Sunday, 19 May 2013

Credit - It's a Wonderful Life

"It is best to avoid the beginnings of evil."- Henry David Thoreau 

Watching with interest Moody's savage six notch down-grade of the Cooperative Bank (from A3 to Ba3) on late Friday 12th of May made us wander again this week towards are much beloved cinematographic analogies for our chosen title. The Co-Op banking story sounds a lot like a replay of 1946 great Frank Capra movie called "It's a Wonderful Life" starring James Stewart. In the movie George Bailey after giving up on his childhood dreams, decided to run the Building and Loan community bank founded by his father and faced early in his banking role a collapse. Earlier in his banking life, Georges Bailey witnessed a bank run on his establishment and to avoid the fateful rout of the financial institution used the money for his honeymoon trip to avoid the demise of his local bank. Later in his life as a local banker, Georges faced another liquidation moment when the Building and Loan's cash funds are snatched, and the bank is only saved by the flood of townspeople donations to save George (facing prison) and the Building and Loan institution. Of course, any resemblance between the analogies used in this blog post and real events are purely coincidental...

In these days and ages it seems that, after all, sub-investment grade ratings at European banks, are no doubt, becoming more the norm rather than the exception, given Italian Bank Monte dei Paschi di Siena founded in 1472, the world's oldest bank, was given as well the multiple downgrade treatment by Moody's, falling three notches in the process (from Ba2 to B2). They have just lost 100.7 million euros in the first quarter compared to a profit of 89 million euros in 2012 and have lost 7.9 billion euros in the past two years with an outstanding market cap of 2.48 billion euros.

This multiple downgrades from a trigger happy rating agency is definitely one of the first results of the Cyprus effect, namely the "unintended consequences" of the recent talks surrounding an earlier implementation date for senior debt bail-in.

In its Co-Op decision, Moody's highlighted the "risk of write-downs on junior debt instruments and, potentially, the need for external support to maintain regulatory capital levels".
In its Monte dei Paschi di Siena (MPS), Moody's declared it "is concerned that the risk of burden sharing with creditors in order to ensure its adequate capitalisation has risen and would be significant under an adverse scenario".

We have been warning for a long time and on numerous occasions the risk of total wipe-out for subordinated bond holders, leading in many instances to debt-to equity swaps for some (Portuguese bank Banco Espirito Santo in October 2011), and numerous capital increases for others (Commerzbank in the market this week for its fifth capital increase in four years, this time around for 2.5 billion euros and probably not the last one...). 

While the case for the Co-Op could eventually lead to the first test of a bail-in of subordinated creditors in the UK, the SNS case and the acceleration of the implementation of "bail-in" are as well putting significant pressure on the ISDA to come up with new "credit event" definitions to save not only the Sovereign CDS market, which has been impacted by the Greek saga, but to conjure the potential demise of the subordinated CDS market if it doesn't take into account the "expropriation" trick from the SNS case as a "credit event" given the lack of deliverable subordinated obligations thanks to the total wipe-out. 

Therefore, in this week's conversation, we will look at the complacency in the subordinated market in this "Wonderful Life" of credit, where spreads are tightening at lightning speed, and credit risk is so much a "thing of the past", but, there we go, rather than rambling, you find us grumbling. Oh well...
But first our quick market overview.

Credit wise Itraxx Main Europe 5 year CDS index (Investment Grade credit risk gauge based on 125 entities) and Itraxx Crossover 5 year index (European High Yield risk gauge based on 50 European entities)   have marked a pause this week with Itraxx Crossover rising 5 bps to 387 bps and cash credit was also flat following four consecutive weeks of uninterrupted tightening  - source Bloomberg:
While credit has moved significantly tighter in 2013, following "whatever it takes 2" courtesy of "Abenomics", we have yet to touch the lowest spread of 255 bps between both indices from 2011.

