
-Spanish Prime Minister Mariano Rajoy has decided to side step the 4.4% deficit target for 2012, for 5.8%."
The core of our macro thought process is based upon the difference between "stocks" and "flows", as we indicated in our conversation "The Spread Also Rises", Cheuvreux Cross Asset Research from the 19th of March validated our macro approach we think:
"The sovereign debt constraint in Italy is that of a stock - a high accumulated indebtedness - rather than a flow due to operational deficits. Accordingly, the arithmetic of sovereign sustainability in Italy is much more sensitive to the ratio of the cost of debt to trend nominal GDP growth than in Spain."
"Spain's ten-year yield closed above 7% for only the fourth time in the euro era, as auction costs for two- and five-year issues spiked and bid-to-cover levels fell significantly, further pressuring the ECB for action. The associated impact on its banks and their funding costs drove the Bloomberg Industries Spanish Banks Index (BIERBESC) to fresh lows." - source Bloomberg.

Spain on Friday said its recession would extend into next year in conjunction with the region of Valencia asking for a rescue from the central government. Spain's GDP will fall 0.5% in 2013 rather than rising by 0.2% in 2013 as the government had predicted on the 27th of April. Regions face about 15 billion euros of debt redemptions in the second half, with Catalonia and Valencia making the bulk. Spain is truly in a deflationary trap with unemployment reaching 24.6% in 2012 instead of 24.3%. The forecast for 2013 is unemployment to be 24.3% instead of 24.2%.  Clearly a case of "A Deficit Target Too Far".

So the pressure is mounting on the ECB to intervene yet again in the markets as Spanish yields rise.
"In May 2010 the ECB securities market program began, peaking at 219.5 billion euros in March 2012 and recently holding at 211 billion for several months. Two three-year liquidity injections and a June euro area summit release have failed to stabilize yields, which in turn continue to buffet bank stocks and liquidity supply, suggesting new actions are required." - source Bloomberg.

No wonder our "Flight to quality" picture is displaying "Risk-Off" with Germany's 10 year Government bond yields falling again towards record low levels at 1.16% and the 5 year CDS spread for Germany well below 100 bps in the process back to March 2012 levels - graph below, source Bloomberg:

We do agree with our good credit friend namely that considering the lack of liquidity in the credit space and the very high correlation between asset classes, the coming weeks could see a significant spike in volatility in the European space, so "Mind the Gap" because "The Gap is back"- 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 with two years core government going negative making, in true Hooke's law fashion, our "credit" springs are looking increasingly compressed.

As our good credit friend discussed on Friday, in terms of the news flow, nothing has materially changed:
"1-The EU finance ministers adopted the EU master Plan to bail out the Spanish banking system.  The decision paves the way for the EFSF to raise 30 billion euros. Spain’s bailout will start through the EFSF, which has 240 billion euros in remaining capacity. The permanent 500 billion-euro European Stability Mechanism (ESM) is on hold until a German court ruling due in September. But at the same time, the Province of Valencia is calling the Spanish central government for a bailout. Valencia next bond to be repaid is CHF denominated, matures on august 24th and was issued in march 2009 when the Euro/CHF was trading at 1.5350 (it trades now at 1.2000, which means that the municipality is facing an increase of 20% on the payment due, unless it was currency hedged, which we doubt).
Growth is slowing more in Spain, so we think we are heading for a full bail out of the Province of Valencia (Euro 6 billion, including a superb Euro 1 billion brand new stadium built with the help of the Province "credit card"), which will add pressure on the Spanish debt... Do not expect Germany or the ECB to rescue the world, because as we posited before we do not think they will. ("The Game of The Century").
2-EU is still discussing Cyprus bailout conditions. It seems we are talking of Euro 15 billion package, a lot considering the relative size of Cyprus.
3-Greek State Asset Sales Fund CEO (Mr Costa Mitropoulos) submitted his resignation to the government and is gone. Once again, it looks as if the Greek government promises to comply with the bailout conditions will not be met. I tend to think that our German, Finish and Austrian friends will pull the plug very soon.
4-The US economy is slowing down more as the country is following the path of the rest of the world. Remember, we live in an integrated Global Economy, and nobody is immune. Some US counties and municipalities are already defaulting, others will follow.
Quote: If you want to default, be one of the first to do it as there will not be enough money for everybody."

