Sunday, 17 February 2013

Credit - Bold Banking

"Dives sum, si non reddo eis quibus debeo. I am a rich man as long as I don't pay my creditors." 
 - Titus Maccius Plautus (c. 254-184 BCE),

While watching the volatility in currency markets and the decent moves in both EUR/USD and USD/JPY currency pairs, prior to the much anticipated G-20 Moscow meeting to avoid a broader currency war from developing in the world, we thought our title should simply be this week "Bold Banking".

Listening to the many conversations relating to a potential early exit from QE in 2013 and the conflicting analysis around the dire potential for losses the rise of government bonds could have on Credit in particular (Investment Grade), and assets classes in general,  we would have to agree with Exane BNP Paribas recent strategy note from the 14th of February 2013 entitled "When doves cry", namely that 1994, which was a nasty year for risky assets is indeed a case study of the risk scenario:
"A surprise rate hike in February 1994 sent 10-year Treasury yields some 200bps higher in just 3- months. This sparked a period of significant de-leveraging. Fixed income investors fared worst, but equity markets suffered too. The S&P500 fell around 9% in 2-months. But when the US sneezes….European markets were hit harder." - source Exane BNP Paribas

We do agree with their views, namely that while early 2013 are most likely to be still supportive for risky stories, the second part of the year might be a different story altogether:
"Make your money in H1 
The macro backdrop should remain supportive of equity markets through the early months of the year. The global growth / inflation backdrop looks favourable – and equity valuations are likely to rise as a result. We think the oft-cited event risks – be it European elections or US sequestration - are unlikely to result in sustained market weakness. 
H2 could be tougher 
The risk to equity markets rests in the evolution of the macro cycle. The debate around US monetary policy is likely to intensify later in the year. The first move to withdraw monetary stimulus usually prompts a correction in equity markets. This time that move is likely to take the form of an ending of QE rather than a policy rate hike - but we expect similar price action to result." - source Exane BNP Paribas

But, as one looks at the bold central bankers actions taken so far in the US and Europe, with Japan, joining the party as of late, taking its Japanese currency and its Nikkei index to higher levels in the process, as the old pilot saying goes:
"There are old pilots and there are bold pilots; there are no old, bold pilots!" 

Japanese stocks rising in conjunction with Yen weakening versus the Euro - source Bloomberg:
"Stocks in Japan may rally more than those in Europe as Prime Minister Shinzo Abe’s push to halt deflation weakens the yen, according to Morgan Stanley. As the CHART OF THE DAY shows, the benchmark Nikkei 225 Stock Average’s performance relative to the Stoxx Europe 600 Index has tracked moves in the Japanese currency against the euro. Japan’s equities, which have surged 9.4 percent this year, will climb further as investors account for the impact Abe’s policies, Morgan Stanley said. “Japan’s recent strong equity-market performance has substantially further to run as the market further discounts the positive impact of Abenomics,” Morgan Stanley strategists led by Jonathan Garner wrote in a report last week. “Meanwhile, European equities have recently experienced a bigger re-rating than those in other regions versus recent average levels.” The Stoxx 600 has advanced 23 percent from its June 4 low as European Central Bank President Mario Draghi pledged to preserve the euro and U.S. lawmakers agreed on a compromise budget. That has driven the gauge’s valuation to 12.3 times estimated earnings, compared with the five-year average of 11.5 times, according to data compiled by Bloomberg. The yen has dropped 20 percent in the past six months, the worst performer of 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes, as the Bank of Japan announced a 2 percent inflation target and a shift to open-ended asset purchases. In the same period, the euro surged 8 percent for the biggest gains." - source Bloomberg 

While 1994, was the year of a big sell-off in many risky assets courtesy of a surprise rate hike, 1994 was as well the year of the demise of "Czar 52" on the 24th of June 1994 which saw the tragic crash of a Boeing B-52H "Stratofortress" assigned to 325th Bomb Squadron at Fairchild Air Force Base during practice maneuvers for an upcoming airshow. The demise of the BUFF (the nickname among pilots for the B-52 meaning Big Ugly Fat Fellow) was due to Colonel Bud Holland's decision to push the aircraft to its absolute limits. He had an established reputation for being a "hot stick".

