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!

Markets update - Credit - Bedtime story and the European issue of circularity

"Nothing is more frequently overlooked than the obvious."
Thomas Temple Hoyne

Volatility again today. We had a better tone in the morning in the European space credit wise, but we were back to flat at the end of the day. Following the G20, everyone expecting in a week's time big resolution coming out of the European summit. They should be bracing themselves for some disappointment.

As per Bloomberg article today by Tony Czuczka and Rainer Buergin:
"German Chancellor Angela Merkel has made it clear that “dreams that are taking hold again now that with this package everything will be solved and everything will be over on Monday won’t be able to be fulfilled,” Steffen Seibert, Merkel’s chief spokesman, said at a briefing in Berlin today. The search for an end to the crisis “surely extends well into next year.” Group of 20 finance ministers and central bankers concluded weekend talks in Paris endorsing parts of Europe’s emerging plan to avoid a Greek default, bolster banks and curb contagion. Providing a week to act, they set the Oct. 23 meeting of European leaders in Brussels as the deadline."

In this post we will have a look again at bank recapitalization, given it is still the ongoing subject, as a follow up on our previous discussion. We will also discuss the issue of circularity. We touched on the subject in our post - "Macro and Markets update - It's the liquidity stupid...and why it matters again..." in relation to European banks liquidity issues:
"The circularity issue weighting on liquidity:
In highly-indebted Euro zone countries, the issue of circularity comes from the high correlation with their sovereign creditworthiness, meaning they are experiencing very high level of stress on their current funding."

So here we go for another long conversation.

But first, a credit overview.
The Itraxx Credit Indices picture today - Source Bloomberg:

While the tone had been much positive at the open, on credit indices with at one point Itraxx Crossover 5 year index (High Yield) tightening by 23 bps, the market closed the day roughly unchanged, as equities moved from the positive territory to negative. German Finance Minister Wolfgang Schaeuble comments weighted heavily on the market by the end of European close.

Enel, Italy's largest power company came to the market with 2014 and 2015, with a new issue premium to secondary of around 50 bps for the 2014 bonds and a new issue premium of 90 bps for the longer tranche.

There was as well some resurgence in news issues in the financial space with an interesting 2 year Senior Unsecured Floating Rate note from Commerzbank, rated (A2/A/A+ outlook : stbl/neg/stbl), which priced at Euribor +158 bps. On the 12th of October SEB (Skandinaviska Enskilda Banken AB - A1 / A / A+) priced a similar note at around Euribor +120 bps.
We know from the post "Markets update - Credit - Misery loves company" that ABN Amro (Aa3 /A/A+ all stable outlook), priced a similar floater on the 30th of September at around Euribor +130 bps, as a follow up on Deutsche bank which priced at around +100 bps.

So no surprise there, new issues are not only repricing the secondary issues, but coming with big concessions given the need for banks to raise capital. It is interesting to note that apart from these 2 year Senior unsecured notes, for some prime issuers, it seems the subordinated market is still completely shut down.

In relation to flight to quality, convergence of German 10 year Government Yield and German Sovereign CDS seems to have stopped in its tracks - Source Bloomberg:

From 2.18% Yield to 2.08% on the 10 Year German Bund.

But the interesting part today was the new record set in terms of spread between the German 10 year Bond and the French 10 year Bond (OAT), which reached 95 bps - Source Bloomberg:

France still in the crosshairs of the European bond vigilantes.

The liquidity picture - Source Bloomberg:

Some improvement but nothing major so far.

And Nomura had a good comment relating to recent market action in their recent Rates Strategy Europe weekly from the 14th of October:
"Convalescence with relapse risk:
Beyond October, we are worried by the possibility of a relapse in market sentiment. There is ample scope for disappointment on the euro plan (see Euro plan: Bazooka or damp squib?). Our take is that the "bazooka" will not happen. But in a risk-on phase partly triggered by better economic sentiment, it would take a really disappointing announcement to immediately derail markets. In July, there was a very incomplete announcement in a very negative market; the background is different this time. So at this stage, we are not necessarily waiting for a major risk off, but we are aware of the risk of relapse in the aftermath. There are several triggers: (1) the PSI will be revisited with tougher terms, paving the way for a possible CDS trigger, (2) the political situation in Greece is very unstable and the Troika returns to Athens no later than end-November (assuming the next tranche is paid, the government has money only until January), and (3) it is not clear how the ECB's bond buying will continue and how the central bank will react to a GGB default (the collateral issue can be by-passed in the event of a temporary selective default; it would be more complicated with a CDS-triggering event)."
Ouch...so much for all the recent European politicians "Bedtime story"...

