Monday, 25 February 2013

LBO? No problemo!

"No problemo" is a slang expression used in North American English to indicate that a given situation does not pose a problem. It has roughly the same meaning as the expression "no problem," but is rarely heard as a response to "I'm sorry." - source Wikipedia

While looking at the quick succession in LBOs (Dell, Heinz), a subject we have tackled with Dell recently in our conversation "The return of LBOs - For whom the Dell tolls", as a credit investor, the "sucker punch" capacity of inflicting serious pain to the investment grade bondholder is reminiscent of the hay days leading to the burst of the credit bubble in 2007.

In similar fashion to the Dell transaction, the Heinz effect was rather more sanguine than ketchup, and probably as spicy as tabasco when it comes to spicing things up a bit in the CDS space - source Bloomberg:
From 50 bps to 200 bps, given Buffett's new found love for the ketchup is transforming H.J. Heinz into the most leveraged food maker in America as reported by Mary Childs in her Bloomberg article on the 21st of February - Buffett’s Ketchup Fancy Plies Heinz With Junk:
"Buffett’s Berkshire Hathaway Inc. and 3G Capital Inc.’s $23 billion acquisition of Heinz may double the company’s total debt to five times earnings before interest, taxes, depreciation and amortization, according to Fitch Ratings, the highest of any comparable food company. The cost to protect Heinz’s debt from losses soared to a record after the announcement. While Buffett has used takeovers to build Berkshire into a $249 billion company and burnish his reputation as the world’s most successful investor, financing the deal with $14.1 billion in debt threatens to strip Heinz of the investment-grade rating that it’s had for four decades. Fitch cut Heinz to junk on Feb. 15 and credit-default swaps imply a Ba1 rating, according to Moody’s Corp.’s capital markets research group. That’s two steps lower than its Baa2 rating from Moody’s Investors Service and three below its BBB+ grade from Standard & Poor’s. The trading “underscores the hazards of high-grade bonds in an active M&A environment,” said Martin Fridson, chief executive officer of research firm FridsonVision LLC. Investors should be aware of the “inherent danger now that leveraged buyouts as well as strategic acquisitions are once again prominent in the financial landscape,” he said." - source Bloomberg.

The cheap credit environment is indeed sufficiently friendly for shareholders in this on-going releveraging process and arguably very unfriendly and painful, to say the least, for the investment grade portfolio manager, given that the LBO story is clearly more favorable to equity investors than credit investors facing multiple downgrades and Profit and Loss hits.

In a recent note by CITI entitled "Ever Been a Better Time for a LBO?" published on the 22nd of February 2013, they argue that the current cheap credit environment makes the pursuit of shareholder-friendly activity quite compelling relative to historical norms:
"Question: If you could buy the exact same company for $75 today (sale price) or for $100 tomorrow (full price), which would you chose?

Answer: Depends. Paying full price may very well be better than paying the sale price if borrowing costs for the two are different. Price is one part of the “package.”

When considering re-leveraging activity, our sense is that many market participants tend to overlook the “package effect,” and as a result under-appreciate the extent to which corporate managers could favor shareholders. In fact, in a sum-of-the-parts context the argument for LBOs may look as compelling as it ever has." - source CITI

As we have also argued in our conversation "Bold Banking", 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."
"Low borrowing costs: Current borrowing costs are hovering near all-time lows. For example, a typical LBOed company is likely to carry a single-B rating, and Figure 2 (previous page) shows that the yield for the average single-B issuer is almost 4% below the historical norm (5.9% vs. 9.8%). Also noteworthy is that moving from single-A — the typical rating of an “un- LBOed” company — to single-B (likely post-LBO rating) is fairly cheap as well. Figure 3 (previous page) shows that the yield difference between the two is now only 3.4%, vs. the long-term average of 4.7%. And there are other lending features in the current environment that in practice cheapen borrowing costs as well, such as the relative lack of covenants (Figure 4). It really doesn’t seem to cost that much to move down the quality now." - source CITI

The "unintended" consequences of ZIRP courtesy of the Fed is favoring releveraging of corporates' balance sheets:
"Reasonable valuations: So an LBOed company in the current environment can be expected to provide a high income stream due to low interest expense, and equity stakeholders may now have an above average chance of collecting this income stream. But in addition, one also doesn’t have to pay all that much for these advantages; the PE ratio for the typical IG name is currently 12.8 (based on our sample universe as explained below), compared to the historical norm of 16.4 (Figure 6)." - source CITI

