Credit - Dumb buffers

"When the weather changes, nobody believes the laws of physics have changed. Similarly, I don't believe that when the stock market goes into terrible gyrations its rules have changed."

- Benoit Mandelbrot 

A buffer is a part of the buffers-and-chain coupling system used on the railway systems of many countries, among them most of those in Europe, for attaching railway vehicles to one another. Buffers in the very earliest days of railways were rigid (dumb buffers). 

You might wonder where we might be going with this week's railway analogy, but, looking at the recent senate hearings following last year JP Morgan's 6 billion dollar losses, discussions surrounding banks and equity capital have resurfaced as of late. Arguably one of the most pertinent read we have come across was from Bloomberg's editors - JPMorgan’s $6 Billion Loss Shouldn’t Be a National Matter:

"To make the whole system more resilient, banks need to get a larger share of their funding in the form of equity from shareholders, as opposed to loans from depositors and other creditors. We have advocated $1 in equity for each $5 in assets, a level that would absorb a 20 percent drop in the value of a bank’s investments, compared with JPMorgan’s 3.1 percent. The latest global banking rules require only $1 in equity for each $33 in assets, and use a lenient approach for measuring the ratio.
Higher equity requirements reduce taxpayer support to banks in a different way, by making them less likely to require bailouts. The added discipline would also put natural pressure on banks to shrink: Once shareholders fully realized how poorly the largest banks perform in the absence of subsidies, they would have more incentive to demand that they be broken up into smaller, more profitable units." - source Bloomberg

Dumb buffers were the source of many staff accidents and damaged loads and vehicles. The Board of Trade required all new construction in England and Wales from 1889 to have spring buffers, but in Scotland the railway companies continued to accept new wagons with dumb buffers until 1 October 1903. From 31 December 1913 all dumb buffered vehicles were banned from the main line, but the Scottish owners gained an extension to 1915. In fact, the disruption of the Great War meant that dumb buffers persisted in Scotland until at least 1920-21. 

One can argue that the latest global banking rules requiring only $1 in equity for each $33 in assets is akin to the famous dumb buffers that plagued Scottish railways for an extended period of time, which might be leading to many "derailments" for banks in particular and for the economy in general as witnessed with the financial crisis of 2008:

The aftermath of the Gare Montparnasse accident

Similar to Bloomberg editors and Simon Johnson, MIT professor and former chief economist at the IMF, we have long advocated larger equity buffers for banks in order to reduce the systemic risk banks pose to the real economy as a whole. Back in October 2011, in relation to discussions surrounding Capital Regulation, contrary to many beliefs, we argued as well that Bank Equity is not expensive. It is a myth. A study realized by Stanford University by Anat R. Admati is a must read. a summary of the presentation made to the Bank of England by the co-author is available here:

"Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive"

A summary of a presentation to the Bank of England is available below which highlights Professor's Admati's key findings.

http://www.bankofengland.co.uk/publications/events/ccbs_workshop2011/presentation_admati.pdf

Some countries such as Denmark have started asking for higher extra capital. For instance, Denmark's systematically important financial institutions will have to hold 2.5% to 5% of extra capital as recommended by Denmark's Sifi committee. Its recommendations will have to be passed into law by the Danish parliament.

While the European Union us trying to press ahead with global banks standards by March 22nd, if the measures are not in place by month end, it would mean additional delays in implementing the January 2014 target for Basel III accord, which could potentially shorten the transition period and put some additional strain on lenders to adjust by the start of 2014 or delay the implementation until January 2015.

In this week conversation, we would like to focus our attention to this very important subject of bank regulation and capital adequacy, given both the European Union and the US have struggled to agree on legislation to apply the international standards on capital, known as Basel III, which were published in 2010 in conjunction with the Dodd-Frank act, following the demise of Lehman Brothers Holdings Inc.

So far, the Basel rules negotiations also have been stalled on how much additional capital should be required for systemically important financial institutions as reported by Rebecca Christie and Caroline Connan in their Bloomberg article from the 26th of February entitled - Barnier Says EU Needs Basel Deal to Lift Uncertainty for Banks:

"Lawmakers are pushing the EU to include in the capital rules a requirement for country-by-country reports on profits, losses and taxes, according to the document. Nations have been reluctant to expand the scope of the capital rules, preferring to tackle the topic in separate accounting legislation.

The Basel Committee on Banking Supervision brings together banking regulators from 27 nations including to the U.S., U.K., and China to coordinate their prudential rule-making.

The Basel III measures, which must be written into national laws, would more than triple the core capital lenders must hold and set standards for how lenders should manage risks. Representatives of Karas and the Irish presidency in Brussels declined to comment on the paper." - source Bloomberg.