And Nomura to add relating to the periphery:
"The market has largely shaken off the recent euphoria over possible quick fixes to the Eurozone and sovereign spreads have come under pressure to some extent as a consequence. While many would look for a large scale solution on the horizon, from the possibility of extra IMF funds (possible with many caveats), to large scale recap of banks (obviously not a solution in and of itself), to various insurance schemes (which could come with practical and legal challenges), the likelihood of any single solution arriving imminently appears remote.

Against this backdrop we continue to believe that sovereign spreads that are unsupported by the ECB will come under pressure."

So, unfortunately, no Bazooka to be expected anytime soon.

And that leads us to the issue of circularity we previously mentioned. And, in relation to bank recapitalization, don't expect wizards, fairy tales and magic tricks in our "Bedtime story".
The issue of circularity we mentioned earlier again cannot be clearer than the graph realised by Martin Sibileau in his latest post - "The EU must not recapitalize banks":

And as indicated by Martin Sibileau:
"The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital."

To illustrate further the issue of circularity, here is a table from Bloomberg displaying Greek debt ownership:

The 6 top owners of Greek debt are 6 Greek banks.

And I have to agree with Martin Sibileau's view:
"What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility."

And the clear difference between the ECB and the FED in relation to bond purchases is as follows, as pointed out by Martin Sibileau:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…”
"The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”
Stock and flows:
"Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time (say, December 31, 2004), which may have accumulated in the past. A flow variable is measured over an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is roughly analogous to rate or speed in this sense."

And following the circularity, let's discuss current recapitalization issues as there were some interesting developments today namely involving subordinated Tier 1 debt.

BPCE, the French bank decided to launch a tender and offered to buy back subordinated bonds as much as 1.8 billion Euros of four subordinated hybrid securities:

Why so? Given we know that "access to capital is depending on growth outlooks", a cheaper way for a bank to beef up its Core Tier 1 capital is to buy back at a discount its Hybrid Subordinated perpetual bonds in the secondary market.

We discussed this very subject in the post "Markets update - Credit - Crash Test for Dummies":
"In 2009, the game was for weakly capitalised banks to quietly retire bonds at distressed levels to create/boost Core Tier 1 capital, which was precious as long as they could finance the purchase with term debt.

If a financial entity is able to buy back its LT2 debt below par, it generates earnings (the beauty of FAS 159, on that subject see my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.") and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."

and bingo! French bank BPCE strikes today!

And a market maker to comment following the BPCE tender:
"Very big moves in T1 space mainly driven by BPCE T1 tender which came approximately 13 points above secondary (for the low coupons bonds). The market rapidly drew the conclusion that similar moves would be coming on in French names - with a particular focus on low-cash, step-up bonds."

BPCE Tier 1 subordinated perpetual bonds indicative round up:
BPCEGP 4.625% 07/15 (call date) cash price - 61/64 +13.75 points
BPCEGP 5.25% 07/14 (call date) cash price - 62/65 +11 points
BPCEGP 6.117% 10/17 (call date) cash price 61/64 +9 points
BPCEGP 9% 03/15 (call date) cash price 78/80 +4 points
BPCE 9.25% 04/15 (call date) cash price 76/79 -

BPCEGP 5.25% 07/14 (call date) - Source Bloomberg

BPCE commented on its tender:
"The Tender Offer is being undertaken in order to further enhance the quality and efficiency of the Company's capital base."
Of course it is!

On a side note, FAS 159 is fashionable again in the banking space:
DVA/CVA in earnings:
UBS = 1.6 billion USD
JP Morgan = 1.9 billion USD
Citi = 1.9 billion USD
To be continued...(Bank of America, Goldman Sachs, Morgan Stanley, etc.).