In relation to point number 3 above, EU Banks Greek Sovereign Exposure is down by 15.5 billion USD:
"Latest BIS data confirm that after further writedowns and asset sales, the total exposure of European banks to Greek sovereign bonds and public sector debt fell more than 70% quarter-on-quarter to end-March, and now stands at $6.4 billion. Should Greece exit the euro, resolution of private sector debt and guarantees remain the largest outstanding issue. (Corrects currency.)" - source Bloomberg.

We do agree with the following quote from James Hertling Bloomberg article - European Bailout Bid Gets Vote of No-Confidence as Markets Drop from the 20th of July:
We’re looking at a situation when people are realizing we’re at a point of debt restructuring and repudiation,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said in an interview today. “It’s cold-hearted reality. The great blag and bluff of the euro zone has always managed to kick the can down the road, but it is no longer a viable strategy. We’re getting to a crunch point.”

On the 18th of July, Deutsche Bank published in their Bank Research one slide resuming the political stalemate, the opposing positions between stakeholders suggesting the crisis will be a long drawn out affair:

As far as game theory is concerned, we have argued in our conversation "The European iterated prisoners' dilemma": "The only possible Nash equilibrium is to always defect - It looks to us increasingly probable that the outcome could be different to what is expected from Germany. The outcome for the European project is going to be rather binary. It is either "Federalism" or break-up."
We stick to our view.

The options market is validating our views as far as game theory is concerned as reported by Bloomberg. "Game-theory analysis shows the options market is underestimating the risk the euro will slide as European policy makers fail to take actions necessary to end their financial crisis, according to Bank of America Corp. The options market is underpricing the risk of the voluntary exit of one or more countries and a weaker euro,” David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York, said in a telephone interview. “Investors are holding out hope, and are complacent in believing, that policy makers will come in and save the day. That is simply wrong because what is good politics in Europe may not be good policies.”
"The top panel of the CHART OF THE DAY shows implied volatility on one-year options for the euro versus the U.S. dollar has plunged since last year, when yields on Spanish and Italian debt had surged, sparking speculation the debt crisis was spreading. The middle panel is a gauge of option demand for hedges against extreme moves in the common currency over the next year. The final graph shows demand for puts, which grant the right to sell the euro, relative to calls is the weakest since April. A call allows for purchases of the euro. Game-theory and cost-benefit analysis show Germany is unlikely to agree to issue euro-region bonds, viewed by strategists as important to stemming the crisis, and Italy and Ireland have the most incentive to voluntarily exit the currency bloc, Bank of America said. The so-called Nash equilibrium in a game in which Greece has the choice of adopting austerity or not, and Germany can choose between issuing Eurobonds or not, is no austerity and no euro bonds, the bank’s analysis shows. Game theory is a study of strategic decision-making. A Nash equilibrium, named after John Nash, a Nobel laureate in economic sciences, is a scenario in which no player in a strategic game has an incentive to unilaterally change an action. Bank of America forecasts the euro, at $1.2199 yesterday in New York, will trade at $1.2 at the end of September." - source Bloomberg.

Moving on to the "unintended consequences" of this low yield environment will have to corporate balance sheets, to some extent, it tends to explain, why defaults tend to spike in a low rate deflationary environment such as today. The fall in interest rates increases bond prices companies have on their balance sheets, exactly like inflation (superior to what an increase of 2% to 3% of productivity and progress) destroys the veracity of a balance sheet for non-financial assets. The conjunction of low interest rates with higher taxations will undoubtedly damage companies, particularly in Europe, and in a country like France, for instance, where public expenditure as a % of GDP is much higher (56%) than in Germany (45%). 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").

In our conversation "The European crisis: The Greatest Show on Earth", we indicated:
"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 important indicator we follow is the rise in Terms of Payment as reported by French corporate treasurers. The latest report is sending us again 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 +36% of corporate treasurers reported an increase compared to June (+27.8). The record in 2008 was 40%...
According to their latest survey realised early July 2012, the opinion of French treasurers for large corporates cratered in the last two months from -0.7% in May to -19% in July, the most significant drop in two months since this survey exist (first one was December 2005).