On top of that, regulators from the Basel Group have clearly put Bank's debt addiction on scrutiny this year as reported by Ben Moshinsky and Jim Brunsden in Bloomberg on the 12 th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"Regulators are preparing to fight lenders over the details of the so-called leverage ratio as they seek to toughen rules on the minimum amount of capital they must use to back their investments. The Basel group, which brings together supervisors from 27 nations, will meet in the Swiss city tomorrow, according to the people, who asked not to be identified because the meetings are confidential.

 Concerns over how banks calculate reserves has led U.K. bank regulator Adair Turner and U.S. Federal Deposit Insurance Corp. board member Jeremiah Norton to call for tougher leverage ratios. Global supervisors in 2010 included a draft leverage ratio in an overhaul of rules, known as Basel III, drawn up in response to the financial crisis that followed the collapse of Lehman Brothers Holdings Inc.

“Early on, banks did not see it as such a big danger, or as a priority for lobbying, because it looked less likely to be implemented in the EU than other parts of Basel III,” Philippe Lamberts, the lawmaker leading the work on the Basel III rules for the European Parliament’s Green group, said in a telephone interview.

Leverage ratios force banks to hold capital equivalent to a percentage of the value of their assets. Such measures are simpler than standard capital requirements as they don’t give banks any scope to take into account the riskiness of their investments when calculating the reserves they must hold." - source Bloomberg

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.

For instance, since 2009, banks have indeed been very creative in the methodology used to beef up their Core Tier 1 ratio using a new generation of Hybrids securities called CoCo (Contingent Convertible Capital). CoCos, convert to equity or are written off once an issuer’s capital ratios fall below a preset level. This market for these new securities, already amounts to +10 billion dollars. This contingent convertible security pays a higher coupon and automatically convert into equities or suffer a full or partial write-down when the bank's capital ratio falls below a pre-defined trigger. 

The beauty for the issuer is that the CoCo automatically boosts its Core Tier 1 capital ratio in times of stress rather than being forced into a dilutive right issue during difficult market conditions. Owning a CoCo, according to a recent BNP Paribas note is very similar to selling a Down-and-In put option on the issuing

bank’s shares with a knock-in barrier linked to a balance sheet capital ratio as opposed to stock price level.

The issuing bank is effectively buying skew and convexity (crash protection) from the investor, who is exposing himself to losses in stress scenarios. 

It is not a free lunch although a coupon in the region of 7% to 8% is outright appealing in this low rate / low yield environment.

The benefits of such transactions for the issuer of CoCo notes is that not only it enables the issuer to maintain a particular minimum capital level, it also pleases the regulator and allows issuers which have been previously bailed out in Europe, to continue repayment of the aid received. For instance, KBC bank issued in January 1 billion dollar worth of CoCos, allowing them to continue the repayment schedule on time and, following a stress test, the National Bank of Belgium had required an additional 2 billion euros of Core Tier 1 capital to be raised. KBC completed in December 2012 a 1.25 billion euro equity offering and 750 million euros worth of CoCos.

While Europe is falling behind in relation to the implementation of Basel III, Switzerland has started implementing it as of January 2013 as indicated in a recent note by BNP Paribas on KBC's specific CoCo from January 2013:

"It is worth pointing out that due to the implementation of Basel 3 in Switzerland starting January 2013 as planned (as opposed to the delay in Basel 3 implementation in Europe, due to delay in completion of CRD4), the relevant ratio in ascertaining the likelihood of trigger is now the Core Equity Tier 1, rather than Core Tier 1 as it was under Basel 2.5. While this comes as no surprise and should have been fully expected it does make quite a bit of difference. For instance, at its Q3 12 UBS reported Basel 2.5 Core Tier 1 ratio of 18.1%, whereas the pro-forma phased in Basel 3 CET1 ratio was 13.6%." - source BNP Paribas

The fixation bankers have with equity buffers mean that they prefer issuing hybrids securities such as CoCos rather than equity in order to maintain their leverage and generate ROE. As indicated by Dr Jochen Felsenheimer, in case of trouble, the insurer is the taxpayer. CoCos are deemed to be "capital" and automatically improve the capital ratios, pleasing regulators in the process, and avoiding an automatic dilution of existing shareholders via capital increases through right issues. They are not equivalent to "equity", they are debt instruments, paying no doubt, a higher coupon, given the risk taken by the low subordination and risk of capital wipe-out faced by the bondholders.

As a reminder, under the draft Basel III plan in 2010, banks would have to hold so-called Tier 1 capital equivalent to 3 percent of their assets, so capping a lender’s debt at no more than 33 times those reserves, which, we think is way too low.

