Credit - The Sleepwalkers

"Those who have compared our life to a dream were right... we were sleeping wake, and waking sleep."- Michel de Montaigne 

As 2014, marks the anniversary of probably one of the greatest human tragedy, namely the start of the First World War, we thought our title would reflect one of the greatest book written on the subject on how Europe went to war, "The Sleepwalkers: How Europe Went to War in 1914" by Christopher Clark. In his masterpiece, Christopher Clark analyses what caused the spark that led to the Great War. In similar fashion, we think that there is a possibility some future historian will write an opus on how in 2014 Europe went into deflation but, we ramble again. 

In his book, Clark asserted that the Great War was an entirely avoidable and unnecessary tragedy. "Unintended consequences" of the most colossal sort led to the outbreak of the Great War. In similar fashion the "credit crunch" that plunged Europe into a very deep recession and soaring unemployment levels, we have long argued, was as well an entirely avoidable and unnecessary tragedy. 

What accelerated the "credit crunch" was the EBA's decision for banks to reach a certain capital threshold by June 2012 (for the EBA June 2012 core tier one capital target of 9%, banks needed to raise at least 106 billion euros according to the EBA's calculations):

"If banks cannot access term funding, given the deleveraging they ambition to do, it could put additional pressure on bank lending, in effect reducing access to credit for the economy, namely triggering another credit crunch in the process." - Macronomics, November 2011

We have been sitting in the deflationary camp for a while and while last week, we argued that we could not see a significant drop in the Euro versus the dollar unless the ECB resorted to more "unconventional policies" such as QE. One of the main reasons we cannot fathom a rapid depreciation of the euro comes from the current account balance of the Euro Zone in % of GDP which continues to rise as displayed in recent study done by French bank Natixis in a report published on the 14th of January:

As described in Natixis note, the appreciation of the euro drives a fall in import prices which therefore lowers inflation levels in the Euro Zone. This does increase the deflationary pressure on the Euro zone. Given 73% of the turnover from companies pertaining to the Eurostoxx is coming from outside Europe, this can in turn explains the relative underperformance of European stocks versus the S&P 500 or Nikkei index. European stocks, in similar fashion to Emerging Markets, have as well been the victims of the on-going "currency war".

Looking at the recent discussions surrounding the capital requirement favored by the ECB in the upcoming stress tests, it seems it favors 6% of retained capital, slightly above the 5% used in 2011 during the EBA (European Banking Association) stress tests. Of course, this 6% benchmark must been agreed by the EBA which will coordinate the exams. The slight increase in capital requirement is still below the Comprehensive Assessment (balance sheet review), where the ECB will be using a minimum capital requirement of 8% to evaluate the 130 euro-area lenders under review. The ECB will only become a full member of the EBA when its starts its supervision role later in 2014. 

Still on the regulatory front, the Basel Regulators recent ease of the leverage-ratio rules for banks have not improved financial stability for the near future as reported by Jim Brundsen in Bloomberg on the 13th of January in his article "Basel Regulators Ease Leverage-Ratio Rule for Banks":

"Banks such as BNP Paribas SA, Bank of America Corp. and Citigroup Inc. called for amendments to the draft leverage rule published last year, saying it would adversely affect economic growth and job creation, make it more expensive for governments to sell their debt and give banks incentives to invest in riskier assets." - source Bloomberg.

We touched at length the subject of banks equity buffers in March 2013 in our conversation "Dumb buffers":

"Back in September 2011, we quoted Dr Jochen Felsenheimer from asset management company "assénagon" now called "XAIA", we would like to quote him again looking at the current context:

"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. 

Banks have fought bitterly against increasing equity buffers which is the cheapest and easiest way to recapitalize banks. Why? Because allowing high payouts to shareholders, namely bank employees in many cases, allows financial institutions to raise their leverage: "Focus on ROE is also a reason bankers find hybrid securities, such as debt that converts to equity under some conditions, more attractive than equity." - Anat R. Admati."

And if leverage is the issue, when it comes to providing loans to the real economy, although there has been some improvement in the euro-zone fragmentation in lending rates between core Europe and the periphery, resolving this divide has yet to be achieved as displayed by Spanish loan rates which have been jumping up as of late:

"ECB President Mario Draghi noted, in comments following November's rate cut, that while euro-zone fragmentation had been improving since mid-2012, progress had foundered since late summer. The latest data on Spanish loan pricing, often cited as a measure of the North-South divide, paint a dark picture. The two-month jump is the biggest increase in more than a decade and will likely stoke fears about this divide, potentially prompting talk of a rate cut." - source Bloomberg.