CITI goes further in their note displaying a real world example for the sake of the demonstration:
"Based on our sample universe, the typical “un-LBOed” company currently has $3.8 bn in total debt outstanding, current market cap of $13.8 bn, and earnings before interest of $1.8 bn (Figure 7). Given our assumptions, after an LBO this company’s equity value will decline by $9.6 bn and total debt will increase by the same amount." - source CITI
"Impact of low borrowing costs: If we consider an LBO scenario in a historical context borrowing cost rises from 5.1% (long-term average yield of the typical single-A issuer) to 9.8% (average single-B). Higher borrowing cost means that net income would fall from $1.58 bn to $0.45 bn for the typical name (albeit divided among fewer shareholders, of course; Figure 8). But currently all-in yields are low and the yield difference between the average single-A and single-B is only 3.4%, which means that interest expense rises by a fairly small amount (Figure 8, previous page). As a result, net income is not pressured by higher borrowing costs anywhere close to normal, and post-LBO net income is far higher than usual ($0.98 bn)." - source CITI

Given the pressure on CEOs to increase ROEs, the LBO can indeed justify the recourse in leveraging the balance sheet as indicated by the below table from CITI's note indicative of the potential increase of ROE that can be achieved via a typical LBO for an investment grade company:
"Pay less for more! One could normally expect the ROE for a typical company to be more or less flat post LBO (Figure 10). This is not all that surprising, as sponsors get paid to shift through the details. The multiple one has to pay for flat performance is normally 16.4x. But now the increase in ROE is over 11% in a post-LBO scenario (from 12.2% to 23.4%). And to get the relatively high ROE the multiple one must pay is lower than normal, not higher (12.8x vs. 16.4x)." - source CITI

As a reminder, in 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, but , as CreditSights put it in in their 29th of July 2008 report entitled LBO Analysis - It is more than Just Financial Metrics:
"Creating value by adding leverage is, in essence, an arbitrage strategy. And, like any arbitrage return, it will ultimately be arbitraged away as participants increase. 
Despite the favorable lending terms during 2005-2006 credit bubble, it stands that there is even less ability to create value simply from leverage.
LBO management can enhance value by exploiting knowledge of a competitor's play book when on the offense and by taking more financially productive responses when on defense." - source CreditSights

We could not agree more.

Stay tuned!

Sunday, 24 February 2013

Credit - Winner-take-all

"One should always play fairly when one has the winning cards." -  Oscar Wilde

"Winner-take-all is a computational principle applied in computational models of neural networks by which neurons in a layer compete with each other for activation. In the classical form, only the neuron with the highest activation stays active while all other neurons shut down, however other variations that allow more than one neuron to be active do exist, for example the soft winner take-all, by which a power function is applied to the neurons." - source Wikipedia

Looking at the recent raft of European data in general and PMIs in particular, we thought we would venture again towards computational analogies in our chosen title, in similar fashion to our previous post "Banker's algorithm" in 2012.

In similar fashion to the winner-take-all computational principle, when ones look at the growing divergence between France and Germany when it comes to PMI, in the pure classical form, it seems only the country with the highest activation stays active while all other see their growth prospects shut down - source Bloomberg:

In our first credit post of the year, namely the "Fabian Strategy", we sounded the alarm in relation to France being clearly in the crosshair in 2013:
The story for 2013 in Europe we think, will be France:
In relation to France, 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").
Back in November in our credit conversation "Froth on the Daydream" we argued:
"Should industrial production print fell to -3.3%, we believe France will no doubt be in recession, putting in jeopardy its overly ambitious target of 3% of budget deficit in 2013 (A Deficit Target Too Far")."

In this week's conversation, we would like to reiterate our views on France in particular and Europe in general and why France will be in the spotlight in 2013.

While the French government has decided to revise its growth outlook for the year, the overly ambitious fiscal deficit in France of 3% will not be met and even the revised growth outlook of 0.2% to 0.3% will not be reached.