Last week events surrounding German Bank Commerzbank's capital increase is a reminder of not only the lack of sufficient equity buffer in the banking space but is also indicative of the material impact internal models of RWA (Risks Weighted Assets) can have to boost capital ratios as highlighted again in Bloomberg's article from the 12th of March - Bank's Debt Addiction Said to Face Scrutiny at Basel Meetings:

"The temptation for banks to boost their reserves through changes to risk calculations, rather than real steps to raise capital, could be countered by a strong leverage ratio, said Lamberts, the European lawmaker. One example of this is how German lender Commerzbank AG sought to meet EU capital rules in part by adjusting its risk calculations, rather than simply raising fresh reserves, Lamberts said.

“Details that are coming to light about how banks misuse their internal models, for example when Commerzbank said it would make up half of a capital shortfall through changes to its models, show the need for this kind of rule,” he said.

Commerzbank was one of more than 60 lenders told by the European Banking Authority to hold capital equivalent to 9 percent of its risk-weighted assets." - source Bloomberg

On March 2013, Commerzbank AG, Germany's second largest bank announced it would sell 2.5 billion euros of shares to repay the government and insurer Allianz SE. Commerzbank received a 18.2 billion euros bailout in 2009 and the German government had owned 25% of the bank prior to the announcement.

Of course the 15% dilution announcement led to the share sliding 14% in Frankfurt on the 13th of March - source Bloomberg:

 The share declined 14% valuing the bank at around 7 billion euros.

Commerzbank's shares, the intraday proverbial "sucker punch" - source Bloomberg:

This news made us chuckle given that the CEO Martin Blessing, will be using the capital raised to repay 1.6 billion euros owned to the government and 750 million euros to German insurer Allianz, as well as increasing its Core Tier 1 capital to 8.6% under full Basel III capital from 7.6%. 

Why did we chuckle, you might ask? Well, because Commerzbank's largest shareholder SoFFin (Special Financial Market Stabilization Fund), converted already its silent participation in June 2012 to approximately 58.85 million Commerzbank shares,  increasing in effect the capital of Commerzbank to maintain its equity interest ratio in Commerzbank to 25% plus one share. With the 15% dilution, this participation will be now diluted to 20%, meaning in effect a loss for the German taxpayers.

Oh well...

But this painful adjustment for Commerzbank will not be the last one, given we have already established the link between credit and shipping and in particular the exposure of German's second largest bank to shipping woes back in August 2012:

"Commerzbank – the world’s second-biggest provider of ship finance, and reluctant owner of a flotilla of foreclosed ships – said it is shutting down its €20bn (£15.7bn) ship funding operations entirely to “minimise risk and capital lock-up” under tougher EU banking rules."

In April in 2011, in our conversation "Shipping is a leading credit indicator", we indicated:

"Commerzbank’s 2008 takeover of Dresdner Bank AG increased its stake in shipping lender Deutsche Schiffsbank to 92 percent, doubling the size of its maritime-loan portfolio, just before the industry entered its biggest crisis since World War II." - source Bloomberg.

One can wonder what will be the recovery value for its maritime-loan portfolio looking at the boom and bust which occurred in the shipping space - source Bloomberg:

"The marine shipping industry is highly cyclical and susceptible to periods of boom and bust. Cycles are driven by overbuilding during times of growth to take advantage of strong markets. Shipping companies do not have enough lead time to alter orders when economic activity begins to slow, which has a significant effect on freight rates." - source Bloomberg.

Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book:

"Prices of seaborne vessels have crashed since peaking in 4Q08 and have been steadily declining since 4Q09, as excess capacity slowed the new build backlog, along with cheaper builds in China and tight credit markets. Chinese shipbuilders have been using price in attempt to win market share. Price pressure has come on less sophisticated dry-bulk ships relative to LNG tankers." - source Bloomberg

On the subject of banks capital shortfalls and the need to deleverage, and RWAs in particular, Nomura's note from the 11th of March 2013 entitled EU banks - Reconciling weak macro with momentum made some interesting points:

"To illustrate the point on headline capital ratios, the last published EBA Basel 3 monitoring exercise showed that at end-2011, European banks required EUR 225bn of equity capital to meet the minimum CET1 requirement of 7.0% of RWAs (inclusive of GSIB buffers where required). The report implied that the risk-weighted capital ratio rather than the unweighted leverage ratio was more of a bind on banks’ capital needs (given that the bar for unweighted leverage at 3.0% is set rather low, in our view). While we do not expect an official update on the 2012 capital position before September 2013, the EBA did separately disclose that as a result of capital raised for the 2012 stress test as well as other capital measures, European banks increased their capital positions by more than EUR 200bn in 1H 2012 (mostly through measures that directly increase capital rather than reduced assets). Based on the 2011 run-rate of net profit, in 2H 2012 around another EUR 40bn could have been added to banks’ capital bases.