And on a final note I leave you with Bloomberg chart of the day, showing that Asian stocks are yet to reach bear-market floors:

According to Bloomberg:
"Stocks in Asia excluding Japan may extend a bear-market rally for “several” weeks before resuming declines that could send them to new lows next year, according to Mizuho Securities Asia Ltd. The MSCI All Country Asia excluding Japan Index rebounded 13 percent in the six days through Oct. 13, following a 31 percent plunge from its April 28 intraday high. In the four previous periods when the Asian gauge dropped more than 30 percent from peak to trough closing levels since records began in 1988, all were interrupted by rallies of between 14 and 45 percent, before the routs resumed. A minimum drop of 20 percent from a peak signals to some investors a bear market."

"There cannot be a crisis next week. My schedule is already full."
Henry A. Kissinger

Stay tuned!

Markets update - Credit - For whom the vol tolls and the return of FAS 159.

For whom the bell tolls
Definition: "An expression from a sermon by John Donne. Donne says that because we are all part of mankind, any person's death is a loss to all of us: “Any man's death diminishes me, because I am involved in mankind; and therefore never send to know for whom the bell tolls; it tolls for thee.”

Rest in peace Steve Jobs.

Today was clearly a day of volatility in the credit space.
Here is the overview.
The range for Itraxx Financial senior 5 year index was between 247 bps to 266 bps and the market closed around 253 bps.
For Itraxx Financial Subordinate 5 year index, the range was between 480 bps to 517 basis points intraday, closing at around 498 bps.

Although the markets in the credit space felt better, it clearly looked like a short covering move.
And my good credit friend to comment:
"Skew basis trades in the credit derivatives universe had for consequence a tightening of the credit indices versus single names (arbitrage selling the indices and buying the underlying single names components). Meanwhile, the cash market barely moved as we still see a lot of sellers and almost no buyers. The ratio seller to buyer was roughly 8:1, and the selling pressure was broad based. Financial bonds as well as corporate bonds are being offered relentlessly and the dislocation we saw in bank bonds and notes is spreading now to almost all issuers.

The name of the game remain Volatility..."

Yes, the markets expect a bazooka of some sort to relieve the pressure in the European space. The ECB's core mandate is price stability and given inflation has been creeping up recently at 3% in the euro zone, a rate cut, which many were expected today, did not materialise. Jean-Claude Trichet's last meeting, did not generate the bazooka, which the market is still hoping at some point.

Itraxx Credit Indices Market overview - Source Bloomberg

Itraxx Financial Senior 5 year CDS index versus Itraxx Europe Main (Investment Grade) 5 year CDS index - Source Bloomberg:

While volatility has been more muted in the CDS corporate space in recent months. The continuous pressure in the financial space means that volatility remains very high as indicated by the absolute spread between Itraxx Financial Senior 5 year CDS index and Itraxx Financial Subordinate 5 year CDS index - Source Bloomberg:

Spread between both indices still at the widest levels at around 245 bps. The unsecured funding market is still utterly shut and most issues coming to the markets from the financial space have been so far, covered bonds backed by pools of prime loans, apart from last week 2 year senior FRN (Floating Rate Note) issued by Deutsche Bank as discussed in previous post.
Access to capital is therefore still limited, no change there, with Nationwide Building Society (rating A+/Aa3/AA-) selling 1.5 billion euros of five-year covered bonds, priced to yield 130 bps than the benchmark mid-swap rate according to Bloomberg. We know from the post "Markets update - Credit - Crossing An Event Horizon", that
"Lenders, by using prime assets are willing to do whatever is necessary to get funding, as other sources, such as unsecured issuance have dried up, clearly reflected by the very high level reached by the Itraxx Financial Subordinate 5 year index."
We know ING sold AAA 10 year bonds at 80 bps over midswaps on the 24th of August, and Unicredit at 215 bps over midswaps on the 25th. It seems every new issue coming in the financial space is pricier than the previous one, and given covered bonds are the most senior guaranteed bonds you can find, senior unsecured bonds and subordinated are repriced accordingly in the process.

And although credit indices enjoyed a short squeeze tightening move, and ECB has pledged to buy 40 billion euros worth of covered bonds, to provide extra financing for banks, liquidity in the market, remains weak - Source Bloomberg:

ECB deposits still rising. But following today's ECB meeting, banks will be offered two additional unlimited loans of 12 and 13- month durations. Trichet in his last ECB meeting mentioned that the Central bank would continue to lend banks as much money as they need in its regular refinancing operations at least until July 2012 to alleviate current liquidity issues we previously discussed.