Why so? Well, having a look at one definitely scary graph displaying, French industrial production (white line), French GDP (orange line) and French Services PMI (blue line, data available since 2006 only) tells the story on its own, we think - source Bloomberg:
A sobering fact, services in the French economy represent around 80% of the GDP versus 76% for the rest of the European union. the latest read at 42.7 for Services PMI is the lowest since February 2009. Overall French composite PMI is at 42.3, the lowest level since April 2009. 

If the Services PMI contracts at such a rapid pace, it doesn't bode well for France's unemployment levels. Services represent the number one employment sector in France (34% of total employment in 2010 according to INSEE).

Germany versus France, a story of growth divergence and unemployment divergence - source Bloomberg:

In that context, we would have to agree with Nomura's take on French Q1 GDP forecast of -0.3% q-o-q and as well with their annual GDP forecast of -0.5% in 2013, meaning France will have to find additional resources to fill the gap in its public finances.
"At the sector level, the euro area manufacturing PMI dipped slightly to 47.8 from 47.9 in January (Consensus: 48.5; Nomura: 48.4), mainly owing to the fall in the output sub-index (from 48.7 to 47.5). However, the forward-looking indicators seem to be more positive than the headline index, with the new orders component rising to 47.7 from 46.8 previously, thus taking the new order-to-inventories ratio to 1.02, the highest level since June 2011. In particular, thanks to the strong demand in Asia and the US, new export orders, mainly led by Germany, returned to expansion (at 51.7 from 49.5) for the first time since May 2011. In the services sector, the headline index (at 47.3 from 48.6) and almost all the sub-indices declined. Against a weak backdrop for domestic demand, new business and business expectations remained at low levels, suggesting a bleak near-term outlook. Country details again revealed significant divergences across the region, with the situation in France increasingly worrying." - Source Nomura - Euro area composite PMI to increase pressure on ECB - 21st of February 2013.

 The divergence between the US PMI and European PMI, is here to stay in 2013 - source Bloomberg:

But, before we look into more details about France in particular, first a quick credit overview.

The European bond picture, with Spanish 10 year yields staying around 5.15%, whereas Italian 10 year yields below 5% hovering around 4.45% and German government yields stable around 1.60% levels - source Bloomberg:
While this picture has been relatively stable for the last couple of weeks, the uncertainties surrounding the Italian elections could through a spammer and derail this overall picture of yields stability for peripheral countries.

Sovereign CDS wise, Credit Default Swaps in Portugal, Spain, Italy and Ireland have tightened over the last 3 Months, with Portugal showing the biggest improvement, tightening 32% to 381.1 bps. Italy improved the least, but still tightened 12.5bps (5%) to 247.5 since 23rd November according to CDS data provider CMA part of S&P Capital IQ:
Looking at the week ahead, arguably the Italian elections taking place on Sunday and Monday will be key in determining the willingness of the Italian population to push forward reforms: Italian elections (Sunday and Monday) as indicated by Nomura's take in their latest "The Economy Next Week" from the 22nd of February:
"The Italian national elections will be held on Sunday 24 and Monday 25 February, with polls closing at 2pm London time on Monday and the first exit polls likely available a few minutes after that. Our baseline view is for a centre-left majority in both houses of parliament, with Pier Luigi Bersani as prime minister. In the likely case Bersani fails to win the Upper House, we then believe he will negotiate and build a coalition with Mario Monti for the remainder of next week. We view this as more likely than new elections and we expect such a coalition to face difficulties in implementing reforms. The fragmented political landscape and the possibility that the shape of the government will be decided as a consequence of post-election alliances rather than from a decisive vote are recipes for instability and slow reform momentum, our main concerns after the elections." - source Nomura