So what is the link, you might rightly ask, between "bold banking" and "bold piloting"?

A subsequent Air Force investigation found that Colonel Bud Holland had a history of unsafe piloting behavior and that Air Force leaders had repeatedly failed to correct Holland's behavior when it was brought to their attention (not  French president Hollande in that instance but we digress...).

When it comes to "reckless banking" and "reckless piloting", we found it amusing that current leaders have repeatedly failed to correct central bankers' policies, like the ones pursued by former Fed president Alan Greenspan and current Fed president Ben Bernanke, or, the ones pursued by Japan. These policies are instigating, bubbles after bubbles at an inspiring rate. When one looks at the fragile state of the "House of cards" and the "boldness" of credit investors dipping their toes, once again in very risky credit structures such as CLOs made up more and more with Cov-lite loans, we think our title, and our analogy to the crash of "Czar 52" is this time around very appropriate, but once again our thoughts keep wandering.

In this week's conversation, we would like to look at the binary risks posed by not only rising rates and the pain that can be inflicted in the investment grade space, in conjunction with the rising tide of corporate impairments and write-downs (goodwill being one of our long standing pet subject) and its implications but, looking as well into the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis. First a quick credit overview.

The divergence between the performance in US equities (S and P500) and the Eurostoxx 50 has been clearly growing in early February, the red line in the graph being Italian 10 year yields - source Bloomberg:
This growing divergence can not only be explained by the difference in credit growth we have discussed on numerous occasions, you need to factor in the Corporate Credit Cycle.

As displayed by BNP Paribas in their February Credit Markets conference called entitled "Giving Equities too much Credit",  as far as the Corporate Credit Cycle is concerned, the US is ahead of the games:
- source BNP Paribas

This distinction clearly explains the outperformance of European High Yield Credit in 2012 versus US High Yield.  In the deleveraging process, US Households have indeed been able to deleverage more as indicated in the below graph from the same BNP Paribas note:

But, for the "Great Rotation" theory put forward by many pundits such as Bank of America Merrill Lynch, to play out, much more deleveraging is needed.

As far as Europe is concerned and the Eurostoxx 50, we think European stock analysts should be seen as having an established reputation for being "hot sticks" in similar fashion to Colonel Bud Holland, given they are still expecting double digit EPS growth in the European space as per BNP Paribas' note:

And we know that "Great Expectations" can lead to huge disappointments, when ones looks at Economic consensus continuing to be revised down in Europe:

So "mind the gap", because, one the indicator we have been following, has been the 120 days correlation between the German Bund and its American equivalent, namely the US 10 year Treasury notes. This correlation is rising. In "Risk Off" periods we have noticed that the 120 days correlation had been close to 1 in 2010, 2011 and 2012, whereas in "Risk On" periods, the correlation was falling to significantly lower level. Currently the correlation is rising towards 78%, albeit at small pace, but it warrants caution we think  - source Bloomberg:

The European bond picture, with Spanish 10 year yields staying around 5.18%, whereas Italian 10 year yields below 5% hovering around 4.36% and German government yields rising around 1.63% levels - source Bloomberg:

More and more, peripheral risks appears to have taken the back seat and remain fairly muted. But, we think it could come back at center stage quite rapidly. On that note we would have to agree with CreditSights take from the 12th of February in their note - Spanish Deficit: An Entirely One-Sided Risk:
"•The Spanish government is confident that it will deliver on its 6.3% 2012 deficit target, only missing the target by roughly one percentage point of GDP due to the 4Q12 bank bailouts. 
•But meeting the 6.3% target (excluding bank bailout cost), would mean the government balanced the budget in the fourth quarter. The government last ran a balanced budget in the first quarter of 2008 when the economy grew at 2% on an annualised basis. The economy shrank by 1.7% on an annualised basis in the fourth quarter last year. 
•What's more, a one point cost for the bank bailouts might be too low. Bank bailouts contribute to the deficit to the extent that the values of the stakes received by the government are deemed to be worth less than the price the government paid. 
•The three main bailouts that are so far included in the economic accounts (worth a combined €14 bn) appear to have been ascribed very little value. If the government's stakes from the 4Q12 bailouts are treated as harshly, then the deficit will incorporate the full €34 bn cost (nearly 3.5% of GDP). 
•We believe investors should consider lightening up on Spanish government and credit risk, especially beyond the 3-year horizon of the ECB's bond purchases going into late February when the deficit numbers will be announced. If the government misses its target it is likely to undermine confidence in the sovereign. Whereas the government hitting the target is largely priced in." - source CreditSights

Moving to the subject of binary risks posed by rising rates and the pain that can be inflicted in the investment grade space, higher mark-to-market losses could prompt investment grade credit to come under pressure, which has been the case in January in Europe, when Investment Grade credit was hurt in total returns terms by a rising bund (-1.20%). The hunt for yield has, no doubt increased the risk for pain for low coupon, long duration credit investors given a small surge in yields could inflict some significant losses due to bond convexity. For instance a US rate hike in similar fashion to 1994, could inflict considerable pain to bondholders as indicated by the previously mentioned Exane BNP Paribas note above:

The US asset Class performance through 1994 is indicative of the level of peak to through adjustment that Investment Grade credit could face, should a similar risk scenario plays out, as indicative in the below graph from Exane BNP Paribas:
- source Exane BNP Paribas / Datastream

But if you think bondholders would be in their own world of pain, think again, given that the European equity space wasn't spared either in 1994 as indicated below by Exane BNP Paribas graph:
- source Exane BNP Paribas / Datastream

The rising tide of Corporate Impairments and Write-downs, which has been a pet subject of ours, have, we think, serious implications from an earnings point of view. If ones look at a graph displaying stock prices, impairments and purchases in terms of M&A activity as displayed in Fitch's recent report entitled Corporate Impairments and Write-downs:
"Over recent years, write-downs were largely driven by aggressive acquisitions (often at inflated prices / multiples), money ill-spent on large asset investments or weaker cash flow expectations (leading to lower sale values) for specific assets where market conditions weakened rapidly since the onset of the financial crisis at end-2008. 
To combat negative pressure, corporate issuers have been taking stock and refocusing operations on core assets in an effort to conserve cash. Management strategies centred on disposing of marginal / non-core assets in an attempt to weather weaker demand. Weaker growth forecasts, higher cost of capital in certain markets and increasingly uncertain cash flow projections led to the revaluation of assets held for sale as weighted average cost of capital increased across underperforming sectors, reducing the values realised in disposals." - source Fitch

The current level of European equities, do not reflect these growing risks we think, particularly in the light of accounting changes which have been taking place when it comes to the amortization process which had previously prevailed, meaning that now, the risk for earnings, as we have seen recently is binary.

What are Impairments?
"An asset becomes impaired when the company holding the asset is unable to recover the carrying value of the asset either through the use (cash generated over the usable life) or the sale of the asset. An accounting impairment would occur if the carrying amount of the asset is considered to be less than the intrinsic value management believe it can get from the asset, or the price, less selling costs of the asset.
The standard IAS 36 accounting treatment considers there to be several explicit triggers which could lead to an impairment event.
 Significant decline in assets market value.
 Indication that expected performance of the asset is reduced.
 Increase in market interest rates (as seen in Europe during 2011).
 Cash flows from the asset are significantly different from what was originally budgeted.
All, or part of the above, have occurred to varying degrees across different market since the onset of the financial crisis in 2008. This has, however, been more prevalent in more capital intensive sectors, or sectors with weaker fundamentals (such as nickel and pig iron) or competitive pressures (notably telecoms), have reduced profitability expectations.
A recent example is Peugeot, who in Feb 2013 announced that it would write-down the value of its automotive and financial assets in Europe by EUR4.13 billion. This reflects the extent Europe's economic woes are affecting some of the region's biggest companies, particularly in the auto industry. The write-down is a noncash charge, and its timing is partially driven by European regulators, who have urged companies to adjust the valuation of their assets to reflect prospective business more realistically."  - source Fitch