German 10 year Government yield, Eurostoxx, Itraxx Financial Senior 5 year CDS index and volatility - Source Bloomberg:

While volatility remains elevated, you can notice the correlation between the German 10 year bund yield and the Eurostoxx index.

In the Sovereign Index Space, SOVx Western Europe index (15 countries) is now tighter than the SOVx CEEMA (Central Eastern Europe, Middle-East and Africa) - source Bloomberg:

Confirming what we had discussed in "Markets update - the EM contagion" :

"The CHART OF THE DAY shows the Markit iTraxx SovX CEEMEA Index of credit default swaps on 15 governments in central and eastern Europe, the Middle East and Africa now exceeds a benchmark of western European creditworthiness by 14 basis points. Europe’s worsening deficit crisis is hurting manufacturers, eroding demand for commodities and undermining capital flows in developing economies. Investors are pulling money out of emerging-market bond and equity funds as the risk of a Greek default and losses on sovereign bond holdings mounts."

Meanwhile Ireland continues breaking away from Portugal, Sovereign 5 year CDS wise - Source Bloomberg:

While equity markets are enjoying a respite, we have yet to see a break upwards of the 2% yield for the German bond, still consistent with flight to quality in the European space - Source Bloomberg:

Truth is in the credit space, cash bonds felt weak today has commented by a market maker, with clients still reducing risks and selling bonds which, should not be a surprise given that corporate issuance is repricing credit curves. And cash bonds selling is not helping market makers given a lot of them have lost their risk appetite, as vol (volatility), in the credit space has indeed taken its toll.
Bloomberg - Bond Traders Left Adrift as Dealers Reduce Risk - Shannon D. Harrington and Sarah Mulholland - 6th of October 2010:
"Europe’s crisis of confidence is crippling credit-market trading as banks shrink bond inventories to the least since the depths of the last recession.
Federal Reserve data show U.S. primary dealers cut their holdings of corporate debt by 33 percent to $63.5 billion since May, bringing stockpiles to within $4 billion of the five-year low reached in April 2009. Trading in investment-grade company bonds has dropped 27 percent since February, according to Trace data compiled by Barclays Capital, and a measure of the cost to buy and sell debt is at the highest in more than two years."

and the two authors to add, in relation to liquidity in the credit space:
"Evaporating liquidity is contributing to the biggest junk-bond losses since the failure of Lehman Brothers Holdings Inc. three years ago as Europe’s leaders seek to prevent the region’s fiscal imbalances from infecting the global banking system and the U.S. economic recovery struggles to gain footing. Sales of new high-yield securities have all but disappeared and prices in debt markets are swinging by the most since 2008."
Volatility we have indeed and from the same article we learn that:
"Volatility is making it harder for Wall Street to underwrite loans, Julia Tcherkassova, a commercial-mortgage debt analyst based in New York at Barclays, said yesterday.“Originators need to see that stability.”It takes several months to accumulate mortgages to package for sale as bonds, and price swings on the debt mean that lenders may be stuck with unprofitable loans if values decline in the interim."

So dealers are as well de-risking and deleveraging, leading to wider bid-ask spreads, higher volatility and poorer liquidity, and we haven't seen complete capitulation yet as we saw in 2008.

So how do banks expect to sustain earnings in this difficult trading environment with less leverage, smaller balance sheet exposure, weak issuance and so forth?

Here comes again FAS 159!

In July 2010 I commented on the above: "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008"
"Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount."

Wall Street's tricky profits - CNN Money - Roddy Boyd:
"Here's how FAS 159 works: A company can assign a fair (or market) value to its financial assets and liabilities - such as bonds - in order to smooth out earnings. Say a bank sells debt, an IOU, at $1,000 par value. Because of broader credit-market concerns and a slowdown in earnings, that debt trades down to $800. The $200 differential, under standard 159, is allowed to be counted as mark-to-market income, without the bank having engaged in any business activity. The bank then details its use of the rule in footnotes to its regulatory filings."