One thing for sure, the Italian election is going to be a close call and could add potential uncertainty to the European project. As displayed by Bloomberg's Chart of the Day, the Berlusconi effect, while present, might
not be enough to counter Italian premiership candidate Pier Luigi Bersani - source Bloomberg:
"The CHART OF THE DAY shows that Bersani’s average lead in opinion polls of 6 percentage points for elections to the lower house of Parliament is similar to Romano Prodi’s advantage of 5.8 percentage points over Berlusconi in 2006. While Prodi went on to win by just 0.1 percentage point, the victory margin for Bersani will drop to only about 2.4 percentage points assuming the same survey bias this year, as more parties contest the election now than seven years ago. The bias may reflect a so-called Berlusconi effect, whereby voters tell polling companies they won’t support the three-time premier, perhaps out of embarrassment, only to cast ballots for him on election day, D’Alimonte said. The case resembles the “Bradley effect,” named after Tom Bradley, the black former Los Angeles mayor who unexpectedly lost the 1982 California election for governor after most surveys indicated he would win. “There’s certainly a number of people who are reluctant to say they’re going to vote for Berlusconi, but they actually will,” D’Alimonte said by phone. Still, “it’s unlikely they will be enough” to give Berlusconi the edge over Bersani in the election for the Chamber of Deputies, he said." - source Bloomberg

Interestingly we have been tracking over the months the growing divergence in the performance of the Standard and Poor's 500 index and the Eutostoxx in conjunction with Italian 10 year government yields - source Bloomberg:
The lag in European stocks given the very recent negative tone in European economic data has made them much more volatile. Should the "Risk-Off" scenario come back in the coming weeks it should lead to additional weakness for the Eurostoxx and rising Italian yields in the process.

In similar fashion, the recent weakness in European stock has led to a growing divergence between the evolution of VIX versus its European counterpart V2X - source Bloomberg:
While V2X has reached 20.40 from a low of 14.85, VIX has surged from its low of 12.31 towards 15.22.
As we pointed out last year in our conversation "The two main drivers of equity volatility" with the help of our friends from Rcube Global Macro Research:
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates.

The relationship between the Eurostoxx volatility and the Itraxx Crossover 5 year index (European High Yield gauge) - source Bloomberg:
As we posited in "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. 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."

On the subject of credit becoming a crowded trade, it seems some high-yield investors are also starting to take notice of credit entering bubble territory. As reported by Cecile Gutscher and Doug Alexander in Bloomberg on the 22nd of February - Top Junk Bond Manager Marshall Sees Rally Ending:
"CI Investments Inc.’s Geof Marshall, the second-biggest Canadian manager of high-yield debt, said the four-year rally in below-investment-grade bonds is coming to an end as companies begin to take on too much risk. “The high-yield rally is long in the tooth,” Marshall, who manages $6.8 billion as head of high-yield investments, said in a Feb. 20 interview at his Toronto office. Investors can expect “coupon-like returns” this year, he said. The Bank of America Merrill Lynch High-Yield Index gained 18.8 percent in 2012, beating the returns of investment-grade corporate debt for the third time in four years. After using junk bonds to propel his Signature Diversified Yield mutual fund to the top 10 among Canadian balanced funds last year, Marshall is cutting holdings of the securities to 35 percent, from 40 percent in the middle of 2012. Following four years of balance-sheet repair and cost-cutting, many issuers are shifting their preference back to boosting return on equity, while the re-emergence of debt-laden takeovers such as Dell Inc. and HJ Heinz Co. will undermine confidence, he said. “Companies can borrow cheaply, shareholders are clamoring for returns, so to the extent that high-yield companies can borrow for growth or to increase dividends, I think you’ll see more of that,” Marshall said. “The quality of high-yield issuance probably begins to deteriorate in general.”' - source Bloomberg.

In terms of sector allocation and as far as the story of the "Great Rotation" goes, namely allocating from credit to equities, it seems some players are already taking a few chips from the High Yield table and rotate some of their High Yield allocation into equities as reported in the same Bloomberg article:
“What we’re doing is very gradually letting the high-yield weight fall” in funds including the High Income fund, where junk is mixed with other assets, Marshall said. “As we get inflows, the marginal dollars are being invested in equities as opposed to credit.” Apart from equities, Marshall is boosting bets on U.S. dollar leveraged loans, which pay similar coupons of about 6 percent to U.S. junk bonds and get paid first in bankruptcies. “The value gap between loans and high-yield bonds is greatly diminished,” he said." - source Bloomberg.

Geof Marshall concluded is  Bloomberg interview with the following important points:
"“We’re at the cusp of transitioning from a market that’s driven by systemic, macro challenges, risk-on, risk-off, to a market that’s going to be more idiosyncratic,” Marshall said. “I don’t think the high-yield trade is over per se, I just think that returns are going to be lower going forward.” - source Bloomberg.