According to an article from John Glover from Bloomberg from the 20th of July - Europe’s $180 Billion of Maturities Lifts Swaps: Credit Markets:
"Speculative-grade corporate debt in Europe is the most expensive to insure against losses in 1 1/2 years relative to sovereign bonds as companies need to refinance as much as $180 billion of debt by 2014. An index of credit-default swaps on junk-rated European companies exceeds one for government bonds by 2.44 times, up from 1.65 in March, according to data compiled by Bloomberg. Finnish mobile-phone manufacturer Nokia Oyj led the increase among European non-financial companies, with a 136 percent jump in the last three months, followed by Rome-based toll-highway
operator Atlantia SpA, whose swaps climbed 72 percent.
Borrowers in Europe, the Middle East and Africa face $84 billion of junk-rated debt maturing next year and $96 billion in 2014, compared with 2011’s record bond sales of $70 billion, Moody’s Investors Service said. Their ability to service debt is being hurt by the worsening economic outlook, with the International Monetary Fund forecasting July 16 that output will shrink 0.3 percent in the euro area this year."
"Yield Famine" and Hooke's law, from the same Bloomberg article: 
"The divergence between high-yield corporate and government default risk is being exacerbated by investors snapping up bonds of the safest sovereigns, in some cases agreeing to pay to lend to the nations. Germany’s two-year note yield fell to minus 0.074 percent on July 18 while Austrian, Swiss and Finnish rates also turned negative this week for the first time." - source Bloomberg.

The deterioration in speculative-grade European company credit is being worsened by the outlook for economic growth, hence the risk of seeing a spike of defaults, in this low yield, deflationary environment. Lack of growth means lack of unemployment prospects and reduced tax revenues with increasing pressure in cash flows as indicated by the pressure in the terms of payments from the AFTE monthly survey. It is still a game of survival of the fittest. It’s also causing some companies to pay more to raise money or to be taken over when they cannot pay their debt as indicated in the Bloomberg article quoted above:
"Findus Group Ltd., the frozen-food company owned by private-equity firm Lion Capital LLP, will be taken over by its junior lenders in a debt restructuring after it breached debt covenants that creditors had waived in March, four people with knowledge of the situation said July 7. Under the plan led by Lion Capital, Highbridge Capital Management LLC and JPMorgan, junior creditors will write off more than 200 million pounds ($310 million) of mezzanine loans in return for ownership and provide 70 million pounds in a short-term credit facility, said the people, who declined to be identified because the discussions are private. They will inject 220 million pounds into the company, including 125 million pounds to reduce senior debt, the people said." - source Bloomberg.

Consolidation, defaults and restructuring are going to happen no matter what, for struggling corporates, struggling Spanish regions and provinces, as well as struggling countries. We touched on the subject for the European car industry with Peugeot in our last conversation. In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment we argued.

The Bloomberg article concluded with the following quote from Andrew Sheet, European Credit Strategist at Morgan Stanley in London:
"If companies “don’t have cash on the balance sheet” they’re "not in a good place". If a company
generates free cash then it’s in control of its own future."

So, in relation to our title, in true Hooke's law fashion, given the "Yield Famine" we are witnessing, we believe our credit "spring-loaded bar mousetrap" has indeed been set and defaults will spike at some point, courtesy of zero interest rates. (The first spring-loaded mouse trap was invented by William C. Hooker of Abingdon Illinois, who received US patent 528671 for his design in 1894).

"If you build a better mousetrap, you will catch better mice."
George Gobel - American comedian.

Stay tuned!

Thursday, 19 July 2012

Credit - Yield Famine

"Hunger knows no friend but its feeder." - Aristophanes

Looking at the recent price action in the credit space with continuous appetite for investment grade credit, with struggling money markets, with high quality issuers spread making new lows, negative core government bonds for some and unquenchable appetite for yield, we decided to step away from literary analogies, and historical references this time around. Last week we saw high quality corporate Nestle issuing 500 million euro worth of a 7 year bond at Mid-Swap +30 bps, then revising its guidance at Mid-swap +15 bps (that means a 1.50% coupon) because there was such a BIG DEMAND for the new issue (there was 6 billion euros plus worth of orders in the book). When you hear that money markets fund in euros are suspending new subscriptions courtesy of ECB cutting deposit rate to zero, it can only mean one thing: it means the “japonification” of the credit markets with dwindling liquidity as well, hence our title "Yield Famine".