This fragmentation can as well be ascertained from this graph displaying the interest rate on MFI loans to non financial corporations (1-5 year maturity,

As far as we can see the European "Sleepwalkers" can either provide sufficient ammunitions via the carry trade for banks to rebuild their capital and deleverage, increasing in the process and not severing their fate with their sovereigns, but cannot provide at the same time the necessary credit support to boost economic growth sufficiently in the periphery, therefore not reducing the solvency issue.

For the time being, the situation is one of stability as indicated by the improving sentiment indicator in the Eurozone and Eurozone Real GDP which should improve at least in the short term - graph source Bloomberg:

Due to the fragility of this "recovery", for a change, the less restrictive approach regulatory attitude in relation to banks is supportive of the macro picture. 

We do agree with Bank of America Merrill Lynch Alberto Cordara when it comes to Italian banks from his recent note from the 15th of January entitled "Rules & Recovery":

"Sovereign spreads on a normalisation trail

Italy was hit hard by the crisis, suffering from the malaise spread by the Greek debacle, the collapse of the Spanish real estate market and in our view, the political quagmire of mid-2011. Italy, the third-largest Eurozone economy, has a strong and diversified industrial backbone, individual wealth is high and households are underleveraged. So far, the Italian government has seemed reluctant to implement structural reforms, which have come under fire from the traditional lobbies. In our view, the recent change of guard in the Democratic Party bodes well for reforms, in particular for the labour market, which is in need of modernisation. We think this may lead to further tightening of Italy’s spreads (still higher than in mid-2011).

A punitive regulatory attitude would be plainly ineffective 

As we highlighted in Breaking with tradition 18 October 2013 Italian banks’ lending businesses are currently loss-making and are thus subsidised by profits from elsewhere (AM, product placings, sovereign carry trades). Banks have been damaged by i) high sovereign spreads affecting their ability to issue term funding, and ii) low ECB rates which destroyed their ability to extract margins from depositors. Both variables are exogenous to banks (i.e. not related to their credit worthiness). We do not believe an increase in capital requirements would help address these issues.

Domestic authorities set out a favourable backdrop

We believe that the best way to reactivate the lending cycle is to allow banks to extract more profits, loosen capital requirements and (to a degree) front-load future losses. Recent steps by Italy’s authorities are supportive allowing full tax deductibility of credit losses, a shortening of the DTA amortisation cycle (from 18 to five years), and turning existing IRAP goodwill DTAs into tax receivables, while AFS sovereign losses will continue to be sterilised. Further, banks may ultimately be allowed to benefit from the revaluation of BOI stakes. On the other hand, it stands to reason that banks will be pushed to a credit clean up in 4Q13 as part of the AQR." - source Bank of America Merrill Lynch

When it comes to Italy Bank of America Merrill Lynch makes the following important points:

"In contrast with the rest of the Eurozone, Italy remained in recession in Q3 with unemployment at 12.5% and GDP growth contracting by 0.1% (-1.9% yoy) albeit at a softer pace (Q2: -0.3%; Q1: -0.6%). The overall framework for recovery remains fragile but signs are emerging. Business confidence is improving steadily and industrial production turned positive in November (+1.4% after 26 consecutive months of decline). On latest available data (June 2013), household gross wealth declined by 1% mainly as a result of a fall in house prices, but this was also counterbalanced by a fall in financial debt that currently stands at around 65% of disposable income compared with about 80% in France and Germany and 120% in Spain. Only 25% of Italian households have financial debt and the share of financially vulnerable households is low (3%). Italy’s historically high saving rates have contributed to the formation of a relatively high stock of wealth and a high degree of wealth dispersion among the population." - source Bank of America Merrill Lynch

In relation to Italian banks, the situation is much more different than the poor lending standards and risky loans and real estate exposure which decimated the Irish and Spanish banking sector as pointed out by Bank of America Merrill Lynch's note:

"Capital not the answer although politically appealing

In theory, more capital may help reduce funding costs for those banks that are issuing at a premium to sovereign spreads and potentially reactivate lending to the economy. However, experience suggests that the end result may be exactly the opposite. Higher capital requirements mean that banks are pushed to enforce stricter lending criteria and will adopt suboptimal practices to satisfy the regulator and avoid shareholder dilution. This goes beyond the check dates outlined by the regulator as there is always the risk that the regulator may come back asking for more (this has happened every time…).