Moving back to our French subject, and in continuation to last week conversation around goodwill impairments on corporate earnings, French giant France Telecom, in similar fashion to its French relative Credit Agricole wasn't spared either by goodwill writedowns and took a 1.84 billion euros impairment charge on its units in Poland, Romania and Egypt which dragged down its 2012 profits. As we indicated last week in our conversation "Bold Banking", the Telecommunications sector has seen some large goodwill impairments in recent years, such as Deutsche Telekom 7.4 billion euros goodwill writedown in November 2012 on its T-Mobile USA unit and Vodafone as well with a 5.9 billion pound writedown on assets in Italy and Spain.
Whereas France has been one of the worst performer of core European countries, its flagship France Telecom has been arguably the worst performer in French CAC40's index falling 32.4% during the past 12 months.

But, what have the factors plaguing French GDP?

In a recent note entitled French GDP - Drivers of Corp Revenues and Investment, CreditSights indicated the following:
"The shrinkage is primarily a result of weak corporate investment spending, which is in turn the result of weak household expenditure and, since the fourth quarter, falling export demand." - source CreditSights.

What are the swing factors according to CreditSights:

"It is household consumption and investment spending that tend to be the swing factors. Government's purchases of goods and services from the private sector have tended to be reasonably stable.

But investment spending (to the extent that it is corporate investment spending) is not only a driver of corporate revenues, it is also responsive to revenues. If companies are experiencing weaker sales they will run down inventories and then look to cut back on capex.

That relationship between investment spending (including building of inventories) and company revenues is illustrated by the scatter plot on the right hand chart above. It shows annual changes in investment spending versus annual changes in revenues. Even ignoring the outliers in investment and revenues during the 2008 recession, the R square (the extent to which changes in revenues are associated with changes investment spending) is still 33%. That suggests that French companies' investment plans are, unsurprisingly, heavily reliant on their revenues. And therefore French companies are unlikely to start investing unless it is in response to a pick up in demand somewhere else. In short, corporates require an external stimulus either from greater household spending or greater export demand." - source CreditSights.

Truth is when it comes to greater export demand which could offset the current headwinds plaguing the French economy, France is indeed the outlier, has displayed in the following graph from Deutsche Bank's note "Why Italy and France lack competitiveness from the 20th of February 2013:
As far as our title and computational analogies goes "Winner-take-all". While Germany has been the clear winner in the period going from Q1 2008 to Q3 2012, both Spain (+12.2%) and Ireland have seen their performance improve as far as peripheral countries are concerned.

As a follow up on our introduction relating to the significance and importance of the recent poor display in France's Services PMI, France export underperformance is not due to unfortunate sectorial diversification as indicated by Deutsche Bank note:

"French machinery exports in cumulative terms increased 68% in the 12 years to 2011. But they would have risen by twice as much if they had kept pace with the trading partners’ demand levels in the machinery sector. Indeed, France’s performance gap in the machinery sector is 0.5.

An advantage of developed economies is a more advanced service sector. Unfortunately, France’s poor performance was not limited to exports of goods, as shown in Figure 9. Even in services, the country did not manage to keep up with the expansion of trading partner demand." - source Deutsche Bank.

Regarding the growing divergence between Germany and France, both countries have taken different paths leading to different outcomes as indicated by Deutsche Bank's note:
"France and Germany have followed different strategies to take advantage of globalisation. German companies have outsourced only part of their production process to low-cost countries, mainly located in Central and Eastern Europe. Germany’s geographical position facilitated this process. Using the intermediate low-cost inputs allowed German firms to reduce overall production costs and increase the productivity of their own production plants as well as their profitability. Conversely, French companies often outsourced the entire manufacturing process to lowcost countries. So although the product is sold by a French company, it does not enter French exports." - source Deutsche Bank

A stark reminder of the "Regret Theory":
"The Regret theory (also called opportunity loss) being defined as the difference between the actual payoff and the payoff that would have been obtained if a different course of action had been chosen by our European politicians. The Regret theory is also a model of choice under uncertainty defined as the difference between the outcome yielded by a given choice (credit crunch, economic recession) and the best outcome (muddle through) that could have been achieved in that state of nature (deflationary forces at play).