Credit is increasingly becoming a crowded trade, forcing yield hungry investors to get out of their comfort zone and reaching out for High Yield as well as Emerging Markets in the process. In that context of falling yields and falling volatility, we do agree with the recent comments our good cross asset-friend made in our recent post "European Credit versus volatility looks increasingly appealing":
"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions looks increasingly appealing on current levels.
Following the Greek Elections and the European Summit, implied volatilities levels on equity indexes have corrected dramatically while other risk measures are clearly not validating any “blue-sky” scenario (Spain/Italian sov spreads, bund yield, credit spreads…). On current relative valuations long credit vs long equity volatility positions look particularly interesting.
On the credit side you benefit from the relative backing of huge flows from institutional investors hungry for yield, while still enjoying relatively solid balance sheets from a corporate universe that has consistently been rolling over debt maturities.
On the equity side you are paying reasonable volatility levels, almost in line with the recent subdued realized levels with a large upside should any stress materialize in coming months."

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:

In our credit conversation, before our credit overview where we will discuss default risk in low yield environments in a deflationary world and revisiting our calls on upcoming financial bonds haircuts, we would like to highlight once more, the complacency prevailing in the credit space with dwindling liquidity pressuring even more quality issuers yields, causing famine in the process.

Truth is nothing has really changed, when it comes to the outlook in the credit space. While demand for Core European bonds remain very strong, pushing more and more core government spread towards negative yields, peripheral names continue to be shunned with atrocious liquidity given inventory levels for market makers remain at record low level. Therefore activity levels in the secondary space remain more or less subdued in terms of flows. We are witnessing indeed some sort of "japonification" in the credit space (a theme we previously wanted to approach). In a June note UBS indicated the following worrying trend in credit:
"A troubling ongoing development for the credit market is the significant decline in trading liquidity (which has been accentuated by European concerns). A challenging liquidity environment is not conducive to a healthy marketplace and is incorporated into overall risk premiums. Coping
with the logistics of trading realities has led to rational decisions from market participants that have influenced the ongoing decline in liquidity.
Unfortunately, this liquidity dynamic is unlikely to see a meaningfully reversal anytime soon given global uncertainties, constrained risk appetites, and the shifting regulatory backdrop." - source UBS - Macro Keys, 7th of June 2012

- source UBS - Macro Keys, 7th of June 2012

While everyone is happily jumping on the credit bandwagon in this "yield famine" environment, we would advise caution given liquidity, as we discussed on numerous occasions (and liquidity mattered a lot in 2011...), is an important factor to consider in relation to investor confidence and market stability.

Pick your poison:
- source UBS - Macro Keys, 7th of June 2012

Deleveraging for banks means a significant reduction in RWA (Risk Weighted Assets) leading to dwindling liquidity for cash rich investors as dealers play close to home.

Courtesy of "improved" bank regulations, banks have been piling up Treasuries, agency, and MBS securities as indicated by UBS:

"The result for the credit market is a more cautious stance from market makers whose reluctance to
be aggressive in a less liquid marketplace is in turn hindering market liquidity."
- source UBS - Macro Keys, 7th of June 2012.

Using a baseball analogy from our Americans friends, investors and dealers alike do not want to try stealing third base in this market environment:
"The credit market appears caught in an adverse cycle where both liquidity providers (dealers) and liquidity users (investors) are reluctant to be aggressive, preferring to stick with close-to-home risk positions of light balance sheets for dealers and near-benchmark exposures for investors." - source UBS - Macro Keys, 7th of June 2012.

The Itraxx CDS indices picture, with indices tightening with rising equities and falling core government bond spreads - source Bloomberg:
In that context the Itraxx Crossover (High Yield CDS risk indicator - 50 European high yield credit entities) fell significantly towards the 650 bps level, tighter by 14 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 fell significantly in the process, respectively by 10 bps and 15 bps.

While we have been monitoring closely the relationship between Itraxx Financial Senior 5 year index and the SOVx index representing the CDS risk gauge risk for 15 Western European countries (Cyprus replaced Greece in March in the index), the discussions of a Banking Union during the last European summit, has led to the SOVx index trading very marginally tighter (nearly 7 bps apart) than the Itraxx Financial Senior index - source Bloomberg:
The sovereign-bank link as indicated by the above credit indices touched recently a low of 18 bps, the bank-sovereign crisis has yet to be resolved meaningfully.