Given that some banks will choose to build additional capital buffers, we do not expect the next monitoring exercise to show zero capital shortfall at end-2012 (several of the large often wholesale banks such as Deutsche Bank still had a gap at end-2012). However, we expect the reported capital shortfall to be substantially reduced for end-2012.

We are aware in 2013 that regulators are looking to improve harmonisation of the measurement of RWAs, moving away from internal models. In some cases, the banks have been well prepared (such as in Sweden) while in others it will delay the timeline to full Basel 3 compliance (such as in the UK). In general, we find that it is the wholesale banks with the lowest RWA/total asset ratios that might have the most need for additional capital actions or balance sheet shrinkage to meet regulatory goals. 

However, our main concerns for the banks are less about the measurement of RWAs and more about the fact that in some economies (such as Spain), the historical cost carrying value of banks’ assets is too high compared with their market value considering the fall in real estate prices in those economies. These unrecognised bad assets (along with deteriorating GDP and rising unemployment) require banks to divert profits to loan loss reserves rather than new lending." - source Nomura.

Moving back to our discussion around bank regulation and capital adequacy, we need to ask ourselves what have been accomplished since the demise of Lehman in 2008? Not enough, as indicated by the Bloomberg editors on the 10th of March in their article - Getting the Banks Around the World to Play by the Same Rules:

"Since that 2008 pact, progress has been made on the road to convergence. One example: Starting on March 11, Wall Street’s largest banks, including Goldman Sachs Group Inc. and JPMorgan Chase & Co., must process derivatives trades through clearinghouses, an accomplishment of the 2010 Dodd-Frank financial reform law, itself part of the U.S.’s commitment to convergence. By holding collateral and standing between buyers and sellers, clearinghouses can prevent one participant’s default from infecting all the others. In another step forward, the EU decided in December to create a single bank regulator. 

In Reverse 

But the dream of convergence remains, well, a dream. Conflicting national and regional laws, regulations and accounting standards have blocked the world from getting on the same page on financial reform. This, in turn, has jeopardized the ability of regulators to work across borders to address the next crisis. Shutting down a large failing bank that, say, loses all its capital because of a trading strategy gone haywire isn’t possible without universal rules for resolving sick banks. Moreover, financial companies will be able to take advantage of regulatory arbitrage -- shifting operations to countries with the loosest rules.

What happened? Let’s take a tour.

 In the U.S., regulators have been lobbied to a standstill. They have yet to name a single nonbank financial company or industry as systemically risky, despite the immense size and vital roles played by money-market funds, hedge funds, insurers and nonbank lenders. 

The Commodity Futures Trading Commission is backing away from some of its early positions on derivatives, moves that could have broken the big-bank stranglehold over the swaps business. The agency looks likely to revoke a proposal that would have required large investors to solicit quotes from at least five dealers, as a way to promote pre-trade price transparency. 

Regulatory agencies have also stalled over the Volcker rule, named after former Federal Reserve Chairman Paul A. Volcker. The measure is supposed to limit speculative trading by federally insured banks. For more than a year, five agencies have been debating with large banks and among themselves about where to draw the line between trading and making markets for clients, which the law exempts from the Volcker rule. On Capitol Hill, meanwhile, lawmakers from both parties and both chambers want to repeal parts of Dodd-Frank, including the requirement that banks move derivatives trading to separate affiliates with their own capital. 

Nasty Split

In Europe, the situation is no more auspicious. A nasty split has opened between the Continent and the U.K. The European Parliament and national governments have moved in recent weeks to tax financial transactions and cap bankers’ bonuses. This has (rightly) rubbed the British the wrong way, as their model of finance -- the Anglo-Saxon model -- is less regulated, more centered on trading and pays bigger bonuses than its counterparts in, say, France or Germany. 

Another rift is between Europe and the U.S. -- this one over capital requirements. New rules being written in Basel, Switzerland, have been watered down after much bickering. The level is now set at 7 percent of risk-weighted assets, up from 2 percent. Still, it falls short of the 10 percent initially sought by the U.S., and way short of the 20 percent of total assets that some economists and academics recommend. France and Germany led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors, Bloomberg News has reported. Not only is the global financial system no safer now than it was in 2008, it’s also clear that the project of convergence is badly stalled. Is the world really prepared to let the great convergence turn into the great divergence?" - source Bloomberg.