As far as Europe is concerned, one can wonder what would have been the "economic outcome" if a different course of action would have been undertaken. On that matter we wonder why our "European elites" did not use the minimax regret approach being a decision rule used in decision theory, game theory, statistics and philosophy for minimizing the possible loss for a worst case (maximum loss) scenario." - source Macronomics 

Not only France has lost ground in industrial exports but more critically in high-tech sectors as displayed by Deutsche Bank:

"France’s export market share in high-tech products decreased sharply from 7.1% in 1999 to 4.4% in 2006, rebounding modestly to 4.8% in 2008. Over the 1999-2008 period, Germany’s export market share in high-tech products increased slightly from 7% to about 8%.

The EC sees France’s decreasing market share of high-tech exports as a consequence of insufficient innovation. While – contrary to Italy – R&D in France is not too far from that of Germany (Figure 19) and public investment is high, private investment in R&D lost ground compared to Germany. According to the EC, over the past decade R&D spending by companies in France remained broadly constant at 1.4% of GDP per year, while in Germany it rose to 1.9% of GDP." - source Deutsche Bank.

Finally, loan growth in France to households and corporates points to additional weakness in economic growth, as indicated in the below graph from Nomura's economic research:
We hate sounding like a broken record but, no credit, no loan growth, no loan growth, no economic growth and no reduction of aforementioned budget deficits.

After all the "Japonification" of Europe is a story of a broken monetary policy transmission channel, leading to liquidity constraints to the private sector with and therefore no impact whatsoever to the real economy, so no potential for economic growth to resume in France in particular and Europe in general.

"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom." - Viktor E. Frankl, Austrian psychologist.

Stay tuned!

Saturday, 23 February 2013

Time for a pullback? Get some greenbacks!

"If a window of opportunity appears, don't pull down the shade." - Tom Peters

As we highlighted in our conversation in May 2012 - "Risk-Off Correlations - When Opposites attract": Commodities and stocks have become far more closely intertwined as resources have taken on a greater role with China's economic expansion and increasing consumption in Emerging Markets.

In numerous conversations, we pointed out we had been tracking with much interest the ongoing relationship between Oil Prices, the Standard and Poor's index and the US 10 year Treasury yield since QE2 has been announced - source Bloomberg:
Looking at the recent weaknesses in commodities such as oil and copper, one could decently argue that the time might have come to take a few chips off the gambling table.

This feeling of "uneasiness" seems to be shared by Bank of America Merrill Lynch which indicated on the 21st of February the following important points:
"This week’s Thundering Word from our investment strategists reiterates their view that a pullback is likely across risk assets but that this would be very healthy for the longer-term reflation story. 

On this basis they advocate buying volatility near term. We highlight 3 key reasons for a near term pullback in risk assets: 

-Market complacency: our Global Financial Stress Index (GFSI) is at a multi-year low, while the new BofAML Bull &Bear index which measures market sentiment is at a multi-year high (chart 1).
 -Easing has eased: Monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end. 

-Defensive price action: The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. We remain bullish on the reflation story in Japan but note that domestic small caps, a key barometer of local belief in domestic demand, just dropped 20%. 

A longer term trade is to buy the USD which is no longer correlated with volatility and has benefitted from the recent increase in risk appetite. Our house view is that the USD may be embarking on a strong secular uptrend; the only risk being any unexpected derailment of the US house price recovery.

A key element of the USD strengthening story is global rebalancing with Asia no longer deemed the world’s producer and the US the world’s consumer. As a result assets tied to the China production story are slowly derating - note the underperformance of materials stocks versus the global equity market in the past 12 months. However, some currencies also tied to the story such as the Australian dollar and the Canadian dollar are taking longer to derate and hence constitute good shorts against our long USD stance."

As per our previous May 2012 conclusion, whereas opposite attracts during "Risk-Off" periods, the greenback could still prove to be a powerful magnet should we experience a bout of pullback in risky assets.

"If you are not willing to risk the unusual, you will have to settle for the ordinary." - Jim Rohn, American businessman

Stay tuned!

Friday, 22 February 2013

Spread Volatility 1 year EEM (ETF Emerging Markets) vs S&P500: Head or Tail?