Given the decision of the German Constitutional court to postpone its ruling by three months on the ESM, it leaves the EFSF as sole agent in the recapitalization process of the ailing Spanish banking system.

The current European bond picture with today's rise of Spanish yields back towards the 7% level while German government yields closing back to lower levels around 1.20% (1.32% last week) with other European core bonds (France, Netherlands) making new lows in this "yield famine" environment - source Bloomberg:

As far as our "Flight to quality" picture is concerned, Germany's 10 year Government bond yields are falling again towards record low levels and the 5 year CDS spread for Germany has fallen recently well below 100 bps in the process for now - graph below, source Bloomberg:

Italy's 5 year Sovereign CDS versus Spain 5 year Sovereign CDS with Spain coming again under pressure on the back of Sovereign government yields - source Bloomberg:

As far as credit is concerned, we like to repeat our cautious stance in this unquenchable appetite for yield environment. In that context we do agree with Citi's recent Credit Strategy Cheat Sheet from the 13th of July:
"The net result is that we are near the tights with few obvious positive catalysts, but a long way from the wides. In effect, we believe that the upside / downside ratios for at least some segments of the market are not overly compelling at this stage."

In fact we are reminding ourselves we have seen similar "complacency" before. Back in November 2011, we posited the following in our conversation:
"In a low yield environment, defaults tend to spike. Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation."
"Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike." - Morgan Stanley - "Understanding Credit in a Low Yield World.

We already touched in depth the European car market deflationary environment in our April conversation "The European Clunker - European car sales, a clear indicator of deflation", where we discussed as well French car manufacturer Peugeot (PSA) European woes. To illustrate the point we mentioned above, risk of defaults can indeed rise suddenly. As our good cross-asset friend pointed out recently, Peugeot is indeed a good case study in the sense that the basis between cash and CDS was around 200 - 220 bps, on the 13th of July, in a single day the credit curve repriced by around 150 bps to 200 bps, with the CDS not moving much - source Bloomberg, anonymous dealer cash run:

The last column on the right indicates the change in spread for Peugeot cash bonds rising suddenly ("COD" = "Change On Day"). This clearly indicates that the CDS market had indeed sent out much earlier a warning signal on Peugeot bond prices, which eventually led to a repricing of the cash market for Peugeot. Peugeot announced on the 12th of July that it would shed 14,000 jobs. Its equity price touched its lowest level today at 5.864 euros. Peugeot is currently burning 200 million euros per month and is rated Ba1 by Moody's.
In similar fashion to our conversations involving shipping (Shipping is a leading deflationary indicator) and air traffic (Air Traffic is a leading deflationary indicator), the auto industry is as well facing a game of survival of the fittest in this current deflationary environment.

It was therefore not a surprise to see Peugeot's  5 year CDS jumping above 800 bps, which amounts to a cumulative probability of default above 50%. Peugeot's CDS has risen by 27.42% last month and by 244% in 2011 according to Thomson Reuters and Markit. Peugeot SA 5 year CDS touched 838 bps on the 16th of July according to CDS Data provider CMA, a 9.73% change on the day and a 74 bps move.

Moving to our pet subject of upcoming financial bond haircuts and debt to equity swap, for those who follow us, we have been sounding the alarm for a while:
"At some point, as we argued recently (Peripheral Banks, Kneecap Recap), losses will have to be taken.
We correctly foresaw this process for weaker peripheral banks.
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.
"The CHART OF THE DAY shows that the Markit iTraxx Subordinated Financial Index is underperforming the Markit iTraxx SovX Western Europe Index by the most since 2010, when
Ireland forced lower-ranking bondholders to share the cost of saving its banking system.
The gauge of credit-default swaps on 25 banks and insurers now exceeds the sovereign benchmark by 1.67 times, up from a ratio of one to one in March. Bank debt risk is rising at a faster pace than that for governments after Spain said it will require burden sharing measures from holders of junior debt in lenders receiving public funds. The move minimizes the cost to taxpayers and was required as a condition for international aid."
- source Bloomberg.