On a final note the principal reason for banks to hold a larger equity buffer is to be able to face risks such  as real estate bubbles. For instance both Credit Suisse and UBS have been asked to hold more capital to that effect as reported by Bloomberg:

"The 1.2 swiss-franc-to-euro cap and low interest rates have prevented the Swiss National Bank from tightening monetary policy to avert soaring real estate prices. To mitigate the risk of a property bubble, the authorities plan to curb lending growth by requiring banks to hold an extra 1% of capital on residential mortgages, starting 4Q13. UBS and Credit Suisse had 252 billion francs of mortgages outstanding at end-November." - source Bloomberg.

"What we define as a bubble is any kind of debt-fueled asset inflation where the cash flow generated by the asset itself - a rental property, office building, condo - does not cover the debt incurred to buy the asset. So you depend on a greater fool, if you will, to come in and buy at a higher price." - James Chanos 

Stay tuned!

Credit - Interval of Distrust

"Realism doesn't mean outright pessimism" - Max Lerner - American journalist.

"The principle behind confidence intervals was formulated to provide an answer to the question raised in statistical inference of how to deal with the uncertainty inherent in results derived from data that are themselves only a randomly selected subset of an entire statistical population of possible datasets. There are other answers, notably that provided by Bayesian inference in the form of credible intervals. The idea of confidence intervals is that they correspond to a chosen rule for determining the confidence bounds, where this rule is essentially determined before any data are obtained, or before an experiment is done. The criterion for choosing this rule is that, over all possible datasets that might be obtained, there is a high probability that the interval determined by the rule will include the true value of the quantity under consideration. That is a fairly straightforward and reasonable way of specifying a rule for determining uncertainty intervals. The Bayesian approach appears to offer intervals that can, subject to acceptance of an interpretation of "probability" as Bayesian probability, be interpreted as meaning that the specific interval calculated from a given dataset has a certain probability of including the true value, conditional on the data and other information available. The confidence interval approach does not allow this, since in this formulation and at this same stage, both the bounds of interval and the true values are fixed values and there is no randomness involved." - Philosophical issues - source Wikipedia

Given recent events relating to significant losses suffered by JP Morgan due to (mis)-measured VaR (Value at Risk), we thought our title would be appropriate, following the aforementioned events. JP Morgan restated its 1Q12 VaR associated with its Chief Investment Office from 67 million USD to 129 million USD. A VaR of 67 million USD at a 95% confidence level (hence our title...) implied that JP Morgan should not have incurred losses in excess of 67 million USD on more than three business days during the quarter. But we ramble again. We will refrain going into more details about yet another example of being fooled by randomness in true Nassim Taleb fashion, or the mis-behavior of markets as depicted by the great Benoit Mandelbrot. We already touched on "optimism bias" in our "Bayesian Thoughts" conversation:

"Humans, however, exhibit a pervasive and surprising bias: when it comes to predicting what will happen to us tomorrow, next week, or fifty years from now, we overestimate the likelihood of positive events, and underestimate the likelihood of negative events. For example, we underrate our chances of getting divorced, being in a car accident, or suffering from cancer. We also expect to live longer than objective measures would warrant, overestimate our success in the job market, and believe that our children will be especially talented. This phenomenon is known as the optimism bias, and it is one of the most consistent, prevalent, and robust biases documented in psychology and behavioral economics."

Tali Sharot - The optimism bias - Current Biology, Volume 21, issues 23, R941-R945, 6th of December 2011.

Hopefully for JP Morgan, should their bonds widen significantly, they might be in a position to recoup some of these losses courtesy of FAS 159 and DVA... So in our credit conversation "The Tempest" where we touched on the issues of the banking system in Spain leading to the recent "partial" nationalization of Bankia (for now...Spanish Government to convert 4.5 billion euro of FROB aid previously given to Bankia group parent BFA into shares, giving government as much as 45% ownership), we will focus this time around on the ongoing deleveraging process and the impact of upcoming downgrades in the financial sector (Moody's is reviewing 114 European financial institutions). But first, a credit overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Credit markets this week have indeed hit "bad weather" courtesy of the news flow in both Spain and Greece, with the Itraxx Crossover 5 year CDS index (High Yield risk gauge, 50 European entities) crossing the 700 bps level and 40 bps wider since last Friday, a new series 17 high since the last rebalancing of the index which occurred on the 20th of March this year. Once again the dominating force in the widening movement was in the financial space, with a clear underperformance for the Itraxx Financial Subordinate 5 year CDS index, wider by around 12 bps to 438 bps (40 bps wider since last week) whereas Itraxx Financial Senior 5 year index was wider by around 7 bps to 266 bps (20bps wider since last Friday). Credit Agricole posted a 75% drop in first quarter earnings impacted by exposure to Greece and the Spanish Government pushed forward a plan to ramp up provisions in the financial sector.