"Looking back, I wince at the careless way I tossed out my opinions." - Luke Ford, Australian writer.

When one looks at the spread between the convergence between 1 year volatility level of EEM US (ETF MSCI Emerging Markets) with the S&P500 1 year volatility level, one can wonder if there is more to it - source Bloomberg:
-In white EEM ETF 1 year 100% Moneyness volatility
-In orange SPX (S&P500) 1 year 100% Moneyness volatility
-Bottom screen, absolute spread between both.

What could be the reasons behind the convergencen and, is it logical?

Two possible reasons:

Head: There is a logical convergence, we might even get an inversion going forward when one think about Emerging Markets' debt to GDP levels which are much lower. This could drive in the coming years the volatility for Emerging Markets to fall below the volatility of developed economies.

Tail: The US private sector's deleveraging is moving in the right direction, the S&P500 being the most liquid market in the world, the USA have a sound legal system versus Emerging Markets, which have more troublesome political systems, and not the same governance levels, meaning less liquidity and therefore a higher volatility level.

We thought these remarks from our good cross asset friend would make some interesting food for (macronomics) thoughts.

Stay tuned!

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!

Monday, 11 February 2013

Credit - Promissory Hope

"The man who promises everything is sure to fulfil nothing, and everyone who promises too much is in danger of using evil means in order to carry out his promises, and is already on the road to perdition." - Carl Jung

"A promissory note is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms." - source Wikipedia 

Promissory notes differ from IOUs in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists.

While looking at the political success of Ireland in obtaining finally some debt-relief, which could be seen as an interesting step for European politicians in helping struggling European countries, we thought our chosen title should be "Promissory Hope" given S&P has just raised Ireland's outlook from negative to stable, in the footsteps of rating agency Fitch's revised outlook on the 14th of November. Our title also reflects that while the ECB agreement brings some relief, it doesn't reduce in no way the stock of debt and the impact on the Irish budget deficit will be limited to 0.6% in 2014 and 2015.

No doubt the liquidation of IBRC (the remnants of former Anglo Irish Bank and Irish Nationwide Building Society has put to rest the burden of 3.1 billion euros of annual repayments for the next 10 years.

But, our chosen title is also directed towards the negative spread reaction in subordinated CDS and Lower Tier 2 cash bonds (used as reference obligation in the CDS space) since the announcement of the SNS nationalization and expropriation. We discussed this touchy subject in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

Therefore in this conversation, we will focus on the implication for the Credit markets in general and the CDS market in particular.

While subordinated bondholders met their makers in the case of the nationalization process of SNS, at least Senior Unsecured bondholders got some welcome respite as indicated in the below Bloomberg graph on a specific SNS bond:
But given Germany, the Netherlands and Finland are looking at speeding up the European plans as soon as 2015 rather than 2018, to force losses on senior unsecured bondholders of failing European financial institutions, the bail-in push to protect European taxpayers looks to us that, rather that financial unsecured bonds are now more akin to "Promissory Notes" (or hope) rather than plain IOUs.

As indicated by Jim Brunsden and Rebecca Christie in their Bloomberg article from the 4th of February entitled "German Push to Accelerate Bank Bail-Ins Joined by Dutch, Finns":
"Senior bank bondholders so far have mostly avoided losses, while European governments and the International Monetary Fund have committed to 486 billion euros of aid since 2010. Under the EU plans, drawn up by the European Commission, regulators would be given the power to impose losses on holders of senior unsecured debt, as well as derivatives counterparties, once a lender’s capital and subordinated debt are wiped out. Regulators could also force debt to convert into common shares, so shoring up a struggling bank’s equity. 
Once the new rules take effect, national authorities would be expected to exhaust bail-in options before resorting to public money to stabilize the bank. 
 The nations are seeking a date as soon as 2015 because it would provide time to adjust to the measures while not putting individual countries at a competitive disadvantage if they apply bail-in rules ahead of 2018, one of the officials said."

Arguably this is what we have discussing in various conversations and is even more likely to happen sooner rather than later, we think as we posited in"Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"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.