At the same time European Credit has marked a pause in their rally, European government yields have moved back from their lows with German 10 year Government yields moving towards 1.30%  - source Bloomberg:

Equities wise, the Eurostoxx which has lagged the continuous rally seen in the S&P 500 has catch up is now moving in synch with the US index, whereas Italian government bonds, indicated in the same graph have been trading below the 4% level - source Bloomberg:

Whereas are Japanese friends are still recording significant increases, in their successful art of deceit, enticing even more investors in the rally game while creating significant headaches to local Asian countries in the process - source Bloomberg:

What is increasingly stirring our interest, when it comes to Japan is, as we indicated last week, has been the disconnect between credit spreads and volatility, which has been rising in the case of Japan as of late - source Bloomberg:
As indicated in last week's credit conversation, the shorter 3 months Implied volatility has been telling a different story since the beginning of the year and has been rising significantly. We are wondering now if Credit Risk which has been significantly tempered by Abenomics as displayed by the significant rally in the CDS Itraxx Japan 5 year index is not going to reverse its trend and start surging again.

For us Japanese equities and Japanese credits are indicating that investors are no doubt buying purely on hope. Yes, the three Japanese megabanks have reported an aggregate 11% rise in net profits for FY12 (+30% adjusted for prior year exceptionals) to a multi-year high of 2.2 trillion yen (22 billion USD). As reported by CreditSights in their 15th of May note entitled "Buying On Hope", the ROE ranged from 14% for SMFG to 10% for Mizuho and 8% for MUFG: "Profits were indeed helped in the last quarter by the lower yen which boosted overseas income and much reduced stock impairment losses as the stock market recovered; lower tax charges have also helped." - source CreditSights

Given that for these Japanese banks profits are tied up to substantial trading and "unrealised" investment bond gains from abroad and looking at the recent rise of JGB yields since the arrival of Mr Kuroda at the Bank of Japan, and knowing the very large size of JGB portfolios for these Japanese banks, in the absence of investment bond gains (which would mean selling some European government bond holdings...yikes!), unrealised losses on their JGB portfolios will not doubt put pressure, not only on their shareholder's equity and regulatory capital, but on their CDS spreads as well and their earnings. The CDS for these Japanese banks is trading closer to the more highly rated Australian banks but also Korean counterparts such as Kookmin according to CreditSights. Therefore, should "Abenomics" disappoint, there is indeed some room for these Japanese banks CDS to widen "significantly" at some point...(sorry we are not paper fortune tellers).

In terms of the recent poor macro data, and the continuous rally in risky assets with a fairly muted VIX (around 13), the recent move in the MOVE and CVIX indices warrant caution we think.
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
Graph - source Bloomberg:

"If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallied hard with the same type of cross-asset vols opposite moves.

Looking at the recent disappointing batch of macro data and the huge rally in risky assets in similar to the move we have seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space.

As we argued last week, Investment Grade is therefore a more volatility sensitive asset to interest rate changes, whereas High Yield is a more default sensitive asset. The correlation between the US, High Yield and equities (S&P 500) since the beginning of the year has weakened recently. Investment Grade as indicated by the price action in the most liquid US investment grade ETF LQD is more sensitive to interest rate risk  - source Bloomberg:

Moving on to our subject of complacency in the "Wonderful Life" of the subordinated credit space, the Cooperative Bank's capital gap is according to the FT at around 1 billion GBP, truth is their is 1.3 billion GBP in outstanding subordinated bonds, so as the saying goes "mind the gap", because the capital gap, is going to be filled and most likely in the first place by subordinated bondholders rather than  by a flood of townspeople donations like in the 1946 movie. On the complacency in the "Wonderful Life" of subordinated bond holders, we would have to agree with Bank of America Merrill Lynch takes on the subject from their 13th of May note entitled "It's all at the Co-op - now:
"A still complacent market – what next?
The precipitate decline of the Co-op’s bond prices highlights that bondholder haircuts are not in the price, even though the market ‘knows’ about bail-in. In spite of the recent chilling lesson from Cyprus, sub yields touch new bottoms and prices reach new highs. We believe there is no room for error in either. Our Credit Investor Survey last week saw more money going to subordinated financials, not less. We thought complacency reached its apogee last month when we saw Unicredit, a bank with 20% NPLs in its core Italian business, place sub bonds in the USD market. Capital is king in a bail-in world." - source Bank of America Merrill Lynch.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