As indicated by John Glover in his Bloomberg article - Senior Bondholder Immunity to Losses Begins to Fade on the 17th of July:
"The shelter available to bondholders in senior bank debt is starting to fracture as the escalating
cost of reinforcing Europe’s financial institutions prompts policy makers to seek to share the burden more widely.
Bank bonds that rank ahead of subordinated and junior debt for payment have been almost unscathed by the debt crisis. Bankia SA, Spain’s third-biggest lender, has seen the value of its 4.625 percent undated subordinated bonds plummet to 27 percent of face value, while its 4.25 percent senior securities repayable in May 2013 trade at about 92 cents per euro."

It has long been a shared position with our good credit friend that subordinated bondholders as well as bank shareholders, would be facing the music at some point:
"EU will give Euro 100 billion to Spain in order for the country to recapitalize its banks. Meanwhile, Finland has asked for and got collateral for its loans to Spain. As we all wait for these funds to be delivered to Spain, subordinated debt holders will pay a nice contribution. Translation: the Iberian barber will make a nice haircut "à la Irish". The European funds will be lent by the EFSF as the ESM is still non-existent and may remain until September when the German Constitutional Court will give its assessment."

The new Subordinated Liability Exercises (SLEs), to be introduced with new legislation by the end of August by Spain, will allow banks to enforce mandatory exchanges if "liability management offers fail" on a "voluntary basis" – similar to what happened in Ireland a couple of years ago which led to significant losses for subordinated bondholders (30% of which were retail investors versus 60% in Spain...). Translation: "Tender your bonds or else...".
Subordinated debt - Love me tender? We wonder...

On top of that, according to Bloomberg on the 16th of July:
"The European Central Bank would no longer oppose the forcing of losses on senior bondholders of euro-area banks, said two officials with knowledge of the ECB’s thinking.
A key condition to imposing losses is if the bank in question is being wound down, one of the officials said. The ECB supported imposing losses on senior bondholders of ailing Spanish banks at a meeting of euro-area finance ministers in Brussels on July 9, though the proposal didn’t get much traction, the other official said. Both of them spoke on condition of anonymity as the talks are confidential."

On that very subject of losses on senior bondholders, CreditSights in a recent note entitled "What if the Bail-Out Had Been a Bail-in?" made the following key points:
"Bankia is a current example of a big taxpayer bail-out, which provides a good case study for how things might have turned out if proposed bail-in, mechanisms had already been in force.
Their scenarios are hypothetical, and they do not expect senior bail-in mechanisms to be invoked at this stage in Spain or elsewhere in the EU, although subordinated debt is already under threat.
They walked through a revaluation of Bankia’s balance sheet to reflect the write-downs that led to the recapitalisation request, as well as an exercise in segregating out the bank’s encumbered assets and collateralised liabilities, including substantial covered bond issuance and ECB repos.
In future, resolutions authorities might go through a similar sort of exercise to justify the haircuts that they impose on senior debt in a bail-in.
Their estimate is that haircuts of up to 22% could have been justified if Bankia’s senior unsecured liabilities had been the subject to bail-in, based on its end-2011 balance sheet and a recapitalisation need of 12 billion euro. This is predicated on an asset segregation scenario, whereas a full liquidation scenario would imply a higher loss rate."

An interesting exercise indeed, we think.