And Roddy Boyd to add:
"Moody's Investors Services has also warned investors about FAS 159, noting that it risks giving false perceptions of a bank's financial strength. The agency says it "does not consider such gains to be high-quality, core earnings.""

So we have a similar pattern than what I discussed in 2010 namely that:
"With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard time to reap in similar profits they made in Q1."

Bank Profits Depend on Debt-Writedown ‘Abomination’ in Forecast - Bloomberg July 2010:
“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”
Any similarities to today's situation are of course purely fortuitous.

And from the same article we learn:
"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

And as David Hendler, Senior Analyst from CreditSights sums it up in the same Bloomberg article:
“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much.”

So, when you have heightened volatility, FAS 159 and Debit Value Adjustment allows banks to increase earnings in bad times but when CDS spreads tighten it works the other way as discussed in "Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings".

FAS 159 is the reason why UBS is expecting a "modest" net profit in the third quarter - Source Bloomberg - Elena Logutenkova - 4th of October 2011:
"UBS AG, Switzerland’s biggest bank, expects a “modest” net profit in the third quarter as gains from a widening of its credit spreads and the sale of bonds helped cushion the $2.3 billion loss from unauthorized trading.
The bank expects to book a fair-value gain of about 1.5 billion Swiss francs ($1.6 billion) as its credit spreads widened in the third quarter."

So, in coming bank earnings, you can expect more of the same, courtesy of the perfectly legal FAS 159 accounting trick which was as well very effective in 2008.

On a final note and as a follow up on our discussion about contagion to Emerging Markets and the Chinese slowdown, here is the updated picture for Australian Financials - Source data provider CMA:


"All of us might wish at times that we lived in a more tranquil world, but we don't. And if our times are difficult and perplexing, so are they challenging and filled with opportunity."
Robert Kennedy

Stay tuned!

Credit Value Adjustment and the boomerang effect of FAS 159 accounting rules on Banks Earnings - Citigroup latest results

Citigroup's latest results clearly show the impact of tightening CDS spreads on earnings.

Credit valuation adjustment (CVA) refer to the fair value of liabilities which in the case of Citigroup equates to a 1.1 billion USD hit on its earnings. The company incurs a negative revenue mark when the value of the debt/liabilities increases.

In my post "Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008", published in July 2010, we studied the impact on earnings with FAS 157 and FAS 159.

For more on FAS 157 and FAS 159 please check the link below to the American Academy of Actuaries paper on the subject:

http://www.actuary.org/pdf/life/fas157_0209.pdf

Citigroup's hit on earnings is linked to a tightening in its CDS 5 year spread. The more the CDS 5 year spread tightens in 2011, the more pressure Citigroup will face on its earnings.

In April last year Citigroup had the following positive results thanks to CVA in its Quarter 1 results:

http://www.businesswire.com/portal/site/home/permalink/?ndmViewId=news_view&newsId=20090417005227&newsLang=en

"Fixed income markets revenues of $4.7 billion reflected strong trading performance, as high volatility and wider spreads in many products created favorable trading opportunities. Interest rates and currencies and credit products had strong revenue growth. Revenues also included (all reflected in Schedule B):
o A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi’s CDS spreads
o A net $30 million positive CVA of Citi’s liabilities at fair value option"

There you have it, the boomerang always come back, in that case FAS 159...

For more on Citigroup's past CVA:

Monoline Insurers Credit Valuation Adjustment (CVA)

During the first quarter of 2009, Citigroup recorded a pretax loss on CVA of $1.090 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty's current credit spread, to the expected exposure profile. The majority of the exposure relates to hedges on super senior subprime exposures that were executed with various monoline insurance companies. See "Direct Exposure to Monolines" for a further discussion.

This excerpt taken from the C 10-Q filed May 11, 2009.

Monoline Insurers Credit Valuation Adjustment (CVA)

During 2008, Citigroup recorded a pretax loss on CVA of $5.736 billion on its exposure to monoline insurers. CVA is calculated by applying forward default probabilities, which are derived using the counterparty’s current credit spread, to the expected exposure profile. In 2007, the Company recorded pretax losses of $967 million. The majority of the exposure relates to hedges on super senior positions that were executed with various monoline insurance companies. See “Direct Exposure to Monolines” on page 70 for a further discussion.

These excerpts taken from the C 10-K filed Feb 27, 2009.