Since November last year we have been arguing about the heightened probability of seeing more and more debt to equity swaps in the financial space (and no, it wasn't a question of "optimism bias" from our part or outright pessimism...). In fact we learnt that the governing body of the Credit-Defaults swap markets ISDA and its credit steering committee are about to begin a formal process to revamp the CDS contracts to take into account how debt-to-equity exchanges would be treated after bankruptcy, as indicated by Matthew Leising in Bloomberg on the 9th of May - ISDA Said to Begin Biggest Revision to Credit Swaps Since 2009:

"Credit-default swaps users will meet this week in New York and London to discuss changes to the contracts in what may become the biggest revisions since 2009, according to people familiar with the situation.

Possible changes to standard contracts, which are governed by the International Swaps and Derivatives Association, include how debt-for equity exchanges would be treated after a bankruptcy, specifying that credit swaps only cover losses from defaults that occur after their purchase and clarifying how the date of a so-called credit event is determined, said the people, who asked not to be named because the discussions are private."

The importance of debt-for equity exchanges in CDS contracts from the same article:

"The concern arose in the bankruptcy of CIT Group Inc. when the commercial lender proposed to exchange its debt for equity before the credit swaps settlement date, one of the people said. Because only bonds and loans are deliverable under the current standard swaps contract, that left the possibility of having no debt with which to settle the contracts."

"Unintended consequences" and fixing flaws relating to Sovereign CDS contracts, the Greek example as reported by Matthew Leising in Bloomberg :

"Credit swaps payouts after a government debt exchange would be tied to the ratio of the face value of the new bonds to the old bonds. That would seek to prevent scenarios where payments are limited to swaps buyers because the new bonds are trading close to par, a concern of market participants after Greece undertook the biggest sovereign-debt restructuring in history. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt."

Good intentions, given you probably want to "cash in" while you can on your Sovereign CDS contract, but as the Greek example is clearly showing, new bonds have not been trading close to par for very long...

"Greece’s 10-year bond price has dropped below that of the security it replaced in the biggest-ever debt restructuring two months ago, suggesting investors are betting the nation will default.

The CHART OF THE DAY shows the price of Greece’s 2 percent bond maturing in 2023 sank to 18.995 percent of face value yesterday, below the 19.005 closing level of the bond it superseded. The security, which began trading after the March 9 debt restructure, has tumbled as deadlocked talks over the formation of a new government reignited concern Greece won’t meet the terms of two international bailouts, increasing the risk it will leave the euro currency bloc and fail to pay back its creditors." - source Bloomberg.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

Spanish bonds came back above 6% while German bund yields hit record new lows. In our conversation "The European Opprobrium" back in February, our good credit friend and ourselves had been discussing the following:

"Will subordination of private bondholders versus the ECB lead to insubordination?

If true, here are the questions you should ask yourself:

Will the new bonds be senior to the old bonds? If so, expect private investors to go on strike and buy much less sovereign bonds as they will be subordinated to the ones owned by Public institutions in the future. Also, some private investors may decide to try their chance in Court and argue against the subordination de facto."

When it comes to Spanish debt we have already started to see "insubordination" leading to a private investor "buyers strike" ("Mutiny on the Euro Bounty"):
"The Spanish Treasury, in the ship's bunker, might encounter some problems in placing Spanish debt, which until recently had been absorbed by docile domestic banks. The two largest Spanish banks, Santander and BBVA have said they had reached the maximum levels allowed in terms of their policy in risk concentration and consequently will not increase their purchases of Spanish debt from now on."
So next week auctions for both Spain and Italy should be interesting, given the bank recapitalization exercise taking place which could further more erode confidence in Spanish sovereign debt. The additional burden of providing support for the "problematic" 184 billion euros of assets identified by the Bank of Spain is indeed a cause for concern in relation to the financial aspect of the operation. The government is expected to demand banks to set aside a further 35 billion euros to cover sound loans in their real estate portfolios. The government has already obliged banks to make provisions of 54 billion euros to cover bad assets, and in our last conversation, we already touched on the level of provisions already passed by Spanish banks. Some banks haven't really started (BBVA, Santander need to provide around 2.3 billion euro each in 2012 under the RDL). The government asked the banks to set aside 30 percent of their sound loans to house builders, up from a current 7 percent, but the banks, including major players Santander and BBVA, had pushed back with a lower number (call it "insubordination" or mutiny...).

If it were only Spanish banks being on a "buyers strike"...
"Gao Xiqing, president of China Investment Corp., said the nation’s sovereign wealth fund has stopped buying European government debt on concerns about the region’s financial turmoil: “If European governments want to issue bonds, CIC is not a main target institutional investor,”
source Bloomberg - CIC Stops Buying Europe Government Debt on Crisis Concern.