On a final note many pundits are discussing the need for an additional round of QE by the Fed, Bloomberg Chart of The Day indicates that Fed easing may do little to lift bank lending:
"As the CHART OF THE DAY illustrates, banks reduced the amount of reserves held at the Fed’s regional banks and made more money available to businesses in the past 12 months. The shifts took place even though the central bank’s total assets were little changed, according to Michael Shaoul, Oscar Gruss & Son Inc.’s chief executive officer wrote two days ago in a report. "“This point is sadly missed by those looking for a new round of quantitative easing,” the report said. Between 2008 and last year, the Fed bought $2.3 trillion of debt securities in two rounds of easing to support economic expansion.
Bolstering reserves through a third round of purchases “will not increase the supply of or demand for credit,” the New York-based analyst wrote.
Reserves for the week ended July 4 were $179.2 billion lower than their peak last July, according to data compiled by the Fed. The decline coincided with a $171.2 billion increase in commercial and industrial loans, based on central-bank data. “This is precisely how monetary policy can affect domestic activity,” wrote Shaoul, who also helps oversee more than $2 billion as Marketfield Asset Management LLC’s chairman. “What it cannot do is magically increase employment.”
- source Bloomberg.
As far as the ECB is concerned, we should know very soon the true impact of the cut in the deposit rate:
"The CHART OF THE DAY shows financial institutions may meet reserve requirements at the ECB as early as today, three weeks early, if they increase their current-account deposits at the rate of the past few days. Once they reach that level, they won’t earn any more interest and might seek alternative investment opportunities, Klaus Baader, an economist at Societe Generale in Hong Kong, said. “Banks will have to choose what to do with the excess reserves: accept zero return, buy safe and liquid assets that do yield an acceptable return -- not many of those these days -- or, of course, reduce the amount of reserves,” he said. “The best of all worlds, of course, would be if banks started to lend to each other again, but the chances of that happening are remote.” Banks have shifted money from the deposit facility, where funds no longer earn interest, into reserve accounts, parking about five times as much per day as they need to on average. The ECB remunerates these holdings with interest equivalent to its benchmark rate, currently at 0.75 percent, until requirements are met." - source Bloomberg.

"From the gut comes the strut, and where hunger reigns, strength abstains." - Francois Rabelais

It will be interesting to monitor where this "yield famine" will lead us to.
Stay tuned!

Monday, 9 July 2012

Guest post - European Credit versus volatility looks increasingly appealing

"The facts will speak for themselves. Credit them or not, but read!"
Ralph Chaplin - American activist.

Back in January 2011, in our credit conversation "A tale of two markets - Credit versus Equities", we indicated the following in relation to credit and the relationship with equity volatility:
"In theory Credit can be assimilated to a long OTM (Out of the Money) equity option. A Credit Default Swap (CDS) is a proxy for a Put Option on the Assets of a Firm. This means that by going long on bonds the bondholders are long the face value of the bond and short a put option on the assets of the firm with the strike price being the face value (principal) of the bonds.

In recent years, according to a research published by Morgan Stanley in March 2009 by Sivan Mahadevan, correlations between changes in credit spreads and changes in various implied volatility metrics, have been very similar to short-dated ATM (At The Money) equity options. Liquidity being an important factor and short-dated ATM being the most liquid in equities, whereas the 5 year point being the most liquid CDS point (Credit Default Swap). Given there is an extremely low probability of an entire equity index going bankrupt, Morgan Stanley's research team further comment that ATM volatility can be used to make comparisons between equity and credit. The cash equity/credit relationship is apparently less stable than the volatility/credit relationship according to Morgan Stanley's study."

In continuation of our previous conversation relating to the relationship between equity volatility and credit, please find the recent analysis from our good cross-asset friend pointing to the current relative attractiveness of being long credit and long volatility:
"Long 1 year atm (At the Money) volatility on Equity Indexes versus long credit via short CDS Indexes positions look increasingly appealing on current levels.
Following the Greek Elections and the European Summit, implied volatilities levels on equity indexes have corrected dramatically while other risk measures are clearly not validating any “blue-sky” scenario (Spain/Italian sov spreads, bund yield, credit spreads…). On current relative valuations long credit vs long equity volalitility positions look particularly interesting.
On the credit side you benefit from the relative backing of huge flows from institutional investors hungry for yield, while still enjoying relatively solid balance sheets from a corporate universe that has consistently been rolling over debt maturities.
On the equity side you are paying reasonable volatility levels, almost in line with the recent subdued realized levels with a large upside should any stress materialize in coming months."

Below the Itraxx Crossover 5 year index vs German DAX Index example :
Chart1 – DAX 1 year volatility ATM (At the Money) chart - source Bloomberg:

Chart 2 : Ratio of Itraxx Crossover versus Dax 1year ATM (At the Money) Volatility since early 2011 - source Bloomberg:

Chart 3 : Using a power regression with a very strong R2 (0.80) here is a chart displaying the implied Itraxx Crossover spread versus the current 1year DAX ATM volatility - source Bloomberg:

Nota Bene: Itraxx Crossover in the above charts has not been adjusted for the 6 month roll effect.

Stay tuned!
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