For instance BNP Paribas posted a 33% decline in its fourth quarter profit, missing estimates, on a goodwill writedown at its Italian branch network BNL of 298 millions euros on and due to an accounting charge tied to its own debt (see our post: Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks earnings). French bank Societe Generale posted a fourth-quarter loss on a goodwill write-down in its stake in broker Newedge as well as taking a hit courtesy of 686 million euros courtesy of debt value adjustments.

Why does goodwill represent nowadays a binary risk to corporate earnings?
"Under IFRS goodwill is no longer amortised. Pre-IFRS, goodwill was amortised and faded over time - now it remains at the original level and it is likely that it may have to be impaired in a weaker economic / cash flow environment." - source Fitch

Goodwill: "When a firm makes an acquisition for more than the fair value of identifiable assets acquired, the additional value is held in the form of goodwill on the balance sheet. Should the value of the purchased asset become permanently less than its initial value, then the asset must be written down." - source Fitch

What are the risks and consequences of low growth / low yields on impairments and the volatility of earnings?
"Old Acquisitions and Investments, New Economic Reality:
Before 2008, many firms in Europe purchased assets, or invested heavily, with the expectation of continued strong growth. There was a belief that high cash flow projections were acceptable considering the boom period preceding the downturn. Acquisitions reached their height in 2007, leaving companies. balance sheets reflecting large amounts of goodwill. However, as the economy soured, many firms were left with assets which were unlikely to produce the significant cash flows which had been projected previously, forcing revaluations and in some cases asset disposals at prices well below original acquisition costs and multiples. Similarly, corporate capex relative to sales reached a peak in 2008 (7.52% capex/revenue). Nominal capex however continued to rise in 2011 and 2012, notably in the utilities and industrial sectors, peaking at USD503.6bn in 2012. This, coupled with weaker growth expectations, may drive increased levels of impairments over the next two years to end-2014." - source Fitch
What are the consequences of cheap credit, consequences of our "Bold bankers" policies?
Falling Return on Capital:
"Capital invested and large acquisitions pre-crisis in 2007 and 2008 have in some cases been on the premise that cash flows would continue in line with, or even accelerate, compared with historical performance. Firms which acquired or invested heavily in assets pre the 2008 financial crisis saw a significant fall in CFO return relative to the amount of capital employed.
Following acquisitions at inflated prices and money ill-spent on significant capex, economic reality hit hard between 2009 and 2012, requiring these assets to be written-down as its value in use decreased significantly, along with market value, leading to lower market and sale values of these underperforming assets.
The chart below highlights the sectors that had the largest impairments in 2011, with the telecoms sector recording by far the largest impairments, followed by the retail and technology sectors."
- source Fitch
Our bold bankers have effectively with their policies completely distorted corporate balance sheets:
"Judging Impairments by Market Sentiment:
Market capitalisation is driven partially by market sentiment and, although typically volatile and pro-cyclical, includes an expectation of future cash generation and returns on assets. When a firm's market capitalisation falls below its equity value, it may indicate that assets are overvalued relative to market expectations." - source Fitch
"An equity / market capitalisation ratio above 100% is considered in assessing the realistic values of assets. IAS 36 states that assets may be impaired when the carrying amount of the net assets of an entity is more than its market capitalisation. The average equity / market capitalisation ratio of the 235 firms used in the ESMA study rose from 100% at end-2010 to 145% at end-2011. At end-2011, 43% of the sample showed a market capitalisation level below equity, compared with 30% in 2010 – indicating that impairments / write-offs are likely to accelerate if the weak market conditions continue." - source Fitch

The ESMA study (January 2013) found that 47% of issuers whose equity exceeded market cap recognised impairment losses.