As usual the credit markets are only waking up to the rising risk and acceleration of what pains could be inflicted higher up in the capital structure. On that specific subject, we would have to agree with CreditSights note from the 10th of February entitled "Exploring the Sub-Conscious":
"The market is much more used to the idea of "burden-sharing" in hybrid debt, be it through non-calls, coupon deferrals, discounted tenders or principal write-downs. Even so, most of the latest crop of announcements does not help sentiment across the subordinated asset classes." - source CreditSights.

In similar fashion that the Greek CDS saga, followed up by the ban on naked Sovereign CDS last year questioned the existence of the Sovereign CDS market, the SNS episode is no doubt, raising serious questions on the value of subordinated protection as we argued in our previous credit conversation.

On this specific subject, CITI's note from the 11th of February entitled "What bail-in means for CDS" poses some serious questions:
"CDS protection in question – The consequences for CDS may be at least as far reaching as for bonds. Even if expropriation is deemed to be a trigger event, there is a real risk that no subordinated bonds will be left outstanding to be delivered into the contract. This would render subordinated protection practically worthless in the particular case of SNS (given that senior bonds are trading close to par)." - source CITI

In similar fashion to the sovereign CDS markets, it could no doubt, inflict some serious liquidity constraints to the credit markets as well as much needed reality check as per CITI's note:
"If any bank bondholders had not previously noticed that the rules were being rewritten on them, then the 80-point drop in SNS subordinated debt ought to have served as a wake-up call. Yet to our minds the implications for CDS may be almost as dramatic, and yet ironically may cause the market to rally rather than to sell off. 
Broadly speaking, the problem is that CDS contracts were designed prior to the invention of bail-in. Unless lawmakers are careful, they risk situations in which CDS protection turns out to be worth much less than protection buyers would have hoped and expected, either because it is not triggered at all, or because of problems with a lack of deliverable obligations. This would not only be very damaging for the CDS market; it would have very negative consequences for bank bond liquidity too." - source CITI

The Greek PSI in conjunction to the naked ban on naked Sovereign CDS have indeed somewhat "killed" the trading in the Itraxx Sovereign index SOVX as indicated by CITI:

We have as well to agree with CITI that, increased likelihood of bail-in is probably negative for cash bonds but how negative?

EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of 
the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 
bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

Therefore, as we indicated in our previous conversation, if the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral to say the least given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS.

What are the implications and "unintended consequences" for the financial credit markets? CITI's note gives some additional insights:
"Likewise, lawmakers may feel that the decline in liquidity in sovereign CDS following the ban on naked shorting may not seem to have had an immediate effect. But here too we would argue that this is mostly because we happen to have been in a rallying market, and that the future consequences may stretch well beyond just CDS itself. If investors become forced sellers following downgrades to junk for Spain and Italy, as we think quite likely, the lack of liquidity in CDS would exacerbate the movement in bonds. While some liquidity remains in single-name sovereign CDS, the effect on the SovX index of the shorting ban has been quite dramatic (see graph above on Itraxx SOVX weekly trading). 

The potential problem in bank CDS is almost as large. Although net notional outstandings for single-name European bank CDS are only $68bn,7 DTCC data show that traded volumes are some $36bn/month. This compares with gross turnover in €-denominated bank bonds of only €15bn/month (on €600bn of outstandings). CDS plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity. 
These issues over triggers and deliverables could all too easily jeopardise the validity of the CDS market as a hedge. If it were accidentally “killed off”, the consequences for the bond market would be severe. Unlike in sovereigns, where the underlying cash market has normally been more liquid than CDS, in the corporate market liquidity is heavily fragmented. Without the signaling and hedging role of an active CDS market, bond transparency would fall, trading would become more lumpy, and ultimately the cost to bank issuers would increase, as an increased illiquidity premium became factored into spreads. This hardly seems a desirable outcome." - source CITI

On a final note, as far as Europe is concerned, whereas the US was all about the "fiscal cliff" recently, we think investors in Europe should be focusing on the potential "earnings cliff" given we think analysts are somewhat a little bit too optimistic in their expectations. As an illustration Dutch KPN fell 18% recently to its lowest level since September 2001, following a 4 billion euros right issues in conjunction with earnings well below expectations, leading S&P to downgrade the credit to BBB-, one notch above junk - source Bloomberg:

"Everyone's a millionaire where promises are concerned." - Ovid

Stay tuned!

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