As far as the Co-op's sub debt bonds are concerned, get ready for some "Bayesian learning", dear subordinated bondholders:
- source Bank of America Merrill Lynch.

Can you smell bond tenders or debt-to-equity? Because we can and so does Bank of America Merrill Lynch in their note:
"Liability management
Ironically, the precipitate fall in the bonds of the Co-op has increased its optionality with respect to using its subordinated bonds to bridge its capital gap. We estimate that the current gap between the face value of the Group’s tradeable subordinated bonds and their market value as of Friday close is £416m (there are other bonds which are much less liquid too in addition to this number). The monetization of this could be a key part of the solution, assuming that the bonds don’t jump in value next week as bottom fishers may come in.

That would be risky, we think, because all forms of liability management are potentially on the table, in our view, both coercive and voluntary. We can even see the possibility (though admittedly unlikely) of a debt-for-equity swap – the bank is a PLC after all, so it does have shares. The Group would resist this, we would expect, as it would hardly want to share ownership of the bank with sub bondholders, but it depends on how truly desperate the situation is and how the UK authorities decide to address it." - source Bank of America Merrill Lynch.

Of course the "unintended consequences" of Cyprus and "Abenomics" make us believe that in the "Wonderful Life" of the financial credit universe, no one is really prepared to "face the music" when the music, will stop, because at some point, with the implementation of "bail-in" it will!

It looks like Bank of America Merrill Lynch is facing our rather "sanguine" views as well on that matter:
"Is it priced in?
In our view the price action of Co-op bonds on Friday shows that the market is ill-prepared for bail-in of bank bonds, which rather undermines the idea that the concept is so well-known and talked about that it is ‘in the price’. It is not in the price in our view.
Our investment case for European bank bonds became much more cautious post-Cyprus. In summary, we think that the positive investment case for European bank bonds has faltered as a result of Cyprus. However we believe that has not been reflected in spreads or positioning. In fact, our recent investor survey shows that investors have been consistently increasing their allocations to subordinated debt and moving away from senior debt. Whilst we understand the concept that you don’t get paid for bail-in in senior debt, we have to underline that you don’t get paid for bail-in in subordinated debt either." - source Bank of America Merrill Lynch.

So, sorry to spoil the 'credit party mood', because current subordinated bond prices do not reflect the fundamentals and the underlying credit risk we think and we are not the only ones:
"We maintain our view that a more cautious stance is warranted, especially in the periphery where European bank asset quality problems are concentrated. We saw the recent USD 6.375% subordinated bond of Unicredit as the apogee of complacency in the market. This bond is currently trading well above 102 (a yield of nearly 5.9%). We can see the attraction of the yield but it is not normal for a bank to have NPLs of 20.1% in its domestic business. On a consolidated basis, a 14.1% NPL ratio (up from 13.6% at year end) with 44% coverage should not be considered normal either. It represents a significant risk to bondholders, in our view." - source Bank of America Merrill Lynch.

On a final note, given a few days back we pointed out that Air Traffic is pointing to additional economic activity weakness, we would like to add there is indeed a high correlation between passenger air traffic and GDP growth - graph source Bloomberg:

"Passenger air traffic correlates with GDP growth at a 1x multiple in developed countries and about a 1.5x to 2x multiple in developing markets. Consensus GDP forecasts provide insight to the trend for air traffic growth in the coming years." - source Bloomberg.

"It's not what you look at that matters, it's what you see." - Henry David Thoreau

Stay tuned!

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