On top of the rising risks in corporate earnings courtesy of our "bold bankers" repeated intervention and distortions, the rising risks in the credit space with the returns of all the riskiest structures of the recent 2007-2008 credit crisis is a clear signal that in similar fashion to "hot stick" Colonel Bud Holland, our central bankers have decided to "push it to the limit".

Maybe our "bold bankers should reflexionate on the quote below:
"Any statistician will tell you, a good outcome for a bad risk doesn't mean the risk wasn't bad; it just means you happened to get lucky."

When one looks at the return of Cov-lite loans to the fore front, no doubt to us we are entering, once again bubble territory in the credit space. In May 2012, we specifically discussed this return in our conversation "The return of Cov-Lite loans and all that Jazz...":
"Unintended consequences" of low rates environment have led to a flurry of issuance of Cov-lite loans again in the market."
Deutsche Bank in their recent sector analysis from the 13th of February ask an important question:
"Are credit markets overheating?"

"If we look at new issue volumes in Figure 27 we see that the loan issuance in 2012 was very close to the 2006 level, although around $100 billion short of the 2007 level. The HY bond market, on the other hand, has continued growing rather steadily post-crises with 2012 more than doubling the issuance of 2007." - source Deutsche Bank

"Not only has there been a rise in overall volume of cov-lite loans. Cov-lite loans' share of all institutional loans has risen dramatically lately to almost half of all new loans in the fourth quarter of last year at and at the start of this year. Cov-lite loans now amount to about 30% of the outstanding volume (Figure 30)." - source Deutsche Bank
"Cov-lite loans have been a hot topic in the CLO universe for some time now. The focus of this discussion has been whether or not CLO managers should be constrained in how big a portion of a CLO’s collateral can be invested in cov-lite loans. Most would agree that it is better for a lender to have covenants, other things being equal. But managers have correctly pointed out that cov-lite loans have historically been made to the more creditworthy of borrowers that, precisely because of their creditworthiness, are not deemed to need covenants to ensure repayment. So, by restricting investments in covlite loans, investors may actually be preventing investment in the best credits. But as more CLOs allow ever bigger portions of cov-lite loans the aggregate CLO universe can purchase ever more of those loans. And so as CLOs, the biggest investor group in institutional loans, are allowed to buy more cov-lite loans, the more cov-lite loans are issued. Figure 31 shows how average cov-lite buckets in newly issued CLOs have crept up as the cov-lite share of new issued loans has grown. Now, this doesn’t change the earlier argument from the viewpoint of a single CLO. A loan universe where a minority of loans has covenants is likely to mean that those loans are considered quite risky credits and it would probably not be a good thing to be constrained to buying those. But it does mean that the benefit of covenants is gradually being removed from the loan market and hence lowering borrowing costs and expected investment returns in loans, other things being equal." - source Deutsche Bank

So we might have some "hot sticks" in the credit cockpit at the moment but at least, one member of the pilot crew at the Fed is getting jittery like us: "You're a little low. You're a little low. Come on, buddy, pull up. Pull up, Cougar." Top Gun - Maverick to Cougar
Federal Reserve Board Governor Jeremy Stein recently discussed credit markets and overheating credit markets in general and is monitoring the situation.

Deutsche Bank concluded their note with the following comment:
"The credit markets and financial stability are not the key concern of the Fed right now but there is clearly someone on the Board watching credit markets with policy implications on his mind so we will do the same."

Watching credit markets: this is exactly what we have been doing for a while...

"There are old wise central bankers (Paul Volcker) and bold bankers (Ben Bernanke); we have no old central bankers, just bold central bankers". - Macronomics. 

 Stay tuned!

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