No wonder our "Flight to quality" picture as indicated by Germany's 10 year Government bond yields dipping below 1.50% is so telling (10 bps tighter in a week). It is indeed deflation (デフレ). - source Bloomberg:

In this game of survival of the fittest, as we posited before, it is all about capital preservation rather than capital appreciation. As David Rosenberg put it recently: We are no longer in the era of capital appreciation and growth. "The “baby boomers” are driving the demand for income which will keep pressure on finding yield which in turn reduces buying pressure on stocks. This is why even with the current stock market rally since the 2009 lows – equity funds have seen continual outflows. The “Capital Preservation” crowd will continue to grow relative to the “Capital Appreciation” crowd."

We agree with Nomura's recent note - European political implications: new bund target 1.25%:
"Recent developments have reinforced our strategy recommendations: short non-core markets, and stay long Bunds. We are close to our 1.50% initial target on 10yr Bunds, but see the rally extending further so move our target to 1.25% on DBR 1.75% 07/22. This new target could be breached if no fresh policy response to the crisis emerges. After all, we still believe that absent a proportional policy response, a break-up of the euro is probable rather than possible."

The "D" world (Deflation - Deleveraging) - 2 year German Notes evolution versus 2 making again new lows versus 2 year Japanese Notes - source Bloomberg:

In a deleveraging/deflationary world:
"The corner stone of asset management is not capital “appreciation” but capital “preservation”."

In a recent note published by Credit Suisse focusing on Japan and deleveraging:
"It seems there is plenty of evidence to suggest that global overleveraging and bursting of various asset bubbles (ranging from banking to property to trade imbalances) is moving most developed countries/regions along similar progression line as what occurred in Japan over the past 20 years."

"As can be seen in the above graph, in 1998, the key developed economies (i.e., the US, the UK, Eurozone and Japan or G4) carried a total debt burden (public plus private) of around US$65 tn, or approximately 300% of the GDP.
However, by 2008 (amid the unfolding crisis), the overall level of debt expanded to US$131 tn or 370% of GDP. It continued to climb to US$140 tn or almost 400% of GDP by 2011. On the current trajectory, the overall level of debt should climb to almost US$143 tn by 2013 but should be slightly down in proportion to GDP to around 380%.
In order to place this debt burden into perspective, one should remember that since the end of World War II, the average burden was not much more than 240–250% (broadly 60% each for household, business, financials and government sectors). In other words, if the overall debt burden were to return back to more normal levels (say by the end of 2013), the overall debt level would need to decline towards US$100 tn (i.e., fall of US$35–40 tn).
A return to the 1998 levels would still require a drop in debt levels to around US$115–120 tn or a fall of up to US$20 tn." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Balance Sheet Recession? It's the private sector stupid!
"Clearly, the area of greatest expansion of debt burden between 1998 and 2008 occurred in the private sector. Once again, looking at G4, the overall private sector debt was around US$50 tn in 1998. However, by 2008, it reached US$100 tn, rising from 230% to almost 290% of GDP versus the historical average of around 190%. Since 2008, the private sector has embarked on a de-leveraging process, which is likely to reduce G4 private sector debt by around US$3–4 tn (by 2013), easing debt burden as a percentage of the economy to around 260–270%.
The other side of the private sector de-leveraging is a rising public sector debt. We estimate that by 2013, the public sector debt across G4 will rise to 120% of GDP (excluding significant contingent liabilities and unfunded liabilities). In other words, debt to GDP of the public sector, which was broadly in line with the historical average of around 60%, could easily double by 2013." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

So what happened in Europe? Bank leverage...

"There was a similar acceleration in Eurozone’s total and private sector leverage levels over the last 10–15 years (paralleling the US experience, except that most of the increase in Eurozone was driven by financial and corporate rather than household sectors). As can be seen below, Eurozone’s private sector’s leverage is currently close to 290%, up from just over 200% in 1998." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

"Most of the key Eurozone economies have so far failed to achieve any meaningful reduction in private sector debt, with the prevailing levels broadly in line with the US and Japan for France and Spain (around 270–290% of GDP), although the Italian and German private sectors are far less leveraged.

At the same time, leverage of some of the more vulnerable economies such as Portugal and Ireland as well as larger non-Eurozone economies (such as the UK) remains uncomfortably high. Private sector debt to GDP in the UK is between 300% and 400% of GDP (depending on the degree of adjustment for the UK’s global financial hub status) while Irish private sector debt is a crushing 550–600% of the country’s GDP and Portugal’s private sector debt is close to 280–290%." - source Credit Suisse - Japan: Back to The Future - 10th of May 2012.