The Italian case is very telling: in early/mid-2011, most Italian banks (BP, UBI, ISP and MPS) carried out massive recapitalisations, which proved completely ineffective as funding costs skyrocketed when the price of Italy’s sovereign bonds hit the skids in July 2011. In other words, banks are price-takers and are impacted by Italy’s sovereign – probably a different situation to in Spain and Ireland where poor lending standards and the collapse of the real estate markets were the very epicentre of the crisis. This is also very different from the US situation where TARP was introduced and is often cited as an example of regulatory foresightedness, a panacea for all ills. Italy’s problem resides with the country’s high level of public debt and disappointing ruling class, not with bad banks’ underwriting nor obscure asset values (subprime, etc.)." - source Bank of America Merrill Lynch

While the "stabilisation" is a welcome respite in the Euro-zone, our European "Sleepwalkers" should not take this recovery for granted and continue to push forward for some additional much needed structural reforms, in particular for France which as of late has been significantly lagging its European peers. Nevertheless the increase in European Consumer Confidence has been reflected as well in the EU27 new passenger car registration increases - graph source Bloomberg:

Credit wise, the correlation between the US, High Yield and equities (S&P 500) since the beginning of the year is back on track. US investment grade ETF LQD is more sensitive to interest rate risk than its High Yield ETF counterpart HYG  - source Bloomberg:

What caught our attention is Credit Indices, when one look at the positioning of credit investors, as displayed in a recent note from Morgan Stanley entitled "The Future of the CDS Market", US investors are net long credit risk in the US, particularly in Investment Grade via the CDX IG index:

"In terms of positioning, investors are net long credit risk in the US, particularly in IG (via a net short position of $40 billion in CDX IG). As such, there is some demand from index users to be simply long the market in an unstructured form via the indices." - source Morgan Stanley.

2014, is indeed a continuation of 2013, namely that the liquidity backstop continues to provide ample support for a continuation of carry trades, releveraging and an increase in the search for yield in the riskier part of the credit space as indicated by Lisa Abramowicz in Bloomberg on the 15th of January in her article entitled "Firms Tripling Junk Returns Lure Most Since '07":

"Firms that use borrowed money to lend to the smallest and riskiest companies are attracting cash at the fastest pace since before the crisis, wooing buyers with returns that are triple those of the broader junk-debt market.

Investors from retirees to wealthy individuals plowed $4.1 billion into publicly traded business development corporations last year, the most since 2007, as the firms known as BDCs gained an average 16.4 percent. The entities are juicing returns by borrowing about 50 cents for every dollar raised from equity investors, up from 36 cents in 2011, as Keefe, Bruyette & Woods predicts average gains of as much as 13 percent this year.

BDC shareholders are wagering that an accelerating economy will bolster earnings for companies that are the most vulnerable to default, even as the Federal Reserve starts scaling back the unprecedented stimulus that suppressed borrowing costs. After shunning funds that used derivatives and leverage in the years after the 2008 credit crisis, buyers are returning to pad yields that reached record lows last year while seeking shelter from bonds that face losses as rates now rise." - source Bloomberg.

So we wonder if investors are not indeed indulging themselves into "sleepwalking", although generally sleepwalking cases consist of simple, repeated behaviours, there are occasionally reports of people performing complex behaviours while asleep. 

On  a final note, and in relation to our European Sleepwalkers, the recent surge of the EONIA and Euribor, seems to point to some additional concerns when it comes to credit supply in the Euro area as shown in this Bloomberg graph highlighting the rise of the EONIA index and Euribor:

"The decline in excess liquidity in the euro region, driven by a decision by southern European banks to repay LTRO cash early, is raising key short-term interest rates, threatening the supply and cost of credit to Europe's struggling small- and medium-sized companies. A near doubling of one-month Euribor and EONIA since late November poses a growing threat, even though the ECB has pledged to do whatever necessary, including further rate cuts, to defend the euro zone's recovery." - source Bloomberg.

Let's hope Mario Draghi is not sleepwalking towards the deflationary slippery slope.

"Each man should frame life so that at some future hour fact and his dreaming meet." - Victor Hugo 

Stay tuned!