Moving on to our second subject of upcoming Moody's downgrade of 114 European financial institutions, Morgan Stanley caught our interest with their recent note on European banks - Who Will Catch the Falling Banks?":

"Moody’s review has been pushed back, but we don’t believe that indicates any softening in approach. With many bonds expected to drop out of the IG indices, or at least go sub-IG at Moody’s, we believe there are few investors willing to step in – at least at current levels – to meet any forced sellers/nervous holders."

We've been ranting like a broken record in relation to subordinate debt; Morgan Stanley's note is indeed confirming our long standing position:
"Downgrades in LT2 could be 5-6 notches, not ‘just’2-3, in our view. We are concerned that investors haven’t fully grasped that LT2 will be affected by Moody’s downgrades of senior ratings plus removal of support notching – with BNP’s LT2s potentially dropping five notches to Baa3 and UBS’ six notches to Ba1, for example.
59% of the € iBoxx Tier 1 index will have dropped out once Moody’s downgrades are done, compared to 1 January 2012, we expect. LT2 indices will see dropouts too, with an expected 19% in the same time period. The volume of falling angels – €18 billion of Tier 1 and €17 billion of LT2 – is unprecedented and hence we are concerned about subsequent price action.
Will HY buyers save them? We don’t think so. Our survey of HY investors suggests most don’t have to closely follow an index and a move from 25% to 32% of the €HY iBoxx index, still wouldn’t make those who don’t look at banks now suddenly get interested. In our view, prices have to cheapen significantly from here to attract them; the same going for insurers who have spent years de-risking bank capital. Retail investors are ratings insensitive, but demand here is not enough to avoid a price correction, in our view."

Bracing for a sell-off impact, from the same Morgan Stanley note:
"We appreciate that a number of Tier 1 index dropouts, including large names like UniCredit, have recently happened without much disturbance to the market. However, the sheer volume of bonds dropping out in the next couple of months will be unprecedented – following the Moody’s downgrades, we expect €18 billion of Tier 1 and €17 billion of LT2 to have dropped out of the € IG indices since the start of the year."
Hence our "interval of distrust"...Oh well...

In this deleveraging process, capital rules for bank capital have yet to be addressed. We have already argued like many before us, that contrary to many beliefs, Bank Equity is not expensive. It is a myth as clearly demonstrated by Anat R. Admati - “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive.”
We share the same views as Simon Johnson, the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management, as indicated in his latest views published in the New-York Times:
"Breaking Up Four Big Banks"
A view which is gathering traction, courtesy of the latest losses incurred in the financial sector due to oversized positions that went badly wrong.
Rules for Bank Capital Still Aren’t Mended Four Years On: View by Bloomberg Editors - 7th of May 2012:
"Bank capital is of paramount importance because it is capable of absorbing losses. If a well-capitalized bank gets into trouble, its shareholders suffer, but depositors, the taxpayers who insure their deposits and the rest of the financial system are protected. Wafer-thin capital -- in other words, huge leverage -- was the main reason the crash propagated as it did.
The new accord proposes that banks maintain equity capital of 4.5 percent of risk-adjusted assets, plus a 2.5 percent added buffer. Equity of 7 percent is an improvement over Basel II, but still far less than needed. Even under the new regime, some supposedly risk-free assets would require little or no capital backing, so equity as a proportion of total assets would be lower. Basel III sets a floor of just 3 percent for equity as a proportion of total assets. A much higher figure -- as high as 20 percent of assets -- is called for."

On a final note, we would like to add that complacency and weak interval of confidence based on flawed assumptions or models can be dangerously deceitful when markets lack direction as demonstrated by Eugene F. Fama and Kenneth R. French, the creators of a model explaining equity returns:

"As the CHART OF THE DAY shows, each component of their three-factor model dropped last year for the first time since 1994. The declines occurred even though the Standard and Poor’s 500 Index was little changed.
Fama, a University of Chicago professor, and French, a professor at Dartmouth College in Hanover, New Hampshire, put together the figures used for the chart. They track return gaps between stocks and Treasury bills, between the shares of smaller and larger companies, and between value and growth stocks.
Although market returns had the biggest swings among the three factors in the past half century, “the volatility of the size and value premiums is nevertheless high,” Fama and French wrote in a paper analyzing the numbers. The research, posted on their blog three days ago, is based on data from the University of Chicago’s Center for Research in Security Prices.
Last year’s total return for all U.S. stocks, weighted by market value, was 0.9 percentage point less than the return on one-month Treasury bills with monthly reinvestment." - source Bloomberg.

"When evil acts in the world it always manages to find instruments who believe that what they do is not evil but honorable." - Max Lerner

Stay tuned!